Do tax incentives influence start-up investments?

The 2021 amendments to the Income Tax Act are aimed at stimulating growth boosting both local and foreign investment. A key amendment to the Income Tax Act provides for exemption of gains made from sale of investment interests by venture capitalists into start-ups. Start-ups are those which are pre-revenue with or without a tested prototype or business model but with a promise of future profitability or growth.

The new Section 54 (1) e) exempts gains made upon disposal of an investment interest by a registered venture capital fund. Registered venture capital (VC) funds are entities with a specific objective of investing in start-ups.  VCs usually provide additional capital to start-ups when they have exhausted the angel investment sources of capital. VCs are the guys betting that start-up founders are onto something so big despite not having generated any revenue yet: they believe that the start-up is going to generate revenue, has the ability to expand and will offer a meaningful exit return in the future.

Currently, no entity is registered as a VC fund because the relevant regulations under the Capital Markets (Amendment) Act, 2016 have not yet been finalised. Nonetheless, we can make assumptions on how the incentive would work if the regulations were in place.

A registered VC fund shall enjoy a tax free gain arising from selling its investment interest in a start-up where at least 50 percent of the proceeds from the sale are reinvested within the year of income when the gain is realised. For instance, if X Limited, a registered venture capital fund buys 250 shares in Bytetech, a start-up, at $5,000 and subsequently sells all their shares to a new investor at a profit of $10 per share, the total gain is $2,500. This gain would be exempt income if X Limited invests at least 50% of the monies received from selling its shares into another venture.

To benefit from the exemption, the VC fund must not only exit from the start-up at a profit but also re-invest a substantial part of the monies from the exit. The topic of exits from investment cannot be discussed without recognising the difficulty of obtaining a successful exit in Uganda and Africa in general. The Africa Investor Catalogue 2021 compiled by Britter Bridges reveals that majority of Africa focussed investment firms in the VC category have not had more than two successful exits from their investments in Africa.

Although Initial Public Offerings (IPO) could be a plausible exit route for VCs in certain jurisdictions, they are not a likely option for exit in Uganda, more so if such exit is made from a company that has no evidence of profitability. Within the past 20 years, only nine companies in Uganda have sold part of their shares through an IPO. All these entities have been well established business enterprises with a clear track record in terms of profitability. The same analysis can be applied to exit through mergers or acquisitions. The most reliable exit route for VCs therefore remains the subsequent equity financing rounds (possibly from another fund raised by the same VCs). This piles pressure on the start-up to have an investment-worthy business model.

The next hurdle is the requirement for reinvestment by VCs after disposal of their investment interest. Investors in VC funds maybe patient but they are still profit seeking capitalists. At some point, VC managers have to make a distribution to their investors. Re-investment conflicts with VC managers’ commitment to provide a return to their investors. Even if few VCs will be enticed to make an investment because of this exemption, something will be gained from it. It will give reason to VCs to insist on investment in high quality start-ups rather than simply investing without regard to the investment outcome.

After a successful exit, the exempt income will be a welcome windfall for VCs who have already invested. The exemption may also push other providers of capital to start-ups like accelerators, innovation hubs and corporate venture arms to consider registration as VC funds with the CMA so as to take benefit of the tax incentive.

The author is a partner at Bytelex Advocates.