15/05/2022

This guide was first published in the Chambers Global Practice Guide: Venture Capital 2024.

 

Although the Australian government has been broadly supportive of the venture capital industry, the industry is now suffering from regulations that have not kept pace with change, as well as the side effects of regulations that are not aimed at venture capital but have a particularly detrimental effect on venture capital funds and, by extension, companies seeking venture capital funding.

First, the good news. The Australian federal government and numerous state governments have long sought to boost the innovation ecosystem in Australia through a range of initiatives designed to support early-stage companies and the investment funds which finance them. These include:

  • creating fund vehicles (most notably venture capital limited partnerships (VCLPs) and early-stage venture capital limited partnerships (ESVCLPs) which provide beneficial tax treatment to some or all investors in exchange for which the funds must make certain kinds of investments;
  • direct investments by the Commonwealth government into venture capital funds by providing matching capital through programmes such as the Innovation Investment Fund programme, the Renewable Energy Venture Capital programme and the Biomedical Translation Fund programme, as well as direct investments by various state governments including the recent Queensland Venture Capital Development Fund by which QIC invests directly into selected venture capital funds;
  • making investors who buy new shares in a company which qualifies as an “early-stage innovation company” (ESIC) potentially eligible for a non-refundable tax-offset equal to 20% of the amount paid for their shares (up to a cap of AUD200,000), as well as modified capital gains tax treatment;
  • providing a research and development (R&D) tax incentive to companies which undertake qualifying R&D;
    requiring any person applying for a “significant investor visa” (SIV) to invest 20% of their required AUD5 million investment (ie, AUD1 million), and requiring any person applying through the “investor” stream to invest AUD500,000 into funds established as VCLPs or ESVCLPs; and
  • tax and Corporations Act reforms to assist with the creation and implementation of employee equity incentive plans.
    A number of these programmes have played a critical role in the development of the venture capital industry and in fostering the growth of the innovation ecosystem in Australia. However, there are several regulatory headwinds which should be addressed in order to ensure venture capital in Australia achieves its full potential.

Fund Structures

Let’s start with fund structures. Normally, limited partnerships in Australia are taxed like companies, but in an effort to create an internationally recognised fund structure, Australia introduced VCLPs and ESVCLPs, which have flow-through status and special tax treatment for certain investors in exchange for which the relevant fund must make certain kinds of investments.

Prescriptive Requirements

The requirements for such investments are prescriptive, increasing the level of diligence required when making investments, and more than 20 years after the legislation relating to VCLPs was drafted, remain subject to significant interpretive doubts (which increases transaction risk).

Even where there is little doubt about interpretation, the requirements hit fintech, proptech and insuretech – all sectors where Australia could be leading the charge – particularly hard. Finance (including banking and providing capital to others), insurance and property development are all prohibited sectors, and the local regulator considers that anything incidental to (or supportive of) any of the above sectors is also prohibited. An effort to reform this was made in 2018 in order to support fintech, but the reforms have not proven useful because they mean that a fintech investment remains eligible for a VCLP or ESVCLP for only as long as the primary purpose of the investee is developing technology; once the investee is predominantly commercialising that technology, it ceases to be eligible and must be sold.

For ESVCLPs, these requirements include an additional regulatory overlay, as each ESVCLP must have an investment plan approved by the relevant regulator which must show that the ESVCLP will target “early-stage” investments. The term “early stage” is not defined (nor would we advocate for a bright line definition), but ESVCLPs can be pulled up by the regulator for making (and accordingly be forced to divest) investments that the regulator considers are not sufficiently early-stage, whether because of the size of the investment, the number of funding rounds that have occurred or the level of commercialisation of products, etc.

Finally, the prescriptive requirements are not nuanced enough to take into account the myriad journeys that start-ups take, through successive rounds of funding, potential redomiciliation outside Australia and multi-layered exit structures unknown in the Australian market (not to mention failed exits!), often in circumstances where the earliest venture capital funds have little say and therefore cannot control whether the entity whose shares the ESVCLP ends up holding is eligible or not.

The consequence is that both VCLPs and ESVCLPs are commonly set up as stapled structures with a ready-made vehicle to make investments that are ESVCLP-ineligible or to accept transfers of investments from the ESVCLP that have been found to be, or that have become, ESVCLP-ineligible.

This creates a layer of complexity in fund structuring which increases the cost of setting up funds. In some ways, this is part of the cost of accessing programmes such as the VCLP or ESVCLP, but a refresh on eligibility criteria to ensure they are fit for purpose 20 years on is warranted.

