ESIC – why these four letters get angel investors excited and what founders need to know about them
Startup investing is risky AF and it’s also very beneficial to the Australian economy so the government has a number of different incentives to encourage it.
Today, we are going to talk about one of these incentives called “Early Stage Innovation Company” (ESIC) which targets angel investors.
If the stars align, then ESIC could mean millions of dollars of extra upside for your investors and considering startup investing is about upside maximisation then this is an important topic.
This article is far from a comprehensive guide to ESIC but rather a practical guide for founders. It covers the main concepts you need to grasp to have an informed conversation with investors.
ESIC is a topic that early-stage founders must understand the basics of because for some investors it really matters and let’s face it, we need all the help we can get when raising capital in Australia.
Firstly, ESIC stands for “Early Stage Innovation Company” and it is used in the tech industry to refer to a tax incentive that the ATO offers to qualifying investors for their qualifying early stage startup investments. (there are a lot of qualifiers for this topic).
Secondly, be kind to yourself when learning this topic, it is difficult, especially if you aren’t a finance person. In my experience, most investors also struggle to grasp the “ESIC” concept.
Thirdly, ESIC is a nice little sweetener for investors, but it is unlikely to be the reason they invest in your company. So, talk about it wisely.
What is ESIC?
So, this term “ESIC” gets thrown around a lot but it is mostly relevant at the Pre-seed and Seed stages as that’s likely the only time a company will qualify as ESIC.
Using the term “ESIC” isn’t actually the correct way to refer to this tax incentive as “ESIC” only refers to the first of three items that must be satisfied in order for “ESIC” to be utilised by investors. So, instead of using the term “ESIC”, from now on I’ll use the term “ESICITI”.
“ESICITI” stands for “Early Stage Innovation Company Investment Tax Incentive”.
So, for an investor to be able to claim their ESICITI there are 3 questions that must all be true which are:
- Company – Is your company an Early Stage Innovation Company?
- Round – Did the investor buy new shares in the company?
- Investor – Does the investor meet a set of criteria?
If your company, the round and investor meet all of the criteria then the investor can claim the tax incentive.
To be clear, this tax incentive can add up to hundreds of thousands of dollars and in some circumstances millions of dollars to each investor so this isn’t something to be snuffed at.
Let’s take a look at each one of these criteria.
Item 1: Company – Is your company an Early Stage Innovation Company?
There is a lot of literature out there on the criteria your company must meet to be considered an Early Stage Innovation Company (ESIC) so I’m going to detail just the main points and then link off to good resources.
According to the ATO, immediately after you issue new shares to investors, your company must satisfy both of the following to be considered ESIC:
- The early stage test; and
- Either:
I’m not going to detail everything but most companies get knocked out straight away from the first test criteria so here are the “early stage test” four criteria:
- The company must have been incorporated or registered in the Australian Business Register
- The company (plus any wholly-owned subsidiaries of the company) must have total expenses of $1 million or less in the previous income year
- The company (plus any wholly-owned subsidiaries of the company) must have assessable income of $200,000 or less in the previous income year
- The company’s equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.
Item 2: Round – Did the investor buy new shares in the company?
This is where it gets interesting because for some reason no one clearly states the obvious for this question and today I’m going to!
The ATO states that “investors must have purchased new shares in a company” which seems simple but many founders get caught out here.
SAFE notes and convertible notes DO NOT qualify because they are notes and not new shares.
Now, this is where it gets tricky, once the notes convert to shares, they DO qualify. Let me explain.
When an investor invests in your company using a SAFE note or convertible note they are at the time of investment only buying a note.
The note details that there are circumstances that mean the note will convert into new shares in your company. There is also an expectation and hope that the notes will convert into shares in your company.
So, if the notes convert into shares in your company then your company must qualify as an Early Stage Innovation Company (ESIC) from part 1 above at that time rather than when the original note investment was completed.
Eg. If I buy $100k of SAFE notes in your company in FY2019 but they convert into shares in your company FY2024 then your company must be ESIC in FY2024 for me to be able to claim ESICITI.
There is a little-known trick that can be inserted into your SAFE and convertible notes that give investors more opportunity to utilise ESICITI. I’ll discuss it in the tips and tricks section further down.
Item 3: Investor – Does the investor meet a set of criteria?
There are a set of criteria that investors must meet in order to be able to claim ESICITI, most you don’t need to worry about as it is up to the investor but there are a few that you should know.
- The investor must be an Australia tax resident so there isn’t much point talking about it to overseas investors but you should definitely ask them if they are Australian tax residents just in case!
- Early stage venture capital funds rarely qualify as they have their own tax incentives called ESVCLP and VCLP which I’ll write an article about one day
- The investor doesn’t hold more than 30% of shares or voting power in your company
- The investor isn’t a public company, listed on the ASX or have more than 50 shareholders
What does this all mean for investors?
If all your company, the round and the investor all meet the criteria then investors unlock the tax incentives! So what are the tax incentives?
