CN&CO is involved in many aspects of the financial services industry, we often come across useful and informative articles that we believe our friends and partners will be interested in reading. This piece is by James Twidale, a Portfolio Manager at Virtuosity Capital.

Collectively, small and medium enterprises (SMEs) account for a significant proportion of South Africa’s GDP growth and employment. According to the Banking Association of South Africa website, “SMEs have been identified as productive drivers of inclusive economic growth and development in South Africa and around the world. Some researchers have estimated that, in South Africa, SMEs make up 91% of formalised businesses, provide employment to about 60% of the labour force and total economic output accounts for roughly 34% of GDP.” They also provide an important link in the chain from microenterprise to large companies. SMEs can reach under-served markets, especially in rural communities and impoverished urban areas that lack the infrastructure necessary to support larger scale public or private sector business activity. In addition, a more developed SME sector can provide support for the overall business and civil society climate, increasing the overall health of our economy.

Recognising the potential and the need to encourage the private sector to invest more proactively in SMEs, Treasury and SARS together created an incentive in 2009 for South African tax payers (individuals, companies and trusts) to invest into certain categories of SMEs.

The incentive was written into the Income Tax Act under Section 12(J) and was designed to incentivise investment from private taxpayers into qualifying SMEs through authorised Venture Capital Companies (VCCs). These investments are given a tax deduction in the year that they are made, based on the size of their investment and their current tax position.

The challenge with investing in SMEs is that investors need to make informed investment decisions, which require specialist expertise. Investing in SMEs through authorised VCCs is risky, many SMEs are unproven, and often don’t have the scale to mitigate the risks they face. Many don’t succeed or stand the test of time. From an investment point of view, they can be difficult to evaluate and value, as the information about them can be limited or provided from a single (and possibly less objective) source. One also may not have the necessary insight into the industry in which they operate or the business model that is necessary for success.

To find sustainable growth and income opportunities that support the economy and your personal investment portfolio – while managing the level of risk you are exposed to – is best done by a professional and someone who specialises in conducting research in the VCCs environment. Investment specialists spend considerable time and resources researching, filtering and risk-profiling the range of venture capital opportunities and learning how best to navigate this area of investing. We believe that your investments in SMEs should be managed by a range of venture capital investment managers whose expertise and full-time job it is to assess and screen businesses against a range of criteria that include sustainability, risk and potential returns.

There are three key areas where investors can harness the potential of investing in SMEs, by using the Section 12J incentive to their advantage. 

Take advantage of an up to 45% tax break
With S12J investing, the full amount invested is 100% deductible from your taxable income in the year in which the investment is made – this applies to individuals, companies and trusts. An individual investor who pays tax at the maximum marginal rate can therefore get a tax break of up to 45% for this tax year.

Maintain the discipline of a long-term view
It is well known and documented that buying an investment and holding it through the short-term ups and downs of market cycles is the secret to investment success. However, we are all, as investors, negatively influenced by the latest headlines and news. Instead of being discouraged by headlines of low growth, rather make a proactive decision to invest back into South Africa’s economy. The only condition associated with the S12J tax break is that you must maintain the investment for at least five years. This provides an added incentive to ensure that when you choose to invest, you make a well-considered, long-term decision with the portion of your portfolio that you shouldn’t need to liquidate within five years.

Make sure that you don’t invest in one SME but in many
While this may sound counterintuitive, it is about the basic adage of not putting all your eggs in one basket. If you have ever considered investing in a SME to benefit from exciting return potential, then you really should consider the benefits of a diversified portfolio of such companies.

As an investor, I encourage you to make an informed decision, get professional advice before making the jump and investing in an SME. The Section 12J investment incentive provides investors with an exciting opportunity to contribute to South Africa’s economic growth by supporting small businesses while benefiting from the rapid growth potential.