Your Taxes: Financing your business with your eyes open

A modern Western business must apply capitalist principles and operate efficiently according to its chosen strategy.

taxes good 88 (photo credit: )
taxes good 88
(photo credit: )
Adam Smith wrote in The Wealth of Nations in 1776 that the four factors of production are land, labor, capital and enterprise. This remains true today, with hardly any adaptations for any business. These are the elements of capitalism. Capitalism has had its ups and downs, but the alternative concept - communism - collapsed with the Berlin Wall in 1989. Communism survives in a few places, such as Cuba, where people still drive around in cars from the 1950s. A modern Western business must apply capitalist principles and operate efficiently according to its chosen strategy. Every day we see Israeli companies with excellent prospects and chances of success if they follow these principles. What about fundraising? Capital means money for operations. Companies large and small need finance just as a car needs gasoline to run. At the research and development (R&D) stage, the planned product may be a world-beater in a few years time, but salaries and expenses must be paid immediately if we are to all live. This requires share capital. Loans may be hard to obtain if there is no income yet to repay them. And finding equity investors is not easy at that stage. Once sales revenues begin, losses from the R&D stage must be recouped. The clients take time to pay. And when the clients do pay, some money must be reinvested in advertising, trade shows, more R&D and so forth. When raising funds, you must prepare a business plan with a budget that takes ALL the above financial needs into account and any others specific to your business. Typically, fundraising is done in several rounds. This is because not all the money needed may be raised in one round. Many investors may want to see the company successfully achieve milestones (R&D progress, revenue progress, etc.) before committing more money. Who are the investors? Investors include: founders; their families and friends; angel investors (private wealthy individuals); venture capital/private-equity funds; institutional investors (pension, savings and mutual funds); the government (e.g. R&D grants from the Chief Scientist's Office and Israel's binational funds; fixed-asset grants from the Investment Center); large companies that need your product; employees, i.e. stock options or purchase plans to retain and incentivize good employees; the public, if you raise money on a stock exchange in Israel, the US, London, Toronto, etc. What do investors look for? Investors look for good companies that seem likely to generate dividends and/or capital gains in the medium term - typically (not always) in the next three to five years. More specifically, investors typically expect a company to have all of the following: • A good product with unique features; • Scientifically proven, i.e. the product works well; • In a hi-tech company, good, well-protected intellectual property; • Good demand for your product from sufficient paying customers. This signifies profitability and also helps to show that the technology works; • Good management: CEO, CFO, CTO, etc.; • A business plan setting forth a clear concise strategy for profit; • A well-thought-out marketing strategy and business model (see below); • Clear presentation of the company by its senior management. A great strategy is worthless if investors don't understand what the senior management is saying to them; • Sales revenues, or at least sales contracts or other solid commitments; • In practice, in a small country like Israel, most sales will need to come from international markets. Have you planned for this? • Stable skilled employees; • All necessary regulatory approvals; • Follow-up products, applications or markets in the pipeline; • No haggling over fundraising terms. What finance terms are reasonable? Typically, for a private finance round, assume 4 percent to 6% of capital raised in cash plus 4%-6% in options/warrants. This has to be carefully structured to avoid unnecessary VAT (16.5% in Israel from July 1, 2009). What about loss of control? If you accept outside investors, their capital will dilute the founders but will hopefully increase the overall cake to be shared out later. The founders will generally NOT lose control over the business, as they are needed to run it; most investors are passive investors just bringing much-needed money to the table. A few will be strategic investors who can open important doors to customers, etc. What about the business model? Investors want the business model of a hi-tech company to be well-thought-out to translate the general strategy into practice. Here are a few elements to consider: • The marketing strategy: How will you find customers? • What will be your pricing policy? • Is it easier to license the IP to third parties for a royalty or franchise fee? What about withholding taxes on these? • What will be your optimal supply chain? Which company(ies) in the group will purchase raw materials, hire labor, process, distribute and sell to customers? • Where will you establish companies? Remember that American customers prefer to buy from Americans, Japanese prefer to buy from Japanese, etc. • How will international operations be managed? • Which company will own the intellectual property? How will it conduct R&D? How will it make the IP available to other companies? • Which company will manage business risks and how? Do you have a well-plannedinternational tax strategy? Most Israeli hi-tech companies expect other countries' tax authorities to share in their Israeli R&D-related losses - but they won't. Most Israeli companies fail to check out withholding taxes and VAT or sales tax on their revenues even if they are not yet in profit. The current generation of Israeli tax breaks is worth checking out. Also needed is a transfer pricing policy; tax authorities around the world (including Israel) require related companies to conduct transactions between themselves on arm's-length, market-based terms. This requires a transfer-pricing study and is an opportunity for tax planning. As always, consult experienced advisers in each country at an early stage in specific cases. With grateful thanks to Barry Plotkin and Norman Freedman of MA Ventures, who reviewed this article and contributed comments. Leon Harris is an international tax specialist and director of MA Ventures.