A heaven for Angels

Under the new fiscal law for 2011-2012 the Israeli parliament approve measures to encourage Angels to invest in High-Tech companies. The law basically recognizes an investment in a High-Tech as an expense over three years.
That law would appear to be a wonderful solution to the need to get more funds invested in High-Tech companies, especially for starting companies in that sector. The law actually holds more than meet the eye at first glance. In this post I will try and point out some interesting side effects that the law holds.
In the first place since the benefit recognizes the investment as an expense it allows a capital investment to be deducted from income in the annual personal profit and loss statement. The idea behind the benefit is that in many cases the angel’s investment is either turned into a loss after a few years (as most start-ups requiring angels to invest do), or that it bears some profit in the long term, and at that time the profit is deducted from the original investment.
High-Tech investment has been reduced since the 2008 global financial crisis. The need for investment in the High-Tech start-up section, is evident (IVA data) . By the benefit offered this investment has advantage (at least in postponing the tax) over other financial investment even for people not considering Angel Investment on regular basis. The law places some restrictions on the investment and the management of the firm in order for the benefit to be acknowledged:
• The firm must use at least 75% of the sum invested by the single investor for R&D purposes,
• 75% of the investment is spent in Israel.
• The year of investment and the following year the firm income cannot be more than 50% on the firm’s R&D expenses.
• Until the year in which the firm’s R&D expanses reached 75% of the investment the R&D expanses should be at least 70% of the total firm expanses.
The law discusses a personal investment of up to 5 million NIS. If we want to have a look at the first point above, we can see that the way it is phrased in the law makes it advantageous to have the investment in the firm done by several angels and not a single one. This requires an example;
A firm requires an investment of 1 million. It finds an angel to invest the whole sum. That means that according to the regulations above, the firm now needs to spend at least 750,000 on R&D, most of it in Israel, and until that is done the R&D expanses should make at least70% of the total firm expenses.
Alternatively 10 angels invest the 1 million paying 100,000 each. Meaning that the firm now has to spend at least 75,000 in R&D and only until they do that they other obligation regarding the firm expenses is in place. Of course these conditions are easier to meet.
Based on the example above it would seem that there are two major changes to the way Angels investments were regarded in the past. Angel’s clubs have an advantage under the law as they reduce the risk of an investment losing its eligibility during the benefit time since the more angels there are the easier it is for the firm to meet the terms.
More than that, if in the past once an entrepreneur found his Angel he would not like to share, but under the law, sharing would actually have a benefit for the entrepreneurs and the angels. So if you have an angel and you friend have another it would be best for them to invest each half in each of you. Everyone gains.
The law would be more interesting if the limit on income being no more than 50% of overall R&D expenses would not pose a most difficult restriction. The restriction exists for the first two years on investment. However, if the firm should have a marketing breakthrough and generate revenues more than 50% of its R&D expenses the benefit would be lost. This creates a conflict of interest between the Angels and the Firm’s directors. The angels want the revues for the first two years to be low and the directors have an obligation to increase the revenues and thus the firm’s value.
The point is further complicated as the law states that the tax reduction should be the main motive for investment, that is a bit complicated to explain when coming to ask for the tax exemption- recognition of the investment as expense.
Will the angels be able to overcome the difficulties and benefit from the advantage? Will former non-angels decide to make such investments due to the attractive benefit? And most important, will the law help increase the overall investment in High-tech companies in spite of the current financial situation?