Incentivising Angels

Innovation is critical for economic growth and provides a broad range of spillover benefits for businesses and the broader community. It is therefore not surprising that many governments around the world have been actively involved in formulating polices to stimulate their innovation systems. Governments have focused their attention on a broad range of initiatives, including those specifically targeted at assisting entrepreneurial start-up companies. Start-ups are a key part of a country’s innovation system as they are the source of many new business ideas, products and services. One of the problems with start-ups, however, is that they often struggle to access funding from conventional sources, such as banks, and must therefore rely heavily on venture capital investment to grow their businesses. The reality is that without venture capital investment, many start-ups will languish or fail. In order to stimulate venture capital activity in Australia, the Commonwealth Government, as part of its National Innovation and Science Agenda, recently introduced the Early Stage Investors (ESI) program. The ESI program provides generous tax incentives to angel investors who invest in ‘early stage innovation companies’. The ESI program is loosely modelled on the United Kingdom’s Seed Enterprise Investment Scheme (SEIS) and sits alongside a number of other Australian venture capital tax incentive programs that have been designed to encourage investment in start-ups through specially regulated venture capital funds. This book examines the ESI program and compares and contrasts it with both the United Kingdom’s SEIS and Australia’s other venture capital tax incentive programs. It critically analyses the programs and draws on the comparative analysis to suggest some ways that the ESI program might be reformed to improve the delivery of its policy objectives.

Innovation involves the creation of new and improved products, processes and services. It is about doing things in new and clever ways that increase efficiency and add value. Although Australia is a clever country that has world-class universities, respected research agencies and pioneering scientific institutes, its entrepreneurs have often struggled to commercialise their innovations. This has been attributed to a number of factors, including a lack of venture capital funding being available to start-ups. Venture capital is a scarce resource because it is an extremely risky investment that can take many years to provide returns for investors. The venture capital market is highly sensitive to economic conditions and is often disproportionately affected during downturns. Angels and venture capitalists are the two main sources of venture capital funding for start-ups. While it is the founders of start-ups that come up with the revolutionary ideas for new products and services, it is angels and venture capitalists who provide the finance necessary to develop and commercialise these ideas. Angels and venture capitalists are therefore key actors in a country’s innovation system, even though they are not necessarily innovators themselves. By providing much needed capital to start-ups, these investors share in the risks associated with these companies. This chapter discusses the importance of innovation and the critical role that start-ups play in a country’s innovation system. It also examines the nature of venture capital investment and the special roles that angels and venture capitalists play in financing start-ups.

One of the common ways that governments support their countries’ innovation systems is by introducing special tax incentives to encourage venture capital investment in start-ups. Designing venture capital tax incentive programs is a complex task that involves a range of different policy considerations. One of these considerations is deciding whether to provide investors with front-end or back-end incentives in relation to their investments. Front end incentives are usually provided by way of deductions and tax offsets in the income year in which an investment is made, while back-end incentives are usually provided in the form of income tax and capital gains tax exemptions in the income year in which investments are disposed of. While front-end incentives provide an immediate benefit to investors, back-end incentives may be preferable from a government’s perspective, as they are deferred and generally only arise in relation to financially successful investments. Over the years, the Australian Government has introduced a number of intricate tax incentive programs to encourage formal venture capital investment. These programs have evolved considerably over time and have provided investors with a range of front-end and back-end tax incentives in relation to their investments in specially licensed and registered venture capital funds. The earlier programs (the Management and Investment Companies program and the Pooled Development Funds program) provide tax incentives for investments made through companies, while the more recent programs (the Venture Capital Limited Partnership program and the Early Stage Venture Capital Limited Partnership program) provide tax incentives for investments made through limited partnerships. This chapter discusses the key features of Australia’s formal venture capital tax incentive programs. The programs are then compared and contrasted with the angel tax incentives provided under the ESI program and the SEIS in the following chapters.

