We all know raising money to either launch or scale up a business can be demanding at times. Especially when the investor market is saturated, and you are competing against other companies for time and attention from potential investors.
So, would you listen if I was to tell you there’s something that would entice investors to invest in your company over others?
Well there is! It’s called the ESIC (Early Stage Innovation Company) tax incentives.
Essentially, Australia introduced the ESIC tax incentives to help both sides of the investment transaction (see below). The first being innovative early stage companies looking for funding, and the second being the investors. The ESIC tax incentives were developed to help innovative early stage companies attract investment by providing eligible investors tax ‘breaks’ for taking a ‘risk’ to invest in these companies.
While this ‘Wild Card’ tip isn’t focussed on the investors, (as they will likely already know about these incentives), it’s definitely worth knowing the basics on what type of tax ‘breaks’ or benefits investors.
Investors — ESIC Tax Incentives
There are certain thresholds that apply to “sophisticated” investors and those who do not qualify as “sophisticated” investors. However, these thresholds and restrictions are not considered below.
- Non-refundable 20% tax offset for the total amount invested to purchase the “ESICs” shares
- Modified capital gains tax (CGT) treatment for shares held for at least 12 months and less than 10 years (i.e. no capital gains tax if sold during this period)
You might be saying, that’s all well and good for the investor but how does this help my company?
Great question! To explain, let me put this scenario to you.
Scenario — Which company would you ‘risk’ your money with and invest in?
You’re an investor deciding to invest between two promising companies. Based on your analysis both companies are in the business of developing innovative products with high-growth potential. All things considered the same, however, one of the companies qualifies as an eligible ESIC. You know by investing in the eligible ESIC, you may be able to benefit from the upfront tax offset and longer-term CGT incentive.
Being a savvy investor you immediately know this means that if you invest in the non-ESIC company you’ll need the company to grow at a significantly higher rate to earn the same ROI. Which ultimately means a ‘riskier’ investment (I’ll share with you a detailed calculation and explanation of how this ROI calculation works in the coming weeks).
As mentioned at the start, these incentives were introduced to help both sides of the investment transaction. It provides investors with an incentive to invest in eligible ESICs, which in turn ‘makes it easier’ for eligible ESICs to attract investment.
So how do you know if you are an eligible ESIC? Well you have to satisfy a couple of tests! These tests are designed to determine if you are an innovative company with high-growth potential and have the ability to scale-up.
There are 3 tests, you need to pass the first and either the second or third.
- Early stage test (objective); AND
2. 100-point innovation test (objective); OR
3. Principles-based innovation test (subjective)
The early stage test is objective, you either pass it or you don’t. It’s made up of 4 requirements and they are relatively simple to understand.
This test identifies whether or not your company is in its ‘early stages’ and you can generally just refer to your income statement and company incorporation certificate to determine whether or not you pass this test.
That’s the easy part!
Assuming you do pass the early stage test you then need to pass either the 100-points based innovation test (100 point-test) or the principles-based innovation test (principles-based test).
Passing the 100-points test
To pass the 100-point test you need to refer to the table provided by the ATO and determine whether your company is able to satisfy the specific criteria and accumulate at least 100-points.
Based on the point allocations, this test is focussed on assisting:
- Companies who have previously had success in utilising the R&D tax incentive (as supports the view that the company is innovative)
- Companies who have been or are part of specific accelerator programs or have received an Accelerating Commercial Grant
- Companies who have previously had a $50k equity investment made by an external/non-related or associated 3rd party
- Companies who have been granted and patents or recognised with other similar IP rights
Ultimately, if your company doesn’t fall within 2 or more of the scenarios mentioned above it will generally be difficult (or impossible) to pass the 100-point test.
So what’s the point? (excuse the pun)
If the objective test is so hard, why would I even try satisfy the subjective test (principles-based test)!?
Well, the 100-point test basically relies on other people or another departments’ assessment of whether or not the product, process or service being developed is ‘innovative’ (e.g. Aus Industries for R&D, IP Australia for patents etc). Whereas, the principles-based test has 5 main principles which all need to be satisfied for the ATO to view a company as ‘innovative’.
Passing the principles-based test
Essentially, to pass the principles-based test a company must prove that:
- It is developing a new or significantly improved innovation (product, process, service) to be commercialised (i.e. to generate income)
- It has high-growth potential
- It is scalable
- It has the ability to address a broad market (national, global)
- It has sustainable competitive advantages
Summing it all up, if you tick each of these principles, you might be able to satisfy the principles-based test.
Now you’re thinking — “You know what!? I do have an innovative company that has the potential to scale-up in various locations with a high-growth potential!”
So how do you gain clarity to know if the ATO agrees or believes you are an early stage innovative company that satisfies the 5 principles?
Well the way I’ve done it successfully is by submitting a ruling in writing to the ATO explaining why and how each principle is satisfied.
This minimises the risk of incorrectly labelling your company as an eligible ESIC and also provides assurance to the investor about their investment in your company.
How long does it take to find out if you are eligible?
Upon submitting the detailed explanation, you can generally receive guidance within 28 business days.
Taking this timeline into consideration, if you are already looking for funding or in conversations about investment, it might be the perfect time to start the process, so you can find out if your company is an eligible ESIC.
I’ve had some successful experience with this process, so I am always happy to help out if you want to know more!
Charl Van Den Berg