Early Stage Innovation Company Investor Opportunities

Hello, I'm Peter Towers, Managing Director of ESS Small Business. Welcome to Survival Hints for Small Business.

There are tremendous opportunities for investors under the Early Stage Innovation Company legislation.

What is an Early Stage Innovation Company? This is a new corporate structure that the Australian government legislated for in May 2016 and commenced operations from 1st July 2016. The legislation is targeted at companies that are developing new products, processes or services. In the main the companies have to be under three years of age, but in some circumstances the companies could be under six of age.

There are three tests with which the companies have to comply. They have to pass two of these three tests.

1. The first test is the "Provisional Test" (that's the name we've given it) because it looks at the age of the company, and whether it's income is under $200,000 in the previous income year, not including any grant income from the Accelerating Commercialisation Grant. The company's expenditure in the previous income year has to be under $1M. The company cannot be listed on a Stock Exchange anywhere in the world. That's the Provisional Test.

1. Assuming that the company has answered these questions, they can then move into what is called the "Gateway Test". Within the "Gateway Test" there are seven subjects for consideration and the company can earn points from each of these subjects. These subjects include:

• research and development - over 15% of expenditure
• whether the company has been admitted to the Accelerating Commercialisation Grant Programme
• whether the company has participated in an Accelerating Programme, delivered by a registered organisation
• whether the company has already achieved investment of, at least, $50,000 from "arms-length" investors
• whether the company has registered a patent, plant patent
• whether the company has an agreement with an organisation that is specified under the Higher Education Act for the Research & Development Act
• whether the company has registered an innovation patent or a registered design

There are points available for each of these subjects, ranging from 25 points to 75 points. What the company has to do if it's going to qualify under the Gateway Test is earn 100 points or more.

If a company has successfully completed the Gateway Test and earned more than 100 points, and obviously the company has already passed the Provisional Test, then the company has self-assessed as an Early Stage Innovation Company.

1. However, if the company was unable to accumulate 100 points under the Gateway Test, it now must move into the third and final series of tests. This is known as the "Principles Based Test".

Companies that gain acceptance as an ESIC under the Principles Based Test will normally be very new companies that have just completed their research and development; perhaps as a sole trader or partnership and have now decided to incorporate a company to assist with the capital raising activities.

To be assessed under the Principles Based Test, the company needs to positively answer five questions

1. Is the company generally focused on commercialisation of a product, process, service, organisational or marketing methodology?
2. Does the company have high growth potential?
3. Does the company have the ability to scale the business?
4. Is there a market opportunity, broader than the local market, in which the company is currently operating?
5. Does the company have competitive advantages?

If the company is able to successfully answer these questions, that would be great, but most companies' boards of directors will have difficulty answering those questions and supplying the required supporting evidence unless they obtain an independent report from an "arms-length" professional consulting firm which is able to review the company's operations, look at the company's business plan or documents as to what it wishes to achieve and have that report as the key supporting document for investors and the Australian Taxation Office to review.

This legislation has been established on the basis that companies can be a self-assess, so that the company will be able to undertake these tests themselves; but then they need to convince investors that they have undertaken these tests in an appropriate professional manner.

At some stage, all of this material is going to have to be submitted to the Australian Taxation Office and AusIndustry. It can be submitted to the Australian Taxation Office and AusIndustry at a very early stage for them to review the material and decide whether the company is an ESIC. I expect that this process will take a considerable amount of time and there is no expectation, from our point of view, that the ATO or AusIndustry will undertake this assessment process unless they receive all of the supporting information.

If a company is able to convince investors that they have successfully self-assessed and this could be in particular relating to the Provisional Test and the Gateway Test, then an investor can invest in those companies, but ultimately the company will have to submit the information to the ATO as part of the company's tax return that follows after the date the investment was made.

Obviously with the Principles Based Test, we believe the company will require an independent "arms-length" report.

ESS BIZTOOLS and ESS Small Business have developed a "package" which we call the ESS ESIC Product Package to assist accountants to undertake this due diligence process of companies to determine whether they have appropriate reasons to be able to classify themselves as an Early Stage Innovation Company.

What's all the fuss about, from an investor's point of view? Well, this is the only investment that I know of in Australia currently that you're able to obtain a 20% tax offset on your investment. The maximum investment for a sophisticated investor is $1M to obtain the offset, so that would mean that for $1M in a year, the investor would obtain a tax offset of $200,000. If you don't use all of the tax offset in one year, it can be carried forward to subsequent years.

For a retailer investor, which is anyone who is not a sophisticated investor, the maximum investment is $50,000 and therefore the maximum tax offset is $10,000.

Investors in an Early Stage Innovation Company are also eligible for a Capital Gains Tax Exemption, if they hold the shares for more than 12 months up to less than 10 years, and then there is no Capital Gains Tax payable on that original investment. If you invested $500,000 into a company and subsequently your share of the sale proceeds of that company was $3M, the $2.5M profit is tax free in the original investor's hands.

Accountants/Advisors can Assist

If you have any questions about any aspect of investing in an "ESIC" type company, you can obtain details from the accountants and advisors registered on the ESS Small Business website.

The accountants that I'm referring to who can assist you are the accountants/advisers who are on our website - www.esssmallbusiness.com.au. If you click onto the Accountants/Advisors Directory and insert your postcode, the system will identify for you the accountants/advisers who are committed to assisting small/medium enterprises, inventors and other businesses to assess whether the company is an ESIC and then to assist the company on the investment readiness and investment presentation phases.