Venture Capital Economies in the EU
Professor Irene Lynch Fannon
In studies conducted by the European Venture Capital Association, covering over 15 different European economies Ireland, along with the UK and Luxembourg scores the highest 'composite score' as a location which, like the other two, is 'most favourable to the development of private equity and venture capital industry.' Interestingly countries with low comparative scores, ie scores which are at least below the average composite score include Germany, (at bottom) France, Sweden, Spain and Belgium. What is interesting about this ranking is that these countries display different indicators for overall economic performance. For example Sweden displays strong economic indicators as does Belgium during the relevant period. Most recently, the German economy has displayed some signs of recovery in the last year. This might lead us to pause and consider the bigger question of the contribution which venture capitalism and entrepreneurial behaviour can make to different kinds of economies. In some economies for example it may not be as important to support and encourage venture capital, start up businesses or entrepreneurial firms, but these are issues which are assumed as moot in the context of this paper. Results for both years of the survey conducted in the successive years 2003, 2004 rank Ireland, Luxembourg and the UK in the top three. In considering Ireland's environment in detail a number of factors were highlighted by the survey as being significant. These factors pertain primarily to the regulatory framework and address both the supply side in terms of support for investment in companies and demand side support for venture capital funds and include the following:
- The availability of the Limited Partnership as a vehicle to organise and manage funds. Limited partnerships are restricted to 20 limited partners.
- No legal restrictions on the investment by insurance companies in private equity and venture capital.
- Similarly no restrictions on investments in private equity by pension funds.
- Low corporate tax rates of 12.5% on trading income and 25% on other income. For SMEs (ie small or medium enterprises) there is a 12.5% tax rate across the board with a 25% tax rate for non-trading companies.
- Comparative to other European countries the individual tax rate which is at its highest rate 42% is considered to be a favourable element in the venture capital industry, although this is higher perhaps than overall income tax rates in the US. Bear in mind however, that there are no significant taxes at local level such as property taxes and so forth.
- The capital gains tax rate is 20% which is considered to be attractive.
- Very significantly Ireland also provides tax incentives for individual investors in private equity and venture capital funds through various tax schemes, for example the BES (Business Expansion Scheme) and the Seed Capital Scheme and other tax incentives for investing in particular kinds of sectors, most notably in recent years property development. These schemes effectively encourage investment by individuals in start up and medium sized enterprises by providing income tax relief to the value of the investment.In some cases even income which is not related to the investment was covered.
- Under the heading bankruptcy and insolvency it is noted that a statutory corporate rescue scheme (the examinership process) provides a pre-bankruptcy system which facilitates company turnaround. Furthermore the average period between declaration of bankruptcy and closure of proceedings is 70 days. It also notes that 'managers and directors of a bankrupt company will not face any limitations in getting involved in the management of another company' although this is not quite accurate as in recent years there has been a considerable enhancement of penalties to which directors and others involved in bankrupt companies may face.
- Finally the report is positive about the administrative aspects of setting up entrepreneurial firms in Ireland. For the private limited company the typical time is noted to be 7.5 business days, below the average of the countries surveyed of 23.5 business days. Costs for the establishment of a private limited company are €1,500 compared with the average €1, 638. (The only thing that is relatively cheaper in Ireland!!) Finally there is no minimum capital requirement unlike many countries in continental Europe which require significant minimum capital. In relation to a plc the set up time is 10 days compared with an average of 25.7 days, minimum capital requirement is €38,100 compared with an average €64,484. These final differences lead us to something which has emerged as a very significant development in the European Union, the development of the possibility of competition for site of incorporation, in other words what is usually described as the Delaware Effect.
Unfavourable factors include the following which are listed in the order of what might seem most significant in the context of entrepreneurial and start-up companies:
- Stock options are taxed when they are granted.
- A lack of fiscal incentives for R & D development and R & D collaboration.
Two further factors are listed in the report as being unfavourable to a private equity or venture capital environment but both of these factors relate to a larger company context rather than to a start up or medium enterprise environment. They are
- The requirement that all mergers which come above statutory merger regulation thresholds must be notified to the Irish Competition Authority and the deal will be suspended pending a decision.
- Secondly, the administrative costs for setting up a plc, a publicly quoted company are higher than the average cost of €2,301 at around €5,000.
