This is the text of a presentation delivered to DIT Hothouse on 13 October 2010.
I am proposing today to cover the structuring of a BES investment from a legal perspective. Gerry Vahey of Mazars has discussed the taxation aspects of BES investment in more detail.
In order to be eligible for BES investment the investee company must be a "qualifying company" and must be:
- incorporated in Ireland or in another EEA State;
- its shares must be unquoted;
- it must be tax resident in Ireland or in an EEA State and, in the latter case, carry on a business in Ireland through a branch or agency;
- must carry on one or more qualifying trades.
Qualifying Trading Activities
These are set out in Section 496 Taxes Consolidation Act 1997 (as amended) and include:
- manufacturing of goods;
- rendering of certain services;
- certain research and development activities;
- cultivation of horticultural produce;
- construction and leasing of advance factory buildings;
- cultivation of mushrooms in the State;
- production, publication, marketing and promotion of qualifying recordings;
- certain waste material recycling activities;
- certain tourist traffic undertakings.
If the company is not trading at the time the shares are issued it must commence trading within two years of the share issue (and in case where the activities wholly or mainly of R&D activity relating to a qualifying trade it must commence trading within three years).
The company must continue to carry on the qualifying trade for the "relevant period" (Section 488 & 496 TCA 1997) which is normally a period of 3 years from the date of issue of the shares to the BES investors (or, if the company has not commenced trading at that time, 3 years from the date on which the qualifying trade commenced.)
In order to qualify for BES relief the investor must subscribe for new shares in an unquoted company. The shares must be fully paid up on issue. This means that if a share has a nominal value of €1.00 then €1.00 must be paid up on that share if the shares are being issued at par. If the shares are being issued at a premium (e.g. a share of €1.00 nominal value is being issued for €5.00 then the nominal value plus €4.00 premium is paid on the share) the nominal amount plus premium must be paid.
Whilst it is possible from a company law perspective to have shares partly paid up (subject to certain restrictions) the point is that the shares will not be regarded as being eligible for BES relief if they are not fully paid up. It is prudent also to ensure that the subscription monies are received in cleared funds prior to allotting the shares. It is also prudent to ensure that the cheque or bank draft for the subscription monies is made payable to the company which is issuing the shares and is lodged in a bank account opened in the name of that company. In that way there will be evidence of the receipt of the subscription monies and a record of the time when the subscription monies were received in case a question arises in the future.
If because of time constraints the company receives a cheque and has to proceed to allot the shares prior to the cheque being cleared it would be prudent in the board minute allotting the shares to provide that the shares are allotted conditionally upon the clearance of the cheque in question. This would avoid technical problems which may arise in the event of the cheque is not being honoured on presentation.
Rights Attaching to Shares
The BES legislation provides that the investment must be made for "ordinary shares" which is defined as "shares forming part of the company's ordinary share capital".
The shares must further qualify as "eligible shares" which is defined as:
"means new ordinary shares which throughout the period of five years beginning on the date on which they are issued, carry no present or future preferential right to dividends or to a company's assets on its winding up and no future or preferential right to be redeemed."
It is therefore normal to structure shares which are offered as part of a BES investment as a class of ordinary shares. These may be the same shares as are held by the promoters or can be structured as a separate class of ordinary shares. It may for example, be decided to structure the shares offered for BES investment as a class of ordinary shares which do not carry voting rights.
However, the shares offered for BES investment cannot carry:
- preferential rights to dividends - present or future;
- any right to be redeemed, present or future.
It is possible (though now relatively infrequent) to place a cap on the value which a BES investor can derive from his BES shares. There are a number of ways of structuring such a cap though tax advice should be sought in connection with the mechanism of capping if it is relevant. More commonly a BES investor will refuse to agree to cap the value of the BES shares particularly if the investment is being made in the early stages of a company's development when the risks are greatest.
The question of capping sometimes arises when companies seek to raise subsequent rounds of BES investment when the company may be a less risky proposition for the investor and BES investors might be open to considering accepting a cap on their return. If there is earlier uncapped BES investment, the subsequent creation of capped BES shares is likely to result in the earlier BES shares holding preferential rights over the later BES shares and thereby ceasing to be eligible shares for BES purposes.
Number of Shareholders and Nominee Companies
An Irish private limited company can have a maximum of 99 shareholders. It would be uncommon to find a private company with anything like this number of shareholders and even a much smaller number can be difficult to administer in terms of passing shareholders' resolutions.
Indeed, a question frequently arises as to whether the BES investors should be required to hold their investment through a nominee company in whose name the BES shares would be registered. The use of a nominee company obviously carries with it incorporation and annual compliance costs which would need to be factored in. It would also require the preparation of a form of deed of authorisation and indemnity which would set out the terms on which the nominee company holds the shares for the BES investors. There may also be regulatory issues to be examined depending on the extent of the powers to be given to the nominee company.
I do not propose to go into any detail on the nature of the powers that a nominee company would have. Suffice to say that if it is sought to give the nominee company extensive powers over the shares registered in its name that this may well be a factor that may turn some investors of making a investment in that particular company.
Can a Qualifying Company have a Subsidiary?
