Australia: Recent trends and issues

Author: | Published: 4 Jan 2001
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The venture capital and private equity sector in Australia has been a dynamic one over the last 12 months, in terms of commercial, legal and regulatory factors. This article summarises trends emerging in the sector and addresses key legal and regulatory factors impacting venture capital in Australia. One major area of regulatory complexity affecting companies receiving private equity and venture capital is the laws governing the issue of options under Employee Share Option Plans (ESOPs). Incentivizing staff and key executives is an important aspect of development strategy for growth companies. The scope in Australia for granting options under ESOPs without a prospectus is limited. This article concludes by reviewing the relevant legal issues in this important area.

Major commercial trends and issues

Continuing growth in funds raised and investments

Australia has followed the global trend of increased growth in funds raised and amounts invested in private equity/ venture capital transactions. This growth in increased funds available for private equity investment in Australia has been triggered in particular by two factors. First, the introduction over recent years of a statutory requirement for compulsory deduction of superannuation contributions for Australian employees. Second, the growing affirmation of venture capital and private equity as a recognized investment class. Typically, fund managers may allocate up to 5% of the expanding pool of funds under management for investment in private equity/ venture capital transactions.

The growth in capital available has led to an increase in the number of venture capital managers, and a segmentation in which venture capital investor funds are establishing and identifying themselves in the following specialization areas:

  • industry specific funds: for example, technology and IT-specific funds. A large proportion of investments made over the last 12 months have been made in IT, technology, communications/ convergence and e-commerce related areas.
  • corporate funds: major corporates are setting up investment funds or divisions to undertake private equity investments. In many cases, this supports a broader strategic initiative for corporates to build alliances with emerging companies to assist in product development, developing distribution channels for product and cross-skilling of key staff. This is particularly predominant in the IT sector. The involvement of corporate investors may create co-investment opportunities for other investors and add further options on exit.
  • larger management buyout funds: with the tendency towards increasing deal size, certain funds are concentrating on a later-stage MBO focus.
  • fund of funds: new funds of this type are emerging to target the need for greater management resources for the growing pool of superannuation contributions in Australia. These funds invest in venture capital funds and may also co-invest directly with the funds in the underlying investee companies.
  • regional funds: there is also emergence of funds directed to investing in specific regions such as Australasia, the US and Asia-Pacific.

Venture capital fund investors have been joined in the private equity sector by a growing number of angel investors, and the emergence of more formalised angel networks. These networks comprise wealthy individuals or entrepreneurs who seek to invest both at early stage and also pre-exit.

The support for emerging and start-up investee companies is bolstered by the growing activities of incubator and accelerator organizations. These aim to develop relationships with investee companies at early stage, and assist start-up investees to become investment-ready in order to attract funding from private equity investors.



Increasing competition for deals and issues for quality deals

The availability of capital and increasing numbers of investment managers have seen a strengthening in the competition for quality deals. Investees differentiate potential venture funding partners by focusing on additional non-funding services and the expertise they offer. Investees seek business management skills and expertise, technical and industry specific skills, introductions to relationships and networks, recruitment and optimal exit opportunities, both domestically and offshore. Increasing competition requires fund managers to assess critically valuation and pricing of potential deals. In particular, the manager must be satisfied with the skills and experience of the investee's internal management team to execute its business plan. It is an important issue for the sector that management skills and technical expertise (both within the investees and the venture capital funds) are of sufficient quality to ensure investments are successful and funds continue to be attracted to the sector.

The size of deals has tended to increase in the last 12 to 18 months. Funds have preferred to manage a smaller number of larger deals, as this is a more efficient use of limited management resources. Funds have also tended to co-invest (either with other venture capital funds or angel investors, corporate investment funds or offshore alliance funds) and this has increased the aggregate funding committed in particular deals.

In investments in developing technology, IT and internet-related businesses, where the rate of funding spend is high, the number of funding rounds is increasing. The pricing of later rounds is a major issue. Where pricing cannot be agreed, the trend is to take the funding under a more simplified convertible note or preference share instrument, with the conversion price discounted to the price achieved at a subsequent funding round, where the value (nearer to exit) is more capable of being properly ascertained.