Both of these factors highlight a significant issue in relation to the provision of private equity or venture capital and that is the potential for exit which is available to the investor. Typically this may occur through buyout or merger, or through an IPO on either a full stock exchange or a smaller companies market of some kind and so both of these factors affect the alacrity with which the investor may exit after a number of years of investment. This is identified as a particular issue for the venture capitalist. This problem of exit can however be addressed by providing for a particular type of security or class of security and in Ireland in the 1990s this issue was addressed by amending the corporate legislation to provide for redeemable shares, which are sometimes referred to in the United States as 'treasury shares'. This phrase does not encapsulate the full extent of the possibilities presented in the Irish legislation. These kinds of securities have limitations most significantly in terms of availability of capital for redemption at particular times when exit might seem most attractive to the venture capitalist. What seems more significant in practise however, is the availability of a less formal securities market which mimics that of a fully developed stock exchange but which provides access to capital without imposing the rigorous compliance requirements of a full stock exchange listing. The London based Alternative Investments Market provides such a model and there are proposals to develop this model at European level. This kind of market will and does at present provide an 'effective natural exit route for venture capital and private equity, bridging the gap between early stage debt or private equity financing and public equity and debt.' AIM has now been in operation for over 10 years and as of the end of 2005 included 37 non-UK EU companies. Irish companies have access to this market providing opportunities for continued investment or exit for venture capital investment. In putting forward proposals for developing a pan-European model based on the London AIM the proponents clearly recognise the benefits of venture capitalism to an economy generally and the potential added value to venture capital activity provided by such an exit option. These benefits include the availability of cheaper capital for smaller companies with a consequent improved potential for growth for smaller enterprises, in turn resulting in job and wealth creation together with added choice for investors. In addition the incentive provided for investors due to the attractive exit option which some kind of flotation provides will, in turn, lead to wealth creation in the supply side. Finally, the impetus to create an attractive pan-European market which supports effective competition with US capital markets is also clearly part of the agenda. 
It might be useful to benchmark Ireland against a European country which displays similar characteristics in terms of population, industrial base and so forth and so Denmark is chosen as a comparator. The problems presented by the comparative imperative are considered in the conclusion. In the context of the surveys conducted it is interesting to note that a country like Denmark which is also a member of the European Union and which displays a similar but not identical regulatory framework to Ireland is ranked almost at the bottom for creating an environment which is considered to be conducive to a robust venture capital economy. This would indicate that the factors which effect success or otherwise are detailed in their nature and that many other factors which might be considered significant are not. For example labour market regulation, social security issues, flexibility in product markets, consumer regulation etc.are not immediately significant. The hostile factors outlined by the reports of the European Venture Capital Association include the following, but the order in which they appear has been rearranged in order of significance to the points made in this paper:
- Corporate tax rate of 30% above the overall average of 28.8%, with no special tax rate applicable to SMEs unlike Ireland.
- Income tax rate for individuals of 59% (which include municipal tax rates, which are insignificant in Ireland), the overall European average is 45.3%.
- A high capital gains tax rate of maximum 43% above the overall average of 16.3%.
- No tax incentives for individuals to invest in private equity and venture capital funds.
- There is the possibility for both pension funds and insurance companies to invest in private equity and venture capital but there are quantitive restrictions.
- The cost of establishing a private limited company is significant with costs estimated at €6, 715 well above the European average of €1, 600. Similarly the cost of establishing plc is estimated at the same and this is above the European average of €2,301. Most notably however, unlike both Ireland and the UK a private limited company must be capitalised to the tune of about € 16,500 which is above the overall average of €13,900 but of course in Ireland and the UK there is no minimum capital requirement for private limited companies. The figures for capitalisation of plcs are similar.
- Finally there are no significant investment incentives for R & D capital expenditure or support for collaborative ventures, although there are some fiscal supports for R & D expenses.
Favourable factors which are specifically mentioned include administrative efficiencies in actually establishing and registering companies, the fiscal incentives relating to R & D incentives mentioned above, an efficient insolvency (bankruptcy system) and a supportive taxation system for stock options when underlying stock are sold.
