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Lack of capital and onerous HMRC rules are restraining tech start-ups

October 12, 2012

The following article by Mark appeared in this morning’s City AM – click here to read it online.

Shares for sackability. The Chancellor’s announcement earlier this week that employees could get a stake in their company in return for waiving certain employment rights seemed a rare flash of creativity from the Treasury. But as Allister Heath noted in Tuesday’s editorial, there are practical barriers to its implementation.

It will come as no surprise if, in a year’s time, the Opposition begins mischievously to ask how many businesses have made use of the Chancellor’s big new idea. With this in mind, now might be the time to consider alternatives for stimulating growth via the government’s approach to share ownership. As ever, the key lies in reducing complexity rather than adding to it.

At a recent City roundtable on intellectual property (IP), I met a former engineer and investment banker who now helps technology start-ups. A few years ago, he had worked as a part-time CFO for a tech spin-out from one of Britain’s top research universities. Backed by a quasi-governmental venture capital fund, in the end the technology was sold prematurely to a large French company as it had proved impossible to eke out limited VC funding to expand the fledgling enterprise. Had it not been for the complexity of HMRC’s rules and an equity gap in first stage VC, he believed, the UK Treasury would by now have been enjoying the rewards of fresh job and corporation tax receipts.

New tech businesses are typically nucleated when a piece of IP is picked up by a small team of high calibre executives who practically apply and market the technology. Seed funding of £50-250k to get these start-ups off the ground is typically not difficult to come by. The founders’ own resources, or those of business angels, can be tapped and new government mechanisms, such as the Seed Enterprise Investment Scheme, incentivise investment in early-stage companies. Instead it is the next part of the corporate journey – obtaining £1-5m in first stage venture capital – that represents the greatest stumbling block to expansion.

The structural shortage of this type of funding in the UK is exacerbated by the fact that before these start-ups begin generating revenue, a large share of funds goes towards paying executives’ salaries. It is the taxman, therefore, that gets much of this VC money through employer and employee NI and PAYE tax – particularly ironic in instances where a quasi-public source has granted the VC funds.

To work round this problem, many start-ups eke out their VC money by instead rewarding executives with ‘sweat equity’. Since many are in the 45-60 age bracket, they tend to have an existing financial cushion that leaves them prepared to work for ‘free’ in return for shares. However, HMRC currently insists that those shares are valued and treated as taxable salary. In order to pay the tax charge associated with the granting of shares for which there is no liquid market (and which may in the end turn out worthless), executives must raid their savings. In short, when a start-up fails, as so often is the case, executives will have paid from their own resources for the privilege of working for free.

Partial work-rounds are in place based on approved share option schemes and the recognition of capital losses on shares in companies that fail. However these are complex, hard for many SMEs to understand (at least without the services of expensive advisers) and costly to administer. As a result, many corporate mentors simply do not bother to become involved, their wisdom and experience lost in the process.

The government could solve this conundrum relatively simply by allowing qualifying early stage tech companies to reward executives with shares on an ad hoc basis that could be held in ‘escrow’ by HMRC but would not crystallise any taxation in the year they were awarded. Instead, a tax charge could be levied (on the individual rather than the company) on withdrawal of the shares from escrow, which presumably would only happen once there was a liquid market for them that would establish their fair value.

The downside for HMRC would be the delay in levying tax but the only net loss would be the employer’s NI. This would be more than offset by the simplicity of collecting the tax which would eventually be forthcoming. And if VC was used not for meeting PAYE bills but expansion and development, it would be HMRC that would reap the reward from the uplift in economic activity.

If the Chancellor is looking to prove that rejigging HMRC’s approach to shares can tick the box for economic growth, this could prove a handy addition to his arsenal.