Saturday, December 17, 2011

Owen McShane: Why We Must Learn to Love Asset Sales ... part one

There is a general consensus that New Zealand must develop more innovative and internationally oriented businesses. Innovation is a prime driver of economic development and can also support higher wages. Yet the election campaign has further locked in place a set of beliefs that deprive innovative companies of the capital they need to fund their forays into international markets.

The campaign promoted wide-ranging capital gains taxes and promoted “No Asset Sales.” Capital gains taxes can be a serious disincentive for venture capital investors because they can make it more difficult to achieve the targeted rates of return required by investors. We should avoid imposing fines for success.

High capital gains tax rates also tend to lock in early original investors because exiting from successful investments can realize a capital gain and incur a tax liability.

Smaller venture capital funds specialize in start-ups and must be able to sell down their shareholding to allow the company to receive investments from larger funds specializing in mezzanine finance. They in turn exit by promoting IPOs which allow the company to attract funding from the widest pool of investors.

Venture capitalists have been recycling their funds for years.

Professor Brophy of the University of Michigan argues that a robust venture capital industry requires the following:
1.     A low or zero capital gains tax. (Tick)
2.     A low cost IPO board. By US standards our NZX is a low cost board. (Tick)
3.     A Prudent Manager Rule. This allows pension funds and the like to invest a prudent percentage of their funds in risk ventures. We now have this rule but it has been interpreted as a Rule requiring fund managers to be super-cautious. (Semi-tick.)
4.     Special or Limited Partnerships. (Tick)

New Zealand, like many agricultural economies, allowed “special partnerships” and Strada used them to become the world’s largest financier of musicals, starting with their investments in CATS. (Tick)

So, four ticks and we should be in. However, the business culture is equally important.

Sadly, the “No Asset Sales” campaign has seriously impeded the development of an entrepreneurial and risk management culture by making false claims preying on public ignorance. Our so-called “expert commentators” failed to explain why partial asset sales are a vital tool for funding the growth of any business, whether in public or private ownership.

Back in the late seventies it was hard work explaining that an entry into the US market with high value innovative products needed an American partner to provide both knowledge of the local market, and the financial grunt to defend the patents, copyrights or trademarks – insofar as they existed at all.

The N.Z. entrepreneurs would all too often consult with some “expert” who would say “But you will have to share your profits with Burroughs, or IBM, and furthermore, they only have 25% market share”. How lone New Zealanders, with virtually no capital, working out of a spare bedroom, thought they could take a 25% market share away from a multinational giant without generating a counter attack, was beyond me.

It gave me no pleasure to watch them go broke.

Then there was the cultural reluctance to sell shares in return for new investment. Many had borrowed against the house to provide the seed capital and were prepared to borrow against a second mortgage rather than sell a minority share in return for equity. “No Asset Sales” was already deeply embedded in their minds.

Venture Capital investors want to see their funds put to good use growing the company rather than paying interest. Many hopeful clients were dismayed to find that venture capital investors were not in the business of providing equity to pay off personal debts rather than grow the business.

This is what seed funding, venture capital, mezzanine financing, and investment banking is about. The aim is to finance the growth of the business at a rate that more than compensates the existing parties for their reduced share of the total equity. We used to say “10% of an elephant is better than 100% of a mouse.”

What surprised me about the “No Asset Sales” campaign was the weakness of the defense.

The so-called financial analysis consistently asked whether reduced interest bills resulting from partial asset sales and the repayment of debt could compensate for the “lost” dividend stream.

The “consensus” seemed to be that any financial benefits were outweighed by the loss of companies that the taxpayers already owned, and by claims that the dividends were lost forever, and could never be bought back – all very appealing to the latent Marxists among us.

Theses analysts also seemed to overlook the difference between the risk associated with a dividend stream compared to interest payments.

There is of course a third revenue stream to consider. The revenue stream from taxation explains why many Governments are prepared to forego some taxes on the capital gains from partial asset sales in new ventures.

The Government claims 28% of all pre-tax profits from every company in New Zealand. Company taxes are paid prior to any distributions based on shareholding.

Partial privatizations as such, have no impact on these pre-tax claims by Inland Revenue. The investors’ aim is to grow the company, and sensible governments know that rapidly growing companies can increase government revenues.

Mighty River Power, which is presumed to be the first SOE “off the block” provides a useful case study.

Last year the Group’s total after-tax profit distributed to the government as the sole shareholder was $110 million.

Selling 49% of the shareholding to private investors would reduce this dividend by $54 million.

However, the taxpayers of New Zealand continue to be compensated for their past “investment” in Mighty River Power by Government’s claim on company tax. The pre-tax profit is $185 million and the Government 28% tax-take (ignoring imputation) will be $52 million per annum, about the same as the “lost” dividend.

The Government also collects all the income tax paid by their 725 staff. Then there is the GST paid by the staff, their dependents, and their customers.

Consequently, many Governments are prepared to waive the revenue from a capital gains tax on new ventures. The long term benefits of growth and expansion into international markets can far outweigh any early costs.

How much tax has been paid by Intel, Microsoft, and Apple?
To be continued...

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