Legislation to encourage enterprise was announced in the Queen’s speech, and, write Duncan Innes and Andrew Sturcke, help in filling the equity gap is at hand from the European Commission
“My Government will introduce legislation to encourage enterprise…” the Queen announced in her speech on 20 June, when she introduced the new administration’s programme for the new Parliament.
So far so good – but it has proved less enlightening finding out from the Department of Trade and Industry (DTI) and the Labour Party itself exactly what measures are proposed to encourage enterprise. However, help for the Government is at hand from two unlikely sources, both of which will be relevant to small to medium-sized enterprises (SMEs). The first comes from Brussels and the second from the implementation of the Financial Services and Markets Act 2000 (FSMA).
In March 2000 the Government revealed the launch of its regional enterprise funds scheme. Briefly, this envisaged a regional venture capital fund to be set up by the Government in each of the English regions to assist SMEs. However, the wheels fell off this particular initiative on 18 October that year, when the European Commission (EC) launched a full investigation into the scheme on the grounds that it breached the arrangements for permitted state aid. The basic rule under the EC treaty is that state aid is, with a few exceptions, incompatible with the common market.
However, Chancellor of the Exchequer Gordon Brown has now announced good news. The proposal to establish regional venture capital funds, now styled as regional development agencies (RDAs), has been cleared by the EC.
The Commission concluded that the RDAs would constitute state aid, due to the subordination of the Government’s return on its investment to that of a private investor. In such circumstances the Government cannot be regarded as acting as a private investor in a market economy.
Given that the Government funds will not be invested at the same time or on the same terms as private funds, they can be viewed as conferring an advantage in breach of the market investor principle.
However, the Commission also concluded that the RDAs can be exempted from the general prohibition under Article 87(3)(c) of the Treaty of Rome, which states that such aid may be compatible with the common market where it “facilitate[s] the development of certain economic activities or of certain economic areas, where such aid does not adversely affect trading conditions to an extent contrary to the common interest”. Important factors in this decision are that the investments are limited to SMEs and that the amount that may be invested in each enterprise is limited.
Another factor was the EC’s recent adoption
of a new communication on risk capital and state aid. The RDAs are the first proposal to be assessed under the communication, and the fact that the ceiling on individual investment of £250,000 per tranche is well within the £500,000 threshold stipulated proved significant.
The fact that management of the RDAs will be subject to public tender and the fact that the RDAs are to be operated on commercial terms also proved decisive.
It is worth bearing in mind the rationale behind the RDAs. These are intended to address the difficulties facing SMEs in raising equity funding in the region of £100,000 to £500,000, caused by comparatively high administrative costs, including financial and legal due diligence, and the perception that investments of this size involve a high risk for a small return.
The proposal is that the Government will provide a total of up to £80m over 10 years, with private investors expected to contribute up to five times that sum. It is also expected that the European Investment Bank will contribute up to £60m. The Government will hold a minority stake in each RDA and its return may be subordinated to that of the private investors at the minimum level required in order to stimulate the creation of a fund.
While companies in a number of low-risk sectors will not be eligible for investment, it is not intended that there will be a specific focus on the high-technology sector. Managers for each RDA will be selected through a community-wide tender and are expected to invest on a commercial basis reaching a modest rate in venture capital terms of at least 12%. The second factor of significance to SMEs is the implementation of the FSMA. The DTI estimates the relevant parts of this will be in force by November.
One of the main difficulties experienced under the regime embodied in the Financial Services Act 1986 is that there is no exemption for sophisticated investors who are individuals. Unlike regimes in other countries the concept of a ‘business angel’ who does not need protecting by the ‘nanny state’ is not recognised.
Under the FSMA, however, two new categories of investors will be established – ‘high net worth’ individuals and ‘sophisticated investors’. The status of individuals in either category will need to be certified by an appropriate person -current proposals include any authorised person (in the case of sophisticated investors) or accountants or solicitors (in the case of high-net-worth individuals). In addition, the individuals themselves will need to sign a statement, not less than 12 months before an investment is made, confirming their status.
The basis of what constitutes ‘high net worth’ for individuals has also yet to be confirmed, but it is likely that income in excess of £100,000 and net assets in excess of £250,000 respectively will be required.SMEs raising capital from high net worth individuals and sophisticated investors will need to draw to the attention of such potential investors, before the investment is made, that the relevant information memorandum or other selling document has not been independently verified and confirming that, in the case of high-net-worth individuals, they cannot lose more than they invest.
Once the new proposals have been brought into force it should clarify a lot of the doubts that currently surround the various ‘fan clubs’ and business angel associations which seek to provide equity funding within the framework of very inflexible legislation.
If the RDAs have sufficient buy-in from the business and finance communities, then this major new source of finance, combined with a more realistic legislative framework, should provide the boost to SMEs that the economy badly needs at this time.
Duncan Innes is a partner and Andrew Sturcke a trainee in the corporate finance department at Marriott Harrison.
