I know I mentioned last time that I was going to speak more this week of entrepreneurs who have sold their companies but there has been tremendous interest in the venture capitalist industry by the media and the taxes they pay so being more topical I thought I would elaborate further.
I have an offer on my desk at the moment from a VC for a business which illustrates the whole situation quite well.
The business is being sold as part of a management buy out and the sellers are receiving £15M. The venture capitalist is investing £5M and the bank is lending £11M of which £10M is going to the vendors and £1M is being utilised to pay all the fees for the transaction. The venture capitalists will end up with a stake of 75% in the business and the management team will own 25% of the business.
The way the VC will invest its £5M is the first area that causes concern from certain quarters. Of the £5M investment the VC is only going to invest £50,000 in shares and will lend by way of loan notes that carry an interest rate of 10% the balance of £4.95M. Accordingly, every year interest on the loan notes of circa £500,000 will mean that the profits of the Company are reduced.
At a recent Commons Select Committee hearing there was veiled criticism that the AA no longer paid any corporation tax because the interest on the loan notes used to buy the AA business had reduced all of the AA's profit to nil. Trade Unions are trying to lobby the government to stop interest payable on loan notes to venture capitalists being deductible for corporation tax purposes.
If the management buy out that I am dealing with now was sold in a couple of years for say £26M, then the bank would receive their £11M back and the VC would receive its circa £5M back on its loan notes. This would then mean that there was £10M to be distributed. The venture capitalist as a 75% shareholder would get £7,500,000 and the management team as 25% shareholders would receive £2,500,000.
Accordingly, the venture capitalist having invested £5M, receives its £5M back plus a profit of £7.5M from a transaction where a business has increased in value from £15M to £26M.
On the sale of the business this is where the second area of concern in some quarters is being raised. Any employee in the venture capital industry receives his remuneration in two forms. First, normal salary is paid which bears the normal higher rate tax and National Insurance. Secondly and this is the area of concern in some quarters, a venture capitalist receives what is known as a "carry" or "carried interest" whereby they take a proportion of the profits in my example above of £7.5M. This carry can be 10% or 20% of the profit depending on various circumstances split between a number of individuals.
Accordingly, the venture capitalists in my situation would receive an additional payment of, say £750,000. That "bonus" or additional payment of £750,000 is not treated as income but as capital. This means that as long as a trading business's shares have been held for over 2 years, the tax rate is only 10% rather than 40%. Other employees who receive bonuses are taxed at the income rate at up to 40% rather than this beneficial capital gains tax rate. For the very technical minded amongst you even the 10% rate can be reduced even further as fund partners are allowed to offset 20% of the initial price paid for the assets they buy meaning that the capital gains tax can be lower than 10%.
As with all things, there are always two sides to the coin. There are many venture capital fund managers who are not domiciled in the UK so do not even pay the 10% tax referred to above so the ones that do pay 10% pay more than them.
The British Venture Capital Association believe that venture capital is a force for good in the UK economy but the reality is that the media focus about the amount of tax paid by a small number of individuals is clouding the more important debate and muddying the waters of a much more important issue. The amount spent on the war in Iraq and Afghanistan in one day probably far exceeds what a few venture capital fund managers pay in tax on part of their remuneration whether it be at 40% or 10%.
I believe the media should allow proper debate whether the Venture Capital Industry a force for good in the UK Economy not focus on what a few people are paying in tax.