Why do businesses create IP and what additional help do they need to encourage this? Incentives come in various forms, monetary or non-monetary, and they tend to be applied to induce product-orientated development ideas, which can be used in combinations of new and existing technologies and resources (Schumpeter,1934, writing in the Theory of Economic Development, published by Harvard University Press, Cambridge, MA).
But why are incentives needed? The reason is ‘risk’. Governments need to encourage companies to take risks to establish new products, new markets, and thus boost the economy. Without appropriate incentives, many companies will elect not to risk the uncertainty about the outcome of innovation. An innovative development may fail and even if it succeeds it may well take considerable time before the company can monetarise (earn money from) the new activity. Without government incentives the innovation needed to drive the economy forward by, for example, creating and using new IP, will be compromised as many companies will simply not take the risk.
So what forms of incentives currently exist and why, in our view, are these completely insufficient to maximise the potential of our innovation and IP creation leading to scaleable multi-national companies?
A significant barrier to IP creation is the raising of start-up and follow-on funding. Whilst there are reasonable incentives for early-stage individual investors (Seed Enterprise Investment Scheme [SEIS], Enterprise Investment Scheme [EIS] and Venture Capital Trusts) these incentive mechanisms are largely used by ‘smaller investors’, i.e. individuals who can support the very early stages of a company but do not have the ‘deep pockets’ to follow their positions as a successful company grows and needs further investment. This leads to a position where new, ‘larger investors’ are required to underwrite the subsequent funding rounds and, in many cases, this can create problems.
The larger investors can demand, and be successful, because the company needs the investment, a preferential position, e.g. via share class and associated rights, compared to the early (high-risk) smaller investors. The result; many would-be early-stage high-risk investors are put off making investments as they fear being ‘squashed’, i.e. being disadvantaged, by the later stage investors. The point where new relatively significant levels of investment is required to support exciting and scaleable companies, particularly technology-based companies, can be a failure point as the clash between the high-risk small investor and the more risk-averse large investor is not satisfactorily resolved.
This failure can result in the immediate collapse of the company but, more typically, results in shoe-string financial models where the small investors struggle-on; a pitfall that compromises economic growth. That is, the small investors continue to support the company as best they can but momentum and opportunity are lost. This scenario may simply lengthen the time the company takes to fail, or creates a company that, whilst it may survive, may never realise its original potential. So, can appropriate incentives be created that encourage yet more early-stage high-risk investors and avoid, mitigate or minimise the failure point described?
Analysing the issue suggests there is the possibility to design appropriate incentives. The objective is to create a smooth and as non-contentious a transition as possible from small, early-stage companies, that can thrive on hundreds of thousands of pounds to a rapidly-growing scaleable company that needs many millions of pounds of investment. One part of the equation is to encourage early-stage high-risk investment from all investors be they small or large. In the event larger investors are part of the initial investment they will have the ability to follow their money and resist any new investor demands for a preferred position. Larger funds typically take the view that the work involved in getting a £50k to £200k investment in place is as much work as placing a £5M investment and thus the effort and resources required to operate as a true early-stage investor simply are not worth the bother.
True early investment can lead to a higher per share return in the long term but if one has the muscle to buy in at a later de-risked stage and get a preferred position, vis-à-vis getting money out before others, why even bother looking at the early high-risk stage? So, to incentivise all investors who invest at the early-stage, perhaps a mechanism whereby capital gains on shares acquired in the initial round of investment (e.g. defined as the first £500k of investment) acquired shares is subject to a greatly reduced tax rate; perhaps 0%. This idea could be expanded to different levels of total investment, e.g. CGT rates of 5%, 10%, 15% and then ‘normal’ rates to apply to, for example the £0.5-10 M, £10-20 M ranges of investment. This increases the value of the early stages of investment and deals with the final level of return. Another way to attract the larger investors at the early-stage might be to introduce the equivalent of EIS and SEIS for larger corporates. It would not be difficult to introduce some form of corporate venturing tax break that encourages the largest companies to invest in early-stage venturing. It wouldn’t be complicated, nor indeed very costly in terms of tax revenue lost, to simply permit an additional tax deduction for investment by large corporates into smaller enterprises, rather like the current R&D tax credit regime for SMEs.
The mechanisms described above still fails to address the possibility that at a 2nd, 3rd or higher investment round the large investors could act together and form a structure that ‘squashes’ small investors with original ‘ordinary shares’. Tackling this could be possible if the tax breaks suggested above were only to apply to any CG arising from the disposal of shares that are equivalent in all respects to the ‘ordinary shares’ held by smaller investors. In addition, tax rules for any capital realised from shares that have any form of preferred position could be subject to a capital gains rate above the ‘normal’ rate, e.g. by a factor of 1.5 (a 50% uplift). Together the mechanisms, a mix of incentive to encourage early-stage high-risk investment and disincentive to create structures that ‘squash’ smaller high-risk investors, could drive behaviours that maximise economic outputs.
Investment in developing technical innovations, i.e. the creation of intellectual property (IP) could be further incentivised (de-risked) if some form of exemption was granted for the gains made when selling IP. The corporate tax substantial shareholding exemption (SSE) goes some way to providing this but it requires careful upfront tax planning and does not always sits comfortably with the company’s overall corporate structure and objectives.
The R&D tax credit system for SMEs has been a powerful and welcome incentive for over 15 years now. It is still unduly complex and many smaller companies still have the perception that it is hard to claim. Further simplification of this is required. The R&D tax credit regime for large companies needs to be far more generous. It seems anomalous that SMEs can claim a tax credits of 130% of qualifying expenditure whereas the benefits to large corporates is only 30%. Maybe there is a perception that large corporates do not need any tax break but the numbers do not back this up. There has been nowhere near such an increase in spending on R&D by large as there has been by SMEs since the R&D tax credit regime was introduced.
So, in a nutshell, the Budget was a missed opportunity. None of the suggestions above really cost very much in terms of tax revenue but the introduction of any of the would be a welcome boost to creation of IP and the chances of successfully scaleable growth by UK business.