Investing in safety: the opportunities of venture funds
We have what we have
Institutes of joint investment, in essence, should be one of the drivers of the economy. Fifteen years ago, when the ISI started working in Ukraine, it was assumed that they would stimulate investment activity.
Venture investments were supposed to contribute to the development of high-tech industries, and venture corporate funds were conceived as mechanisms for implementing innovative projects. But nothing happened. At least on a scale that can affect the economy. There is no investment, no developed market for joint investment. On the contrary, the ISI is driven into some kind of not natural framework. Yes, for the investment fund industry, venture investments are mainly characterized. At the same time, one can not say that these investments are directed to some innovative projects. Just for the investment capital of other “working” mechanisms there. There is nothing to choose from. Open diversified funds are not viable today, given the existing market infrastructure. The industry is regulated. Constantly changing laws, by-laws, reporting forms, often delay the process of registration of the CIF and Mutual Fund, violating or even disrupting the schedules of an investment project. And the registration of the CIF or Mutual Fund, in most cases, is necessary for the so-called legitimate tax optimization. However, many other functions of ISI, which could make a business more efficient, are not used.
The Ukrainian ISI market is fundamentally different from the market in civilized countries. Regulators all over the world are trying to create conditions for the development of all types of ISI – open, closed, venture, etc. The volume of investment in open-end funds is approximately equal to the volume of investment in closed-end funds. More information about the European investment funds can be found here. For example, a European investor has the opportunity to choose from a large number of investment strategies, while a one-sided Ukrainian market does not provide such a choice.
Speculative country credit rating, corruption, political instability, imperfect and constantly changing legislation are a barrier for large investors. At the same time, using ISI for optimization purposes leads to a loss of budgetary funds and, in general, does not contribute to economic growth. However, the main goal of the ISI should not be tax optimization. If the companies understood and learned to use those tools that are incorporated in the legal mechanisms of the ISI, it would help significantly reduce the main risks. And, as a result, increased the efficiency of business, which, on the contrary, began to pay more taxes.
Protection of the investor is the work of the investor himself
Legal chaos and raiding keep many foreign investors from investing in Ukraine. Despite all the problems that arise or may arise in business in Ukraine, it is the functionality of the ISI that contains a number of mechanisms that can protect the investor and his investment. The protection of property rights and the protection of corporate rights are paramount. The reforms that have been carried out in Ukraine recently have worsened the situation. In 2015, the centralized state registration service was reformed. The desire to simplify registration procedures for business has turned into an enormous problem. Since 2016, notaries and state registrars of local governments have been given the right to make changes to state registers. An open electronic register of property rights for real estate began to work. There was an opportunity to make changes to the Unified State Register of Legal Entities and FOP (for the USR) without a notarized certification of title documents. Over the past two years, a lot of cases of illegal re-registration of corporate rights and alienation of property rights on the basis of forged documents have been recorded. Including on the basis of obviously unlawful judgments. Raiders received a new and very convenient tool for capturing enterprises and companies. The owner of the business, who created it all his life, can lose it within five minutes. At the end of 2016, changes were made in the legislation, which complicated the task of the raiders. However, despite all the efforts of the Ministry of Justice of Ukraine, the risks of making illegal changes to the registers by notaries and state registrars remain high. Only the investor can protect himself.
Main protection strategy
The dangers of unlawful alienation of business can be avoided by consolidating fixed assets in a corporate investment fund.
How does this happen. The funds of the CIF, which are attracted from the issue of shares, are invested in the fixed assets of the production (or commercial) enterprise: commercial real estate, equipment, transport and other assets. More details on the procedure for issuing shares are available in article “Procedure for the issue of shares of the CIF”. Fixed assets become an asset of the CIF. The owners (beneficiaries) of this business may own the shares of the CIF. The situation of the so-called change of the nominal owner is possible, when the authorized shareholders of the final beneficiary become shareholders of the CIF. Or, direct investment of funds in the CIF can be carried out – the ultimate beneficiary personally becomes a shareholder. Moreover, he can be the sole shareholder, and serve as chairman of the Supervisory Board.
Let’s take a hypothetical example (see Fig. 1). “Romashka” produces perfumes. The enterprise has a production and storage room, equipment, transport. The CIF created “Field Flowers” invests money in these assets. The money was transferred to the CIF by the beneficiary of “Romashka” LLC. With this money, the authorized capital of the CIF was formed, and in return the beneficiary received shares of the CIF.
Now legally the main assets on which the production and commercial activities of the “Romashka” LLC are built will be owned by the “Field Flowers” CIF. However, the shareholders (the beneficiary himself or his authorized representatives) have the opportunity to manage and control the activities of the CIF, and, accordingly, the activities of Romashka, through such bodies as the supervisory board and the shareholders’ meeting. Between the “Romashka” and the “Field Flowers” CIF, a lease of fixed assets is concluded. The company pays the rent of the CIF, while no changes are taking place with the production activity itself. “Camomile” continues to produce perfume in the same place and at the same production facilities as before. For beneficiaries of “Romashka”, CIF “Field Flowers” becomes an instrument for managing production assets and other fixed assets.