The BES legislation (Section 507 TCA 1997) permits a BES qualifying company to have a subsidiary subject to certain conditions:
- the subsidiary must be at least 51% owned by the parent company;
- the subsidiary must be a qualifying company or carry out certain services for, or functions on behalf, the parent company or its subsidiaries.
Where a company has a subsidiary and if there is any doubt as to whether the requirements of Section 507 are met, it may be necessary to engage with the Revenue Commissioners at the time of seeking RICT outline approval to get confirmation as to whether the Revenue Commissioners would regard the subsidiary as a qualifying subsidiary.
Holding of Shares by BES Investors
A BES investor must normally hold his shares for a period of five years from their date of issue. In the event that the shares are sold within that five year period it will result in a clawback of the BES relief for the BES investor.
BES investors will therefore be reluctant to dispose of their shares within this period unless they would receive a price which would give them at least (a) the amount of their original investment back; and (b) the amount of the tax relief that would be forgone.
In most companies which have taken in BES investment there will be no provisions which would allow the company or the other shareholders to force the BES investors to sell their shares prior to the expiry of his 5 year period and it would therefore be a case of persuading the BES shareholders to sell their shares should an exit opportunity arise during the 5 year period.
It is common in many BES investments for a designated exit mechanism to be put in place at the time the shares are issued to the BES investors and many BES investors will insist in such a mechanism.
Most usually this takes the form of an option deed entered into between the company and the BES investors. Under this option deed after the expiry of the five year period:
- the BES investor is given a option (i.e. a put option) to require the company to purchase back the shares;
- in many cases the company is given a corresponding option (i.e. a call option) to require the BES investor to sell the shares to the company.
It is normally provided that the value at which the shares are to be acquired is the market value at the time of exercise of the option. If the parties cannot agree on the value of the shares in question there is normally a mechanism for the appointment of an independent valuer to put a value on the shares.
There are a number of important features from a legal perspective concerning the approval of these option arrangements and their enforcement.
Firstly, in order to be effective, such option agreements between a company and the BES investor must be approved in advance by a special resolution of the shareholders of the company. There are certain formal approval procedures which must be strictly observed.
Secondly, such an option can only be effectively exercised by the company or the BES investors if the company at the time of the exercise of the option has the necessary "profits available for distribution" out of which to fund the purchase of the shares.
In the event that the company does not have the necessary "profits available for distribution" it cannot be sued for either specific performance or for damages.
In certain circumstances to take account of the risk of non-enforceability of the option arrangements between the BES investor and the company, a BES investor may insist on a similar option deed being given by the promoters of the company. If this requirement is raised it is very important for the promoter to consider this carefully as he would be taking on a potentially serious financial obligation on himself which he would most likely have to finance from his own resources.
Other mechanisms which BES investors may seek include:
- if the BES shares were capped that any cap on those shares would fall away if the shares were not bought back by a certain time;
- that the BES shares would acquire increased voting rights if the shares were not acquired within a certain period.
In a case where there are sufficient funds within the company out of which to effect the acquisition of the BES shares and provided everyone agrees, it would be advisable to structure the transaction whereby BES shares are bought back:
converting the BES shares into a class of redeemable shares; and
redeeming and cancelling the shares. In this way any potential stamp duty charge is avoided and from a company law point of view the shares have been effectively extinguished.
Clawback of BES Relief
Under the legislation governing BES investments the tax relief may be "clawed back" from the BES investor in certain circumstances including:
- arrangement being entered into for the sale of BES shares other than at their market value;
- the BES shares not being or ceasing to be "eligible shares";
- the company ceasing to carry on a qualifying trade within the relevant period;
- certain individuals "receiving value" from the company;
- the BES investor selling or disposing of his shares before the expiry of 5 years
- from the date of issue;
- the proceeds of the BES investment not being used for the purpose of
- the qualifying trade.
BES Information Memoranda
It is common to find a company seeking BES investment will prepare information memoranda containing detailed information concerning the company's business and projections concerning the company's future performance. I would make a few points concerning such documents:
- Care must be exercised to ensure that such memoranda do not breach company law prohibitions on offering shares to the public;
- Companies should avoid disclosing commercially sensitive or confidential information in such memoranda;
- Such a document, if possible, should not contain any provisions, express or
implied, as to the performance of the company or promises as to the company's observance of the requirements of the legislation governing BES investments. Indeed if such memorandum is considered necessary, it should contain a disclaimer in a prominent position to the effect that neither the company nor the promoter(s) are to be considered as making any representations whether expressly or impliedly to the prospective BES investors and that the latter should take their own professional financial, legal and taxation advice or the terms of any investment in the company.
Designated Investment Funds
This is a form of BES investment which is made by a fund which has raised money from private individuals and which invests those monies in a number of investee companies. Such a fund is managed by a professional fund manager. These are several such funds operating in the market.
There are advantages and disadvantages to this type of funding.
One of the advantages is that the investee company only has to deal with one investor but on the other hand such funds usually extract more onerous terms from investee companies their private BES investors (for example, annual management fees etc) and are very focused on securing an exit after the expiry of the five year period.