By Rolandi van der Westhuizen, Head: Venture Capital
New South African unemployment statistics were released on 14 May 2019, which paint a bleak picture. The rate of unemployment in South Africa rose to 27.6% at the end of the first 2019 quarter. At a nearly 15-year high, it’s the worst set of figures since Q3/2017. About 237 000 fewer people had jobs in Q1/2019 compared to Q4/2018. There are now 6.2 million South Africans who are actively looking for a job but who cannot find one.
It is noteworthy that, as it currently stands, more people depend on social grants (17.7 million) than people who are employed (16.3 million). Analysts describe the 55.2% joblessness rate among the youth as a ticking time bomb. If you add discouraged workers, the youth unemployment rate jumps to 69%. What happens to a country when 70% of the youth are unemployed?
At the same time as the government tries to figure out how to meet its objective of creating nearly 300 000 jobs per year, the Section 12J industry also finds itself at an interesting crossroad as this legislation will only be reviewed in 2021.
It has been clearly stated that President Cyril Ramaphosa sees small, medium and micro enterprises (SMMEs) as a key ingredient of his macro strategy to create large scale jobs which are now, more than ever, desperately needed.
Access to funding, especially equity funding is critical to building sustainable SMMEs. The Section 12J tax incentive should, therefore, play a vital part in government’s policy to promote job creation and economic growth, as it motivates private investors to provide much-needed funding to SMMEs, which otherwise would need to come from projects funded by the government. It should be appreciated that SMMEs are typically the entities providing first employment opportunities to job seekers and often employ the youth. Youth employment is clearly a major concern and should be a priority for SA Inc.
Whilst the incentive has been in place for quite some time, we have only seen significant uptake in terms of investments into approved VCCs in the last two to three years, due to positive changes in the 12J legislation, which has created a more enabling environment for SMME funding.
However, recent changes in 12J legislation aimed at curbing some abuse of the incentive resulted in placing the VCC industry in limbo for the greater part of the 2019 fiscal year. This had the result that many transactions aligned with the objective of developing SMMEs could no longer be implemented.
As stated above, the Section 12J incentive is up for review in 2021. The industry has thus started initiatives to enable National Treasury to make an informed decision. The key question floated by National Treasury is whether the value of jobs and tax revenue created by Section 12J is greater than the direct tax revenue lost from deductions claimed.
Although this may be a valid question, it would be wrong to take such a narrow approach to determine an empirical answer when first, one is considering a complex environment and second, the legislation was only amended to create an enabling environment a few years ago. It is also critical to understand that the value of new SMMEs will be realised several years after the initial investment.
In our view Section 12J legislation, while requiring some amendments, is one of the critical components to enable SMME growth. SMME funding is one of the crucial factors determining the ability to successfully set up and grow a new business to be a sustainable contributor to South Africa. SMMEs and venture capital funding are complex, best implemented by businesses and entrepreneurs. It would be naïve to believe this could be done successfully by the government alone. An incentive to invest in a risky asset class critical to economic growth and job creation is therefore of paramount importance.
We are convinced the current legislation has some major flaws, which have resulted both in funding being channelled into some non-productive asset classes and even abuse. This should not, however, be seen as a reason to abolish the incentive, but rather an opportunity to learn from mistakes and introduce amended legislation that can be a key driver for economic stimulation.
As is often the case in South Africa, it appears that a lot of policy and legislation are conceptualised and drafted by academics and politicians with high-level perceptions, without sufficient engagement with entrepreneurs who know what it takes to make a new business successful.
We believe the key is in taking a step back to approach this from a more holistic perspective. Therefore, the main question to be answered is: “What are the challenges South African SMMEs face in order to succeed and become the much-anticipated saviours of and contributors to SA Inc.’s economic prosperity?” Only once this is clearly understood can one look at which components of the current legislation don’t address these challenges and what amendments are required to address them.
Common challenges include matters such as insufficient funding, restricted access to markets, limited or no access to virtuous social capital (access to networks within the necessary ethical boundaries), less than desired levels of training and mentoring, huge administrative and compliance burdens and red tape, as well as limited access to the right level of skills. If we really want to ensure the success of SMMEs in this country, these challenges need to be addressed holistically at a national policy level.
