Forming technology start-ups

When an inventor and a financier team up to develop further and commercialise an invention, the parties can do so through either a joint ownership agreement or a joint venture vehicle – typically a new company.

Joint ownership agreements are generally impractical and provide insufficient mechanisms for dispute resolution. Commercialisation through a new commercialisation company is preferred, provided forecast earnings are sufficient to offset the addition cost of forming and maintaining such company.

The reality is that technology start-ups are notorious for passing through numerous financing rounds. When funds have been exhausted (and the commercialisation company is liquidated), new funding is difficult to raise unless the technology is first “dusted off”, i.e. the rights of the previous funders are largely removed.

As such, most technology start-ups have historically been structured as follows

Should the arrangement fail, NewCo will be liquidated with full dominium in the IP reverting to the Inventor, who will thereafter be free to conclude similar arrangements with new funders.

Clearly, the licence and subscription for shares by the Inventor constitutes a composite transaction / package deal (i.e. each leg is conditional upon the other leg being concluded and should therefore be viewed as a single transaction in law). As such, the Inventor grants NewCo a licence in consideration for a “license fee” calculated at ([value of shares in NewCo received by the Inventor] – [amount paid for such shares]). The fact that the licence makes no mention of license fees or other royalty payments, or even specifically states that the licence is granted “royalty-free” is irrelevant, as the doctrine of Substance over Form prevails.

Example: Assuming that Funder capitalises NewCo by acquiring 70% shares in NewCo for R10m and the Inventor pays R1000 for his 30% shareholding, the “license fee” received by the Inventor is valued at (30/70 x R10m), or R4.3m.

Even if the funder extends an interest-free loan to NewCo, repayable out of distributable profits, after accounting for the discount rate attributable to NewCo (which is seldom less than 35%), the “value” of the loan (i.e. the present value of the discounted interest rate, compounded over the life of the loan) will typically mirror the amount of the loan capital. It is incorrect to conclude that the assets match the liabilities and that the Net Asset Value of NewCo is therefore zero.

Applying fundamental tax principles, the R4.3m upfront license fee is capital in nature, provided the Inventor “completely and permanently divested himself of rights in the IP”. Unfortunately, this principle is overridden by “little known” paragraphs (g)(iii) and (gA) of the Gross Income definition in our Income Tax Act:

Gross Income in relation to any year or period of assessment, means,

g) any amount received or accrued from another person, as premium or like consideration–

.iii) for the use or right of use of any patent as defined in the Patents Act, 1978 (Act No. 57 of 1978), or any design as defined in the Designs Act, 1993 (Act No. 195 of 1993), or any trade mark as defined in the Trade Marks Act, 1993 (Act No. 194 of 1993), or any copyright as defined in the Copyright Act, 1978 (Act No. 98 of 1978), or any model, pattern, plan, formula or process or any other property or right of a similar nature;

gA) any amount received or accrued from another person as consideration (or payment of like nature) for the imparting of or the undertaking to impart any scientific, technical, industrial or commercial knowledge or information, or for the rendering of or the undertaking to render any assistance or service in connection with the application or utilization of such knowledge or information;

In other words, the R4.3m will be included into the Inventor’s gross income in the year in which the shares are received / accrue and subject to tax at a rate of 40%, yielding a tax liability of up to R1.7m.

This significant tax liability could easily be reduced to nothing by merely concluding the transaction in terms of the Corporate Rules in our Income Tax Act (e.g. s42 “Company Formation”). However, this would generally require the Inventor to assign the IP to NewCo, exposing the IP to liquidation risk. Mechanisms that reverts ownership in the IP to the Inventor in certain instances (e.g. insolvency of NewCo) should be mindful of creditor protection provisions in our insolvency law (e.g. voidable transactions). In addition, such mechanisms could easily undermine the true nature of the original “sale”, and consequently the proper application of the Corporate Rules.

For similar reasons, the value of any shares given to a third party for contributing ongoing know-how / services / R&D activities to NewCo will be included into the gross income of that party and subject to tax – consider: (a) managing directors / technical personnel providing services to tech start-ups in consideration for acquiring discounted shares in the start-up; (b) IP attorneys acquiring shares in tech start-ups in consideration for providing discounted patenting services.

Unfortunately, the above flawed company formation transaction is extremely common. In fact, one could even say that it represents “the standard” … and the unexpected tax consequences are typically irreversible.

Leave a Reply