A venture capital (VC) investment may take five years to exit, but the tax consequences of that exit can begin with decisions made on day one.
For example, if a fund invests R20m in a promising South African technology business that is eventually sold five years later for R100m that is a 5x return on paper.
However, say the investment is held by a South African company and the resulting R80m gain is subject to capital gains tax of approximately R17.3m, the R100m exit value would be approximately R82.7m before considering any further tax at fund or investment level - a 4.1x return rather than 5x.
The tax result can further be affected by aspects such as the nature of the fund, investor residence, nature of the gain, available losses, treaties and a multitude of other factors. What the fund and its investors ultimately receive depends on more than the headline exit value.
Mind the tax cap
The gap between the headline return and the return ultimately delivered is where tax becomes relevant; and it is a conversation that is often started too late.
When a VC investment is being evaluated, the focus is understandably on the founders, market, technology, valuation and growth potential. Tax often enters the conversation later, once the structure has been agreed or an exit is already on the horizon.
Yet the tax outcome can be influenced by decisions made years before there is a buyer at the door: how the investment is structured, where it is held, how additional funding is provided, how ownership evolves and, ultimately, how the investment is realised.
Ashford Nyatsumba and Michael Denenga 23 Apr 2024 Flexibility beats prediction
An investor cannot predict exactly what the exit will look like. It could be a trade sale, another financial investor, a secondary transaction, a listing or a restructuring along the way.
That uncertainty makes it more important to consider whether the structure being put in place today preserves sufficient flexibility for tomorrow.
The incentive trap
The same thinking applies to management and employee equity, which is often fundamental to creating alignment in a growing business. A founder or key employee may receive equity intended to give them a meaningful share in the value they help create, but the after-tax outcome may not be what was expected.
South Africa's section 8C rules can result in gains on certain equity instruments being included in an employee's income when they vest, subject to tax at the marginal tax rate as opposed to the CGT rate.
For example, if the executive team holds 10% of a company that is sold for R100m, their share would be R10m. If that gain falls within section 8C, it may be taxed at their marginal rate rather than the effective CGT rate.
In a simplified illustration, tax at 45% would leave them with R5.5m, compared with R8.2m if the same gain were taxed at 18% - a difference of R2.7m. The example is deliberately simplified and does not take into account how section 8C taxation may arise through vesting over the life of the investment.
If the tax outcome significantly reduces the value of the incentive to management, the arrangement may not deliver the alignment the fund intended. A structure can therefore make perfect sense from an ownership and dilution perspective while producing a very different economic outcome for the person it was designed to incentivise.
Four questions for day one
None of this means tax should dictate an investment strategy. It means it should be considered alongside it. The useful questions are relatively simple:
- What structure is an investor participating through, and why?
- Could changes in funding, ownership or geography create unintended consequences?
- Where should key assets such as IP sit as the business scales internationally?
- And when an investor eventually exits, what will the return look like after the relevant tax consequences have been considered?
The best time to ask those questions is when there are still choices available.
The exit may be five years away, but the tax decisions that influence it may already be sitting in front of you.