Migration strategies for funding and exit

The funding and exit strategies for growing Australian investee companies have expanded to include migration of the investee to the US or Asian capital markets (generally known as a flip-up restructure transaction).

Migration strategies seek to access offshore venture capital funding for subsequent funding rounds, offshore exit possibilities and expanded global markets for the investee company's business.

The increase in Australian investees considering or undertaking migration strategies has added to the trend for the venture capital sector to become more global.

Australian venture capital funds are building alliances with offshore venture capital firms, or alternatively are developing their own presence in key market areas (such as the US, Hong Kong and Singapore). This enables Australian managers to manage more effectively their investees which have undertaken a flip-up strategy, and also to build relationships with other offshore investors and potential investees.

In addition, legal and accounting advisors are developing offshore alliances with specialist venture capital expertise so they can effectively address cross-border transaction issues, in particular in relation to securities, migration and residency, employment, stock-option plans and taxation that arise in implementing a flip-up restructure. Australian capital gains tax implications arising under a flip-up have been simplified to some degree by recent amendments to tax laws, which allow for scrip-for-scrip rollover relief. This allows a shareholder to dispose of a share in an Australian investee company in exchange for shares in an offshore company, on the basis that the shareholder's liability for capital gains tax is only triggered upon the disposal of the share ultimately held, not upon the intermediate disposal.

Major legal and regulatory issues

Alongside these commercial trends and issues, the venture capital sector in Australia has been impacted by changes in legal issues and regulatory reform. Three areas of legal and regulatory reform have had a significant impact on the sector over the last 12 months.

Amendments to fundraising laws

Amendments to the Australian Corporations Law under the Corporate Law Economic Review Program (CLERP) became effective on March 14 2000. They introduced changes in the law to directors' liability, takeover provisions and corporate governance. Of particular relevance to the venture capital sector are the changes to fundraising laws:

  • New categories of exemption were added for issues of securities to sophisticated investors. This has made it easier for high net-worth investors to participate in investments or to invest in venture capital funds without needing a prospectus.
  • Alternatives to a prospectus, including a short-offer information statement for raisings up to A$5 million ($2.7 million) and also short profile statements, were introduced. These give greater flexibility to investee companies undertaking fundraising.
  • Procedural steps for lodging a prospectus were streamlined, including removing the requirement for a prospectus to be registered with the Australian Securities & Investments Commission (ASIC), and updating rules on fundraising and disclosure in electronic form.

Effects of proposed wide-ranging tax reform

Under wide-ranging tax reform, sought to be introduced by the Australian government on July 1 2001, certain categories of trust structures will be taxed as companies. This has had a significant impact on the manner in which venture capital funds (typically formed as unit trusts) are structured. A major attraction of venture capital funds to date has been the ability for the fund to distribute all income and proceeds of investments to the fund's unit holders, without being taxed at the fund level – leaving unit holders to arrange their own affairs and satisfy their tax obligations. Throughout this year, venture capital managers have sought to ensure that the structure of their existing funds and of newly proposed funds will retain the pass-through tax benefits for investors.

Collective investment vehicle (CIV) and fixed trust criteria

Before October of this year, the government had indicated the regime for taxing trusts would be tied to the concept of Collective Investment Vehicles (CIVs). In response to consultation and lobbying from various industry sectors, including the Australian Venture Capital Association (AVCAL), the CIV concept was abandoned on October 11 2000 with the Australian government's release of exposure draft legislation entitled 'The New Business Tax System (Entity Taxation) Bill 2000'. Under this draft framework, trusts can preserve tax pass-through. They will not be taxed as companies if they are fixed trusts, under which each unit confers on its holder a vested, indefeasible and undivided interest in the trust's income and capital. This regime is still draft legislation at this point, but must be finalized before July 1 2001.

Pooled development funds (PDFs)

The proposed reform for taxing trusts has resulted in greater consideration of parallel tax-effective structures such as PDFs. These were introduced under the Pooled Development Funds Act 1992. They are a form of investment vehicle afforded concessionary tax treatment by the Australian government to encourage investments in small to medium-sized Australian enterprises (SMEs). As a consequence of the potential taxing of trusts as companies, a number of venture capital funds launched through the year offered investors a composite investment vehicle comprising the more traditional unit trust with a parallel PDF company, offering investors a blended tax position sufficiently attractive to secure their commitment.