We will mainly focus on the first of the listed challenges: Access to funding. A few important points to consider: What type of funding is needed (i.e. debt vs. equity vs. mezzanine), at what stage in the business’s lifecycle do SMMEs require the relevant funding (seed, pre-revenue, growth, etc.) and who will typically be the funders in the various life stages of these businesses?
To create the maximum impact for SA Inc. of a VCC or SMME investment incentive such as Section 12J, we believe the following need to be correctly addressed:
• Ensure funding is channelled into the right investments;
• Ensure the right type of investor is incentivised to invest; and
• Ensure the benefit of the incentive is available mainly for successful investments.
Ensure funding is channelled into the right investments
Africa is not the US, and South Africa is definitely not Silicon Valley! It doesn’t matter how well the spin doctors package it, the reality is that there is very little, if any, funding available for South African early-stage, pre-revenue start-ups.
Where VCCs and, more specifically, S12J VCCs are supposed to fill this gap, current legislation forces them to follow a more traditional private equity structure. This has resulted in funding being channelled to asset-backed investments and/or post-revenue growth capital. This means almost no start-up, pre-revenue funding is available for small businesses, which in our view defeats the object of the incentive.
To ensure that an incentive like 12J stays relevant, policymakers need to have a good, hard look at which sectors and businesses drive job creation and economic growth, thus identifying key target sectors from a policy perspective.
Unfortunately, various stakeholders within the VCC industry without real business experience have actively sought to disenfranchise innovative models for their own economic benefit and are actively trying to force VCC funding models into a traditional private equity model, which will not achieve the desired positive impact. Venture capital funding needs innovative ways of funding and it is highly unlikely that pure traditional private equity models will succeed in attracting the required capital for true start-up and pre-revenue businesses.
It will thus be critical for government to introduce legislation that will, first, promote and accept innovative, tailor-made VCC funding models and second, force VCCs to invest the majority of funds into pre-revenue businesses, as well as limiting or disallowing structured, asset-backed investments such as businesses trading mainly as leasing businesses.
Ensure the right type of investor is incentivised to invest
SMMEs need investors willing to make funding available at a point in the lifecycle of the business when no bank, finance house, government institution or private equity firm is willing to fund them. These funders should, therefore, as per the award-winning 2007 Allan Gray commercial “look for potential and then have the patience to wait for it”.
Patient capital (equity investments) in the early stages of any new venture is crucial. Typically, the ideal early-stage investors are high net worth individuals with enough experience to not only identify a business’s potential and associated risks, but also have the financial means to patiently wait for returns. Unfortunately, these types of individuals have various investment opportunities, including the ability to invest offshore. They need to be strongly motivated to deploy their excess funds for the benefit of SA Inc., rather than take it abroad.
High net worth investors’ value-add is that they can also contribute tremendously to the success of SMMEs by helping entrepreneurs gain access to markets and relevant supply chains, introduce them to social networks and mentor them, thereby positively contributing towards improving the skills shortage in South Africa.
This will unfortunately not be possible if the investor is merely a passive funder.
Ensure the benefit of the incentive is available mainly for successful investments
The current Section 12J incentive allows for an upfront deduction or incentive regardless of the success of the investment. This has allowed for and even promoted investments into depreciating assets by VCCs without a focus on high growth successful investments.
In this regard, South Africa can learn from the UK, where Venture Capital Trusts (VCTs) were established by the government to support Britain’s entrepreneurial businesses. Although Britain and South Africa do not have the same economic challenges, there is no harm in learning from them. Interestingly, VCTs do not provide a 100% upfront tax benefit, but rather incentivise the investor when the company in which the funds are invested grows. This is done through a model where some limited tax benefits are offered upfront, but the real benefit is only realised once the investor disposes of the VCT shares, as no capital gains tax is paid on profits at this time. This aligns the incentive with the government’s objectives, namely to grow SMMEs and the economy as a whole.
In summary, investors don’t like losing money, but their dislike for paying taxes is even higher. At least with investing they have a chance for some potential upside. Jokes aside, investors need to be motivated to invest in high-risk asset classes and an incentive such as Section 12J can do exactly that. But, for Section 12J to have the desired impact, it needs to attract and accommodate an ideal kind of investor and invest in the correct business variety.
Our challenge, therefore, to the Section 12J industry, the legislature and the relevant policymakers, is to take a holistic view and have a long and hard look at what SA Inc. really needs to support its quest of economic growth and the financial prosperity of its citizens.
Contact Rolandi van der Westhuizen for more information.