ost tech startups worldwide raise money through venture capital and use the venture capital method as a way of valuing young tech startups.
This method isn’t strange to African tech startups too. Last year alone, African startups attracted a record $1.34 billion in venture capital. What is not surprising is that 75% of that venture capital went to Nigeria, Kenya, and South Africa. And this is not by chance. Those countries have put in place legal and regulatory frameworks that protect young venture capital investments, unlike Uganda.
1st January, 2018 – Safe Boda raised $1.1 million in a “series A” venture capital round, which is in venture capital speak, known as a qualified round of financing, but before Safe Boda could qualify for a qualified round, like any tech start up seeking to raise seed funding it did so through something known as a “convertible note instrument” where it raised $229,000 on April 1st, 2016.
Remember, a convertible debt deal doesn’t purchase equity in your startup. Instead, it’s simply a loan that has the ability to convert to equity, based on some future financing event.
Properly understood, a convertible note instrument is legally a form of short term debt that converts into equity, typically in conjunction with a future financing round. In effect the investor would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor receives equity in the company.
It’s from this definition of a convertible note, that I want to transition and explain how the ruling in ATC Uganda v. Uganda Revenue Authority would make convertible note instruments very unattractive for venture capital funds in the United States or London to add Ugandan tech startups to their investment portfolios.
Of course the ruling had absolutely nothing to do with a convertible note instrument, but by implication it will have an effect on those tech startups that will use them as a means of raising funds, making the already capital intensive tech startups even more capital intensive.
Briefly, the facts of this case before the Tax Appeals Tribunal concern a shareholder loan agreement of 7 years at an interest of 6.65% per year that ATC Uganda got from its parent company. The loan was worth $124,500,000. The shareholder agreement was structured in such a way that the interest on the shareholder loan would be added to the principal loan amount outstanding.
For over 54 months the accrued interest was added to the principal amount and for that entire time, ATC Uganda did not pay any withholding taxes to URA. URA thus issued an assessment of 24,232,558,369 to ATC Uganda as withholding tax on the purported accrued interest added to the principal amount in the period 2012 – 2017. ATC objected to the assessment.
In the determination of this case, an issue arose as to whether withholding tax is payable on the purported accrued interest which was added to the loan. Should it be charged at the point of accrual or remittance? The ruling indeed rightly cited Section 47 (1) and (2) of the income tax Act which when read as whole state that: “interest in the form of any discount, premium, or deferred interest shall be taken into account as it accrues.” However, Subsection (2) adds that where the interest referred to in Subsection (1) is subject to withholding tax, the interest shall be taken to be derived or incurred when paid.
The tribunal therefore agreed that such withholding taxes should be due on interest when paid and not when it accrues.
What I find particularly dangerous to the future of convertible notes in startup funding is the interpretation of the word “paid” by the tribunal. The tribunal states that the world has changed and payment is no longer restricted to the physical exchange of cash.
“A payment can be made conversion of debt into equity, a relief of a debt, or a swap of a debt with an obligation…..” It said.
Future venture capital stakeholders should brace themselves for costs due to such an interpretation if they are to add Uganda startups into their investment portfolio. The 3 members of the tribunal in their ruling stated that when interest is converted into capital and added to the principal loan, ATC Uganda effectively paid the loan.
From a venture capital point of view, this is bound to make convertible notes very unattractive. One of the most important terms for a convertible note is the discount, which under Section 47 (1) could trigger a withholding tax.
Until recently, lawyers that structure venture capital deals had never seen a convertible note deal that didn’t convert at a discount to the next financing round. Given some of the current market conditions at the seed stage, we have heard of convertible deals with no discount but viewed this as irregular and not sustainable over the long term. Therefore, the discount is very much part of convertible notes.
The idea behind the discount is that investors should get, or require more upside than just the interest rate associated with the debt for the risk that they are taking by investing early. These investors are not banks — they are planning to own equity in the company but are simply deferring the price discussion to the next financing.
Under our taxation laws, especially for capital intensive tech startups, this makes convertible notes look less lucrative for the investor especially if the startup has to withhold such “discount” when filling returns.
So how does the discount work?
Let me give a simple illustration which deals with a “discounted price approach” which is much simpler and better oriented for a seed round investment. For the discounted price to the next round, you might see something like this in the legal documents:
“This Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to eighty percent (80%) of the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors.”
This means that, if in your next round of raising venture capital, investors are paying $1 per share, then the note will convert into the same shares at a 20% discount, or $0.80 per share.
For example, if you have a $100,000 convertible note, it will purchase 125,000 shares ($100,000/ $0.80) whereas the new equity investor will get 100,000 shares for his investment of $100,000 ($100,000 / $1).
The range of discounts we typically see is 10% to 30%, with 20% being the most common. While occasionally you will see a discount that increases over time (e.g., 10% if the round closes in 90 days, 20% if it takes longer), personally I generally recommend entrepreneurs (and investors) to keep this simple — it is the seed round, after all.
