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Brussels, 19th July 2006

State aid: Guidelines on state aid to promote risk capital investment in SMEs – frequently asked questions

(see also IP/06/1015)

What are the differences between the new Guidelines and the Communication on State aid and risk capital of 2001?

The two most important differences are: first, the two phase procedure allowing for a detailed assessment of schemes that do not fulfil certain criteria. Second, the increase to €1.5 million of the investment amount for which the Commission considers that there is a general market failure in all Member States. The experience gained through the application of the 2001 Communication has also led to a number of smaller modifications and clarifications. For instance, alternative market places are now specifically mentioned, the interpretation of words like “significant” has been specified to mean a certain percentage in accordance with the current practice and issues related to the presence of aid have been clarified.

What is risk capital?

Risk capital is financing in the form of equity or quasi equity (as opposed to debt) to companies in their early growth stages, including informal investment by business angels, venture capital and alternative stock markets specialised in SMEs including high growth companies. In the assessment of whether a type of financing is quasi equity or debt, the Commission is not bound by the Member States’ classification of the instrument but will apply a substance over form approach. In short, financing is considered to be quasi equity and not debt if the remuneration is based on profits and losses. The level of subordination in case of bankruptcy compared to debt finance will also be taken into account.

What type of instruments fall under the risk capital guidelines?

The most common instrument is an investment fund, which finances SMEs through funding provided by the state together with private investors. The latter are usually granted certain advantages in order to attract their capital. The guidelines list a number of aid instruments considered effective to leverage private investors’ capital: venture capital funds, fiscal incentives to investors or investment funds, and other financial instruments conferring an advantage to private investors or funds. State guarantees linked to risk capital investments fall within the RCG if the potential losses are limited to 50% of the nominal amount of the investment guaranteed.

Why can’t the State invest in companies without being subject to state aid rules?

Member States can invest in companies without being subject to state aid rules, if they do it under the same conditions as a private investor, if the terms would be acceptable to a normal private investor in the absence of the public intervention and if a certain proportion (normally 50%) of the investment is provided by independent private investors. When these conditions are not fulfilled, the state funding constitutes an advantage for the beneficiaries, which the other actors on the market have not received. This can create a distortion of competition and the state aid rules will apply in order to ensure that the distortion is not contrary to the common market.

If aid is granted to investors will this aid be passed on to the SMEs?

In risk capital schemes, state aid can be present at three levels: (i) the private investors, (ii) the investment vehicle or investment fund or its management and (iii) the target SMEs. The guidelines explain under which conditions aid is present at each of these levels: Normally, if there is aid at the level of the investors or the investment fund, this is considered to be at least partly passed on to the SMEs.

What is the main targeted market failure?

The main targeted market failure is asymmetric or imperfect information affecting young, innovative start-ups. Asymmetric or imperfect information may notably result in high transaction costs to scrutinise potential investment targets, which often make it unprofitable to pursue smaller-size deals. The ensuing ‘market failure’ results in an ‘equity gap’ constituted by the difference between the supply of risk capital and the demand for such funding by SMEs at an acceptable price for investors and target companies. The equity gap particularly affects SMEs in their early stages of growth.

Why does the Commission only allow investment amounts up to €1.5 million?

First of all, there is a possibility to authorise higher amounts subject to a detailed assessment. Second, the new safe-harbour level of € 1.5m over 12 months represents an increase of 50% as compared to the 2001 Communication on state aid and risk capital . This new threshold is deemed to reflect adequately the current level of the equity gap in the EU and the situation of the venture capital market. It is based on the Commission’s experience and practice, the comments received in the public consultation, and the findings of a study carried out by an external consultant. For higher amounts a market failure does not always exist and if there is no market failure, state aid is not justified since it will only harm the functioning of the market. Therefore, for higher amounts, the Commission will require evidence that a market failure exists.

What is the link between the State Aid Action Plan and these guidelines?

The aim of the State Aid Action Plan was to present a comprehensive and consistent reform package based on the following elements:

– less and better targeted state aid

– a refined economic approach

– more effective procedures, better enforcement, higher predictability and enhanced transparency.

The Commission has carefully chosen the conditions for the less detailed assessment to ensure that a measure always targets a market failure and that the distortion of competition will be kept to a minimum. The Guidelines are based on a so-called ‘balancing test’, which weighs against each other the positive elements of risk capital measures (e.g. in terms of economic growth and job creation) and their negative elements (e.g. the crowding-out of private investors and distortion of competition). For measures which do not fulfil a number of conditions the Commission will make a detailed economic assessment. The distinction between a less detailed assessment and a detailed assessment ensures that the assessment will be more proportional to the potential distortion. Finally, based on the experience with the Communication on state aid and risk capital from 2001, a number of issues have been clarified.

Why is there a reduction in aid intensities when risk capital aid is cumulated with other types of aid?

In accordance with the objective to encourage research, development and innovation the Commission allows full cumulation between measures in this field and risk capital measures. However, for other types of aid measures, the aid intensity must be reduced during the first three years of the first risk capital investment and up to the total amount received. This is important to ensure that enterprises are not flooded with different types of aid serving the same purpose. Allowing full cumulation with all types of aid poses a risk that the aid amount will be even higher than the expenses in the company.

Is there a regional dimension in the Risk Capital Guidelines?

There is a regional dimension in the Guidelines when this is considered to be economically justified. The Guidelines for example require less private participation in assisted areas (30% vs. 50% in general). The Guidelines also maintain the possibility to invest in medium-sized enterprises beyond the early stages up to the expansion stage, and allow increased subordination for the state. However, the new investment threshold is not higher in assisted areas than in non-assisted areas, because there is no economic evidence that the size of the investment amounts not covered by the market is linked to the level of regional development.

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