Mandatory Maximum Life

Further, both VCLPs and ESVCLPs have a mandatory 15-year life from the date the partnership was formed under relevant state law.

By way of background, typically, a partnership is formed under state law, and then the fund manager applies to the Commonwealth regulator for conditional registration as either a VCLP or an ESVCLP.  Once conditional registration is received, the fund manager has two years from that time to achieve unconditional registration. From a statutory perspective, this is when the fund manager has raised at least AUD10 million (in the case of the ESVCLP, with the right spread of investors), but in reality many fund managers wait until they have achieved the full contractual minimum of capital commitments (which is typically much higher) to apply for unconditional registration.

While, technically, investments can be made between conditional and unconditional registration, the relevant regulator scrutinises these investments in particular for eligibility, so that unconditional registration can take six to eight months in many cases. As a result, fund managers are being advised to apply for unconditional registration as soon as possible, and to not make any investments between conditional and unconditional registration, even though this is technically feasible.

As a result of the above, in a very difficult fundraising environment, a fund manager can lose up to two years of their fund life just trying to get set up.

In addition, even when a venture capital fund proceeds relatively smoothly to unconditional registration, 15 years has proven too short. While it is common for a fund to have a contractual term limit (as investors tend to expect the fund to be wound up at some point), to have a 15-year statutory cut-off where there is no possibility of extension no matter how extenuating the circumstance makes the life of a fund manager artificially difficult. This requirement has been a significant driver of continuation fund activity in Australia.

What Should Be Done?

We recommend that:

  • ESVCLP and VCLP ineligible sectors be revisited and, in particular, any language in the legislation that suggests that innovative businesses that support ineligible sectors are themselves ineligible should be rectified.
  • The 15-year limit should be scrapped. For the ESVCLP, there are already limits on the gains that can be claimed as tax free, so there should be no need for an artificial time limit; and for the VCLP, the 15-year time limit is arbitrary when there are other fund structures that provide similar tax benefits for investors but have no time limit. Investors will put enough pressure on fund managers to wind up funds in a timely manner, so having a rigid 15-year statutory overlay ignores the very real issues that arise late in the life of a venture capital fund.
  • In the medium term, the eligibility criteria should be revisited to resolve inconsistencies and better reflect real-world, more nuanced circumstances.

SIV Programme

Initially, the SIV programme was considered a win-win in terms of Australia’s immigration policies and its support for venture capital. However, as the processing of visa applications has ground to a standstill, fund managers that relied on the SIV programme as the primary source of their investor base have found themselves unable to reach the critical AUD10 million threshold to achieve unconditional registration of their VCLPs or ESVCLPs within two years after conditional registration, which has significant effects on:

  • investments that the fund may have made in that interim period between conditional and unconditional registration; and
  • investors who have invested in the fund as part of their SIV requirements (if the fund never receives unconditional registration and has to be wound up, the investor’s money will have to be rolled into another complying investment).

Fund managers seeking to raise funds from SIV investors must be mindful of these delays, and should not seek to rely solely on these investors for their capital.

However, SIV investors are not able to invest their complying venture investments into any structures other than VCLPs or ESVCLPs. That means those funds must avoid using a stapled structure (making the fund less attractive to the very non-SIV investors that they may need to get the fund up and running within the requisite period of time), or else set up a structure whereby non-SIV investors could be called into an alternative structure to make ineligible investments.

Foreign Investment Regulation

Venture capital is an unintended casualty of Australia’s strict foreign investment laws. Under the Foreign Acquisitions and Takeovers Act 1975 (Cth) and its associated regulations (FI Legislation), the following require approval:

  • the acquisition by any foreign person of an interest of 20% or more of an Australian company valued above the current monetary threshold (for 2024, that is AUD330 million, or AUD1,427 million for certain treaty country investors);
  • the acquisition by any foreign person of an interest of 10% or more (and sometimes less than 10% - including where a director is appointed) in a national security business; and
  • the acquisition by a foreign government investor of an interest of 10% or more (and sometimes less than 10% - including where a director is appointed) in any Australian company, regardless of value.
    Any veto rights are an automatic 20% interest.

A “foreign government investor” under the FI Legislation is generally understood to include foreign governments and their agencies, sovereign wealth funds, public pension funds, state investment boards, and public university endowments. In addition, the general partner of a private equity or venture capital fund will be deemed to be:

  • a foreign person if a single foreign person, together with its associates, holds 20% or more of the fund or if multiple foreign persons, together with their associates, hold 40% of the fund; or
  • a foreign government investor if foreign government investors from one country hold 20% or more of the interests (there is also a 40% test which can usually be ignored if the investors meet certain passivity requirements).