There are two advantages of the tax incentive and one disadvantage:
- Advantage 1: Investors get a 20% tax offset on investments (max $200k for Sophisticated Investors and max $10k for retail investors)
- Advantage 2: The investment gets a 10-year exemption on capital gains tax
- Disadvantage 1: Investors can’t claim capital losses on the investment
These incentives can add up to hundreds of thousands of dollars in benefits or more to investors.
If the early investors of Canva could have utilised ESICITI then there likely would be an extra couple of hundred million dollars in it for them!
Given we are talking about tax I decided to mock up two examples to illustrate the impacts of ESICITI for investors when the company performs well and when it doesn’t perform well.
Background to Examples
- An angel investor invested A$100k in FY2018 into Company XYZ Pty Ltd
- Company XYZ Pty Ltd was verified as an Early Stage Investment Company in FY2018
- The investment was to purchase new shares in Company XYZ Pty Ltd
- The angel investor was a ‘Sophisticated Investor’ at the time of investment, is taxed at the highest tax bracket of 45% and claimed the 20% tax offset in FY18.
- We are comparing the outcomes for two types of investors, one that successfully claimed the ESICITI and another that didn’t qualify.
Example 1 – Successful Exit
If investors sold their $100k initial investment for $1m in FY2026 then we can see that an ESICITI investor made a $222,500 higher profit than the investor that didn’t claim ESICITI which is astounding. Below is the worked example.
Example 2 – Company Failed
If the company was unsuccessful in fulfilling its mission and shutdown resulting in investor’s investments being worth nothing then we can see that the non-ESICITI investors only had a marginally better outcome than ESICITI investors of around $2.5k which is due to ESICITI investor not being able to offset capital losses but the $20k tax offset in FY2018 almost entirely covers this issue.
Notes, Tips and Tricks
I’ve seen a lot of different edge cases and scenarios play out over the years which means I have a couple of lessons that you can learn from!
- Be careful what language you use when talking to investors. You don’t want to be seen as giving them tax and investment advice. I’ve seen many investors wrongly interpret ESICITI conversations and then get quite annoyed at the company at tax time when their accountant tells them that the investment isn’t ESICITI. Please talk to your lawyer and accountant for help on crafting verbal and written language to investors.
- Your accountant and lawyer can draft up a letter that you can place in your data room for investors on ESICITI.
- A templated verbal sentence or two might look something like “Based on the ESIC eligibility criteria, we expect that our company and this capital raise will allow eligible investors to claim the tax incentives if you invest in this financial year”. Obviously, if you are raising using a SAFE note then this language will be very different.
- Make sure you get an accountant to assist with verifying that your company and capital raise meet the ESICITI criteria before and after your capital raise.
- Make sure that you report your ESIC eligbility to the ATO during the 31 day window from 1st July until 31st July for the previous financial year. Once you’ve successfully reported to the ATO then provide the outcomes to your investors as evidence so that they can claim ESICITI for that financial year.
- If you are issuing SAFE notes or convertible notes and your company meets the Early Stage Innovation Company criteria (ESIC) then you may want to add an additional clause to your note terms called something like “Optional Conversion Clause” which gives investors the option to convert their note to new shares in your company by the 31st of May each year (I wrote an article on why the 31st of May rather than the 30th of June here). This will cost extra $$ in legal fees to draft up as this is extremely uncommon and there are some complexities to work out to get this right. Some complexities to consider:
- Figuring out what share price the optional conversion would happen at is hard. Is it the last share price? Do you use a formula? Do you need an external valuation which will cost many $$?
- I would also negotiate with investors on a lower conversion discount as this clause creates additional admin on your team, legal and accountant fees and has significant upside for investors (eg. Rather than a 20% discount maybe if they trigger this clause then they only get a 15% discount to account for the additional costs and admin).
- Is this optional conversion clause only valid for say the next 2 financial years because your company is only likely ESIC eligible for this period of time or is it indefinite? If indefinite then its likely investors may use this clause for non-ESICITI related reasons etc.
- ESICITI is likely relevant to DeepTech companies longer than software and FinTech as they don’t generate revenue as fast due to the long initial R&D period.
- Each investment by each investor is separate from each other. Meaning, that your investment round may have 10 investors participating but only 4 of them may qualify for ESICITI which is completely fine.
- The ATO has two decision making tools to help investors and founders determine if they meet the ESICITI criteria.
- You want to skilfully and subtly include in your investor presentation and data room if you company and the cap raise are ESICITI. It isn’t the main event but it is worth knowing for investors that it relates to.
Conclusion
ESIC or ESICITI is important for founders to understand so that you can have informed conversations with investors when raising capital but ensure that you lean on experienced professionals around you to ensure you’ve got it right and are communicating it correctly.
The upside for investors can be tremendous so do what you can to enable them to be rewarded for taking a bet on your company!
* Warwick Donaldson is the founder of CapXcentric. This post first appeared on his Substack, The Aussie Startup Capital Nerd. You can read his capital raising tips and insights here.
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