Now the attempt of the raider’s seizure of “Romashka”, by making any illegal changes to the state registers, loses its meaning, since the fixed assets of the production enterprises are not in their ownership. Getting control over the CIF, which is a joint stock company, is too expensive and time consuming for the raider.
The model of the protection of fixed assets with the help of the CIF assumes, as it were, two levels of protection. The first level is a high degree of protection of the rights of the shareholder and is based on the joint-stock organizational and legal form of the fund. All decisions on fund management are taken by the Supervisory Board and the shareholders’ meeting. Control over the register of shareholders is carried out by depository institutions. We must immediately say the legal basis for the creation and operation of the CIF exclude the possibility of its acquisition by raiders through illegal decisions through the Supervisory Board or the shareholders’ meeting.
To conduct any decision through the management bodies of the CIF raider, it is necessary to become its shareholder: either to seize shares of legitimate shareholders, or to try to enter into the share capital at the stage of additional issue of shares. This is impossible, since when registering the issue of a venture capital fund in the prospectus, all future participants of the fund and their shares in the share capital are clearly identified. There can not be undesirable participants here. Trying to make some decisions that are contrary to the interests of shareholders, through the Nabsovet, which consists of representatives of a legitimate beneficiary, also seems unlikely. Moreover, if the structure of the CIF is organized for the purpose of protecting the core assets of the production group.
The only way for the raider to somehow force the custodian of the securities of the CIF to re-register the shares from the account of the legal owner, to another account in securities is the account of an accomplice in the raider attack. Precedents of bribing custodians, theft of equipment and information in depositary institutions took place. This is theoretically possible with shares of classic AO, but there have not been any precedents for the capture of the CIF. Because even swapping shares from one account to another raider can not do anything with them. Here we are talking about the second level – the protection of the fund’s assets. The CIF has a complex structure for making corporate decisions. In the decision-making on certain actions with assets, several entities that serve the activities of the CIF participate: AMC, custodian, valuer (in the case of real estate). Even if we assume that a raider attack on securities of the shareholders of the CIF is completed, in order to complete all illegal actions, the raider needs another confirmation from AMC, which manages its assets. Needless to say, that if AMC at least how much it values its reputation, it will not contribute to the actions of the raiders. Given all the circumstances, the raider attack on the KIF, in which the assets of a certain production group are consolidated, seems unlikely and very difficult.
But on the other hand
The transfer of fixed assets to the CIF will help protect the business from yet another problem – undue pressure from the fiscal authorities. It is quite easy for tax agents to block the work of an enterprise – to arrest accounts, to count tax debt and the like. The entrepreneur can go to court, and try to recognize the tax authorities’ decision as illegal. Since the trial can last for months, if not years, there is a risk of losing business. To leave the situation with the least losses is possible if the fixed assets of the enterprise are on the balance sheet of the CIF and the company rents them from the fund. Let’s return to our example. In this case, the CIF “Field Flowers” terminates the lease agreement with Romashka LLC, to which the fiscal service has blocked the activity. But then he signs an agreement with Romashka Plus, which continues to produce perfume.
Well illustrates the possibilities of the KIF model of real estate management. The main means in this case is commercial real estate, which is consolidated in the CIF. The funds of the CIF, attracted from the issue of shares, are invested in this real estate as an asset. The ownership of commercial real estate passes to the CIF. A property owner or his authorized persons become shareholders of the CIF. Tenants use real estate on the basis of a lease agreement, which is concluded with the CIF. The rent is transferred to the account of the CIF, which is opened by AMC on behalf of the CIF. By the way, raider capture of such a structure will be quite a challenge. The lease agreement protects the ultimate owner from various legal risks, while opening up opportunities for more effective tax planning. The profit that accumulates in the CIF is not subject to income tax and can be reinvested into new projects.
The next opportunity that many companies miss is effective management of the organization’s cash. If there are many companies in the business group, then the corporate investment fund can be a good mechanism for their financing. The legislation regulating the activities of the ICI provides for the venture CIF to provide interest and interest-free loans to the participants of the fund, provided that the CIF owns at least 10% of the authorized capital of the relevant legal entity.
The group will be able to transfer funds from one company to another without tax consequences. If an interest-bearing loan is granted, the borrower includes the interest that will need to be paid to the CIF for the use of borrowed funds in its expenses. The profit tax on the amount of debt servicing will not be accrued. In turn, the CIF is also exempt from the payment of income tax from the interest received. Thus, the group can actually lend to individual units, saving working capital.
To summarize, the use of the listed legal mechanisms will help companies not only to protect themselves from problems, but also to develop. In seeking investments for the development of their business, the fact that a developing company has a well-thought-out system of protection against various risks may not be the last argument for a potential investor. The chances of attracting investments are rising.