To achieve the policy objectives of the PDF initiative to encourage investment in Australian SMEs, a number of restrictions are imposed upon PDFs which mean a PDF vehicle may not be effectively used for all venture capital investments. In particular, unless the PDF board approves otherwise, a PDF cannot, under the PDF Act, invest in an entity that is not an Australian SME or has assets exceeding A$50 million. This poses issues if an investee seeks further funding from its founding investors (including the PDF) at a point when its assets exceed A$50 million, or it undertakes a migration flip-up restructure and ceases to satisfy the Australian SME criteria.

Other Australian government incentives and support for venture capital

The Australian government has introduced a number of other incentive programmes supporting venture capital and emerging and growth SMEs. This year the government launched the second round of Innovation Investment Fund (IIF) licences. It has also continued support through the start grant programme. Under the IIF programme, the government, after an application and selection procedure, selected five venture capital managers to be recipients of an IIF licence to manage an IIF and receive funding from the government matching other investor funding raised. This allows the Australian government to give support to the venture capital sector, as well as ensuring funding is made available to emerging SMEs.

Under the start grant programme the government provides funding on concessional terms to SMEs. The terms of start grants require the benefits of the funding to be directed to the Australian economy. Accordingly, offshore commercialization, change in company control or migration structuring are prohibited under start grant terms unless government approval is obtained.

ESOPs – Legal issues regulating the grant of options in Australia

It is an important aspect of development strategy for growth companies that staff and key executives are incentivized to ensure the investee company delivers on the execution of its business plan. In many cases, this can be effectively achieved through participation in an ESOP. Venture capital investors support this form of incentive as it means cash injected by them is not 'hosed out the door' in salaries and bonuses. It can be more beneficially applied to expenditure required for key milestones of the company, with staff and executives compensated with equity participation through an ESOP. Venture capitalists typically support an equity slice of between 10% and 30% for allocation under an ESOP. Under Australian law, however, there is limited scope for a broad offering of options to large numbers of staff without the issue of a prospectus.

The amendments to the fundraising provisions which became effective on March 14 2000 did not include any specific form of relief for granting of options under ESOPs, particularly in relation to unlisted companies. Moreover, an Australian government standing committee on employment, education and workplace relations, set up in July 1999, further considered a reference on employee share ownership in Australian enterprises. The committee focused mainly on listed companies, and supported the existing broad relief for the offer of options to employees of public-listed companies without the need for a prospectus under ASIC Class Order C00/220. In relation to unlisted companies, however, the committee placed heavy emphasis on the need to fully protect the employee/ investor. This view reflects a broader political debate which has centred on how the law should address compensation of employees of insolvent companies for unpaid accrued entitlements for leave payments, termination pay and redundancy pay. The committee did not want to add to the risk profile of employees by permitting their investment in unlisted companies, unless employees were fully informed and had the protection of prospectus disclosure at the time their money was invested.

The upshot is that unlisted companies must rely on the general fundraising exemption provisions to offer options under ESOPs. One additional form of deferral relief, granted under ASIC Class Order 00/221, allows an offer of options if the company covenants to provide the option holder with a prospectus at each point at which the option is capable of exercise. This Class Order has continued as a temporary form of relief, but will not apply to offers of options made after March 13 2001.

Consultation with government and other political parties to seek more specific relief for the grant of options under ESOPs in unlisted companies continues. Pending further relief being granted, the following fundraising provisions provide the main practical basis for offering options without a prospectus:

The 20/12/2 rule – the law allows personal offers of securities, which result in issues or sales of securities, to no more than 20 investors in a rolling 12-month period with no more than A$2 million raised. In calculating the A$2 million cap, the exercise price of the options (and the issue price of other securities issued) must be aggregated.

An offer to executive officers is allowed. An executive officer is a person who is concerned in, or takes part in, the management of the entity (regardless of title and whether or not a director).

An offer can be made under an Offer Information Statement (OIS), which is a short form of disclosure document, under which A$5 million can be raised over a company's life. The A$5 million limit includes the exercise price of options. The OIS must include an audited financial report for a 12-month period, and be lodged with ASIC.




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