Australia’s ESI program is a revolutionary new tax incentive program designed to stimulate venture capital investment in eligible start-ups, known as ‘early stage innovation companies’ (ESICs). The ESI program operates alongside Australia’s other venture capital tax incentive programs discussed in Chap. 3. Whereas these other programs focus on encouraging venture capital investment made indirectly by investors through regulated venture capital funds run by venture capitalists, the ESI program is targeted at venture capital investment made directly by angel investors. The ESI program offers generous front-end and back-end tax incentives to encourage investors to subscribe for shares in ESICs. Eligible investors can generally claim a front-end 20% tax offset (capped at $200,000 per year) on their investment in an ESIC. In addition, they are also deemed to hold their shares on capital account and entitled to modified CGT treatment when they exit their investments, including a back-end exemption on capital gains made from any CGT event in relation to shares that they have continuously held for at least one year and less than 10 years since their issue. The ESI program is quite complex and requires a range of intricate criteria to be satisfied in order for investors to be eligible to claim the tax incentives. This chapter explains the policy rationale behind the introduction of the ESI program and discusses its technical requirements in detail. Special attention is devoted to the program’s ‘early stage’ and ‘innovation’ requirements, which are crucial for determining whether a start-up qualifies as an ESIC. The tax incentives available under the program are also closely scrutinised and evaluated.

As mentioned in Chap. 1, the United Kingdom has developed its own angel tax incentive program, known as the Seed Enterprise Investment Scheme (SEIS). The SEIS was introduced in 2012 and is designed to help small, high-risk companies raise equity capital by offering tax incentives to individuals who subscribe for ordinary shares in them. While Australia’s ESI program discussed in Chap. 4 was loosely modelled on the SEIS, the programs have a number of significant differences. For instance, although both programs target investments in small early stage companies, they contain quite different eligibility criteria. The SEIS, for example, focuses on criteria such as a company’s gross assets and the number of its employees, whereas the ESI program focuses on criteria such as a company’s expenses and assessable income. The SEIS also contains a blacklist of ‘excluded activities’ that an investee company must not carry on, whereas the ESI program does not have such a list. In addition, while the ESI program uses a ‘point-in-time’ test to determine whether a company qualifies as an ESIC, several SEIS requirements are ‘ongoing’, meaning that if they cease to be met during the relevant period, tax benefits that have been granted to investors may be withdrawn. Another key difference between the programs is that the SEIS does not require investee companies to meet any specific ‘innovation requirements’ like the ones that exist under the ESI program. There are also important differences in the nature of the tax incentives provided under the programs. While both the SEIS and the ESI program use a combination of front-end and back-end tax incentives to encourage angel investment, the SEIS provides a broader range of tax incentives than the ESI program. This chapter closely examines the SEIS and compares and contrasts it with the ESI program as well as Australia’s formal venture capital tax incentive programs discussed in Chap. 3. The comparative discussion in this chapter is then used to inform the suggestions we make for reforms to the ESI program in Chap. 6.

This book has examined the critical role that venture capital investment plays in supporting start-ups and the importance of these companies’ success for the development of a country’s innovation system. The earlier chapters focused on a number of tax incentive programs that have been introduced by the Australian and United Kingdom Governments to encourage venture capital investment. In particular, Chap. 3 examined Australia’s formal venture capital tax incentive programs, Chap. 4 examined Australia’s new ESI program and Chap. 5 examined the United Kingdom’s SEIS (on which the ESI program was loosely modelled). Building on the policy framework and detailed discussion set out in these earlier chapters, this chapter makes some suggestions for reforming the ESI program so that it might be able to better achieve its policy objectives. The suggestions draw on comparisons made between the ESI program and the SEIS, as well as aspects of Australia’s formal venture capital tax incentive programs. The reform options put forward in this chapter involve: providing ISA with the power to make rulings in determining whether a company qualifies as an ESIC; allowing investors to claim capital losses on the disposal of their ESIC shares; introducing reinvestment relief similar to that provided under the SEIS; extending an angel tax incentive to investment in later stage companies to ensure that companies are supported throughout their stages of growth; and removing the 10 year CGT limit. The chapter concludes by recognising the importance of the ESI program to Australia’s innovation system and its critical role in helping Australia remain a clever country in the twenty-first century.