In the words of the tribunal, since “withholding tax on interest shall be due when its paid and not when it accrues,” this effectively means that when a venture capital fund or a seed investor generally invests $200,000 by way of a convertible note and the interest converts into additional equity even at a discount price, on the next venture capital financing during a qualified round, say “series A,” at that point the tech start up should withhold that taxable income and remit it to URA instead of channeling this money to the investor in terms of equity. Isn’t this an additional cost?
Since convertible debt is a loan, it almost always has an interest rate associated with it, as that is the minimum upside an investor is going to want to have for the investment. Lawyers normally advise that interest rates on convertible debt should be as low as possible. This is not bank debt, and investors are being fairly compensated through the use of whatever type of discount has been negotiated.
Therefore, rulings like the one in ATC Uganda might actually not only tamper with discount rates in venture capital financing but even possibly the interest rates, making the cost even much higher to the entrepreneurs of the startup.
The reason why so much venture capital is going to Nigeria, Kenya or even South Africa is that they have attracted that capital through tax incentives. Nigeria forexample passed laws allowing certain tax incentives for venture capital companies and projects since 1993. The Venture Capital (Incentives) Act is Nigeria’s primary legislation for the grant of tax incentives to venture capital companies and projects.
What the Act especially does is to offer more favourable tax incentives than are as applicable under Nigerian corporate and investment law and depending on how a start-up company is structured, start-ups and venture capitalists operating and/or investing in Nigeria can immensely benefit from the incentives provided for under the Act.
Unlike, in Uganda, this law gives Withholding Tax Incentives: This is a type of advance payment of income tax. Withholding taxes (WHT) typically tracks the income earned by investors in a business. What the Act does is to reduce the amount payable as Withholding Tax on dividends payable to an investor in a VPC. The Act provides a 50% reduction in WHT for qualifying companies over a 5-year period.
Why can’t this be done in Uganda? If we are to build our tech capacity and transform this economy, we have to give tax reliefs to young seed stage startups. As general counsel of Pixan Corporation, I drafted a petition to Parliament for seed enterprise investment schemes (SEIS) tax reliefs for venture capital funded startups, talked to people at Safe Boda, but they chose not to take me seriously.
Little do they know that we need these tax reliefs to sustainably attract and keep venture capital flowing in to Uganda so that we create an eco-system and spur innovation. Safe boda should know that they can’t succeed alone without an eco-system, otherwise, they might fail along the way, since it’s not strange even for late stage venture capital startups to collapse.
Now that Covid 19 is here this suggestion of SEIS is even timely in order to deter URA assessments from collapsing venture capital funded tech starts in Uganda few as they are. It has become apparent that the income tax laws are hurting the few tech venture capital funded start-up companies. They are frustrating our operations here in Uganda.
If Uganda is to compete with the innovation in this current industry 4.0, which deals with cyber-physical systems, the Internet of things, cloud computing and cognitive computing, then a conducive tax environment should be given to such small tech startups to innovate and easily create tech businesses in this county.
At the moment, venture capital from places like Silicon valley and other venture capital funds for such tech business investments is going to Nigeria, south Africa, Kenya and Botswana because those countries have progressive laws that favour such investments. Uganda is lagging behind.
My suggestion of Seed Enterprise Investment Schemes (SEIS) for tech startups is not strange. There is a precedent for this in other commonwealth jurisdictions like the UK, Canada, India, Kenya, Nigeria, Singapore, South Africa and many more. This has helped tech-entrepreneurship grow. The Seed Enterprise Investment Scheme (SEIS) should offer great tax efficient benefits to investors in return for investment in small and early stage startup businesses.
SEIS is designed to boost economic growth by promoting new enterprise and entrepreneurship. In the UK, a similar scheme was introduced. The Chancellor George Osborne’s 2011 Autumn Statement which heralded a big shake up of tax incentives for investors, with the Enterprise Investment Schemes and Venture Capital Trusts also being revamped in the UK. the Seed Enterprise Investment Scheme has become one of the most revered government-backed schemes ever created.
Some of the most important points to consider are:
1. Investors can receive up to 50% tax relief in the tax year the investment is made, regardless of their marginal rate.
2. SEIS investors can place a maximum of $200,000 in a single tax year, which can be spread over a number of companies.
3. A company can raise no more than $150,000 in total via SEIS investment.
4. Investors cannot control the company receiving their capital, and must not hold more than a 30% stake in the company in which they invest.
5. The company seeking investment must be based in Uganda, and have a permanent establishment in Uganda.
6. The company must have fewer than 25 employees. If the company is the parent company of a group, that figure applies to the whole group.
7. The company must be no more than 6 years old.
8. The company must have assets of less than $200,000.
9. The company has to trade in an approved sector – tech related