* Irene Lynch Fannon is a graduate of University College Dublin(BCL 1982); Oxford University (BCL 1986, Senior Scholar, Somerville College) and the University of Virginia (Doctor of Juridical Science 1999). She qualified as a Solicitor in Ireland in 1985. She was Head of the Department of Law for the period 1999-2002. She was Dean of the Faculty of Law 2000-2002. She has published various texts, articles and chapters both nationally and internationally on Corporate Law and on Employment and Labor Law, most recently in the area of comparative EU-US corporate governance models. Working Within Two Kinds of Capitalism (Hart, Oxford and Portland, Oregan, 2003).She served on the Audit Review Committee established by the Irish Government following the Public Accounts Committee Enquiry into tax and other corporate financial irregularities.(2000). She was appointed to the Business Regulation Forum established by the Irish government in 2005.
She continues to be involved in research on transatlantic corporate regulation and co-operation and was a Visiting Professor at Cleveland Marshall College of Law in addition to holding the Baker Hostetler Chair at that law school for the academic year 2003/2004.
 ECVA: Benchmarking European Tax and Legal Environments: Indicators of Tax and Legal Environments Favouring the Development of Private Equity and Venture Capital and Entrepreneurship in Europe.(May, 2004).
 Please note that this list replicates the factors which are listed as important by the EVCA. However, references to relevant legislation and explanations are added where appropriate.
 Limited Partnership Act 1907. See also the Investment Limited Partnership Act 1994 which provides a structure for the investment in property.
 Taxes Consolidation Act 1997. Note that these significantly lower than average tax rates or corporations are sustained somewhat controversially, both nationally and internationally with pressure from the European Commission on Ireland to raise rates to a more 'European level'. Accordingly tax on manufacturing and other companies was originally 10% which is still available to certain manufacturing companies but will be phased out by 2010. These are also somewhat controversial domestically when compared with the tax rates on individual income which is much higher at 42% at the highest rate, although this is again lower than the European average of 45.3%
 See Part 16, Section 488-508 of the Taxes Consolidation Act 1997 and Section 18 of the Finance Act 2004 as amended by Section 27 of the Finance Act 2005. See generally details on the BES (Business Expansion Schemes) at www.enterprise-ireland.com/Grow/Finance?Business_Expansion_Scheme.htm Accessed March 9th, 2006. Both the Business Expansion Scheme and the Seed Capital Schemes have been approved by the European Commission. The BES will run until 2006. Similarly, the current Seed Capital Scheme which allows founding shareholders of 'relevant trading operations' as defined in the legislation to reclaim income tax paid in the previous five years on any amounts invested by the individual in a 'qualifying company' where the taxpayer is a full time employee or Director of the company. The scheme is currently described in Sections 488-508 of the Taxes Consolidation Act 1997 and the current scheme is due to expire in December 2006. See futher http://www.enterprise-ireland.com Accessed June 21st, 2006.
 Companies (Amendment) Act 1990. See generally LYNCH, MARSHALL AND O'FERRALL: CORPORATE RESCUE AND INSOLVENCY (1996) Chapters 10 and 11.
Companies Act 1990 and the Company Law Enforcement Act 2001. See further Office of Director of Corporate Enforcment www.odce.org for a description of its activities in particular in relation to the restriction and disqualification of directors of insolvent companies.
 Taxes Consolidation Act 1997.
 However the report notes that changes were made to this structure under the Finance Act 2004. The requirements to encourage R & D will be considered later in this paper.
 See EVCA:Benchmarking European Tax and Legal Environments: Indicators of Tax and Legal Environments Favouring the Development of Private Equity and Venture Capital and Entrepreneurship in Europe. (May, 2004).
Giudici, G and Paleari, S: R & D Financing and Stock Markets in CORPORATE GOVERNANCE, MARKET STRUCTURE AND INNOVATION (CALDERINI, M; GARONNE, P AND SOBRERO, M, EDS. 2003).
 See Companies Act 1990, Part XI as amended by the Financial Intermediaries, Companies, Miscellaneous Provisions Act 2005.
 Gibson-Smith, Chris (Chairman of the London Stock Exchange): Why Europe's Equity Markets Matter FESE Convention 27th May 2005 and AIM for Europe delivered at the Risk Capital Summit October 4th, 2005. See further
 The issue of capitalisation is significant in the European context and will be considered in the next section.
 See further ECVA: Benchmarking European Tax and Legal Environments: Indicators of Tax and Legal Environments Favouring the Development of Private Equity and Venture Capital and Entrepreneurship in Europe. (May, 2004) supra n. p. 17.