In reality, the definition is even more pernicious, because the FI Legislation currently considers each vehicle comprising a private equity or venture capital fund on its own – so a particular vehicle may meet the threshold for being deemed to be a foreign person or foreign government investor, and then any “interest” it is acquiring in an investee is aggregated with the interests of all of its associates (being the other vehicles comprising the relevant fund), meaning a vehicle may need foreign investment approval even if the vehicle itself is acquiring a stake that would not on its own trigger a foreign investment filing. The end effect of this is that a very small passive foreign government investor interest is magnified merely due to structuring, causing many more funds to require approval that would be the case if a more sensible “whole of fund” test were applied. This is further complicated by the use of co-investment vehicles – even where the fund itself does not trip these hurdles, a co-investment vehicle might.

While private equity has been dealing with the effects of the FI Legislation for decades, the increasing interest of foreign investors in Australian venture capital has meant that Australian VC funds are dealing with these issues for the first time. PE funds, being larger, have greater flexibility in structuring, and a higher tolerance for transaction costs, which better equips them to deal with the effects of the FI Legislation. The upshot is that:

  • many foreign venture capital funds are deemed to be foreign government investors by virtue of the FI Legislation and, accordingly, will need approval to make most investments in Australia; this has caused more than one fund to balk at making an investment due to the increased transaction costs (which will often be more than double an investment that does not require foreign investment approval);
  • to avoid being regulated under FI Legislation (and incurring the higher transaction costs mentioned in the above dot point), Australian VC funds have actually limited investment from foreign persons (and in particular foreign government investors); this reduces capital that would otherwise be available to invest in Australian start-ups;
  • where a fund manager accepts investment from a foreign government investor, it may be necessary for that investor to seek foreign investment approval just to invest into the Australian fund – there is a cost to this in and of itself, and a further cost that the investor may not make it into first closing and have to pay extra (usually referred to as a subsequent close premium) in order to come in at a later closing, to compensate investors for their cost of capital, both of which can act as deterrents to invest; and
  • foreign venture capital funds (or Australian funds that are deemed foreign because of the amount of foreign investment in them) can be at a competitive disadvantage to purely domestic funds in making investments, due to the increased time needed to make the investment and the impact that the investment may have on the start-up (which itself could become subject to regulation under the FI legislation).

The government has already introduced one reform that assists at least domestic VC funds, which is a passive FGI exemption certificate. This results in a fund vehicle that otherwise satisfies the definition of a “foreign government investor” to instead be treated like a normal foreign person. Although such a fund is still subject to the FI legislation, the regulation is much lighter touch, particularly for VC funds that would typically be investing in businesses that are below the normal monetary thresholds. The passive FGI exemption certificate is less cost effective for foreign VC funds that are only occasional investors in Australian start-ups.

Another reform that would reduce the number of funds that trip up the FGI test would be to assess each fund’s foreign government investor status on a “whole of fund” basis (rather than vehicle by vehicle and applying association tests as described). Again, such funds would still be deemed to be foreign persons, but would be much less likely to require foreign investment approval.

Fee Disclosure and Superannuation Performance Requirements

Australia has a mandatory superannuation contribution system which means that Australian superannuation funds are one of the biggest pools of investible money in the country. Fee disclosure requirements and superannuation performance tests (pursuant to which the local regulator names and shames superannuation products that fail a benchmark performance test each year, effectively requiring repeatedly underperforming products to close down) both have an impact on venture capital funds.

In terms of fee disclosure, the PEVC asset class is, by nature, actively managed. Significant time, expertise and resources are required to be spent in asset selection, management and then disposal. PEVC is also an asset class with very strong upside (as well as risk) potential. Good PEVC fund managers that select solid investments represent excellent “value for money” for superannuation fund members. Any metric(s) around fee disclosure should not inadvertently penalise PEVC managers that represent good value for money, because they require more resources – which is frequently reflected in a higher cost - than other asset classes or strategies. While many superannuation funds are managing the fee disclosure requirements by requiring significant levels of fee- and carry-free (or discounted) co-investment opportunities pursuant to which their costs of investing in VC funds can be averaged down, the level of burden that is being placed on fund managers with such co-investment opportunities is high (there is extra work involved to administer and report in relation to these co-investment arrangements).

Further, performance benchmarks by relevant regulators do not adequately account for the nature of venture capital investment, which is typically longer-term than the benchmarks that are used to assess superannuation fund performance.

The government is currently inviting consultation in relation to reform of both of the above areas, and we would encourage reforms that do not discourage superannuation funds from investing in the PEVC asset class.

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