A Q&A guide to venture capital law in Sweden.
The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.
For a full list of recommended venture capital lawyers and law firms, see PLC Which lawyer?
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This Q&A is part of the PLC multi-jurisdictional guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-mjg.
Venture capital refers to the equity investments in the early phases of the company, that is, seed, start-up or expansion phases. Private equity refers to equity investments in unlisted companies with an active ownership.
The following figures are based on information from the Swedish Private Equity and Venture Capital Association (SVCA).
In 2010, 47% of the funding of venture capital came from the public sector. 31% of the investments came from corporate investors and 9% from funds of funds. Private investors are among other contributors.
The investment distribution in different phases was (the figures in the brackets refer to 2009):
Investment in seed: SEK53 (70) million (as at 1 November 2011, US$1 was about SEK6.4).
Investment in start-up: SEK1,319 (1,462) million.
Investment in expansion: SEK1,291 (1,455) million.
The investment distribution by sector was as follows:
Computer and consumer electronics: 37%.
Life sciences: 22%.
Communication: 14%.
Energy and environment: 11%.
The amounts invested in venture capital decreased by 11% in 2010 compared to 2009. Without the increased flow of foreign private equity, the decrease has been even more apparent. The Swedish venture market will need to work hard to attract investors who, to a great extent, seek less risky assets.
The public sector is the primary source of venture capital for emerging companies in the early phases and this trend is increasing fast.
See Question 9 and Question 3, Interest.
There are no special tax incentive schemes for investments in venture capital companies. Such investments fall under the general application of tax legislation.
In principle, the general corporate tax rate of 26.3% applies to a company's worldwide business income, including capital income. However, there are several exemptions regarding capital gains and income from dividends.
A foreign resident's sale of shares in a Swedish limited company or partnership is not subject to taxation in Sweden.
For Swedish corporate holders, capital gains from the sale of non-quoted shares are exempt from taxation, regardless of the size or duration of the holding. Losses on unquoted shares are not deductible.
Individuals resident in Sweden holding non-quoted shares are subject to capital gains tax at a reduced rate of 25% (normal rate is 30%).
Dividends on non-quoted shares of a Swedish limited company distributed to foreign holders are generally subject to a withholding tax of 30%. However, the tax rate is normally reduced to 0% to 15% under applicable double taxation treaties.
Dividends on non-quoted shares of a Swedish limited company or a corresponding company resident in another EU state received by a Swedish holder are generally tax free, regardless of the size or duration of the holding.
Dividends paid to shareholders resident in another EU state are exempt from withholding tax if the holding amounts to at least 10% of the share capital, and fulfils the requirements in Directive 90/435/EEC on the taxation of parent companies and subsidiaries (Parent-Subsidiary Directive).
Dividends on a non-quoted Swedish limited company paid to a non-resident corporate holder, comparable to a legitimate Swedish legal entity, are exempt from Swedish withholding tax.
Interest expenses paid by Swedish corporations are generally deductible as long as they relate to loans used in the company's business, including the acquisition of shares.
There are no thin capitalisation rules. Interest payments from a Swedish company to a foreign creditor are subject to the arm's-length principle.
Since 2009, the right to deduct interest payments to affiliated non-resident companies is restricted under certain circumstances. A Swedish enterprise cannot deduct interest expenses relating to a debt to an associated enterprise, to the extent that the debt relates to an acquisition of shares or other participations from another affiliated enterprise. The restriction does not apply if either:
The income corresponding to the interest expense is subject to taxation of at least 10% in the resident state of the beneficiary of the interest.
The acquisition as well as the debt are mainly motivated by business reasons (other than tax reasons).
The Swedish government has announced that legislation imposing further restrictions on the deductibility of interest payments from Swedish companies to foreign receivers would be introduced in 2012 or 2013.
The different types of venture capital funds are the:
Institutional venture capital funds.
Corporate venture capital funds.
Institutional venture capital funds typically receive funding from financial institutions, that is, large companies, pension funds, insurance companies, banks and other financial institutions. Corporate venture capital funds typically receive their funds internally.
In most cases, funds are bound by restrictions imposed by provisions in their articles of association or by their contractual arrangements with their investors. Such restrictions limit the funds in relation to the kind of investments that the fund can make, such as restrictions concerning business areas, amounts invested, and proportion of equity and debt.
It is becoming more common to syndicate investments between several venture capital investors. In some cases, funds do not invest unless there is at least one more investor participating.
The Swedish entity that is most commonly used is the Swedish limited liability company. If some of the investors are residing abroad, a foreign limited partnership may instead be used.
Relatively recent changes in tax laws and in the Companies Act have made it possible to use Swedish private limited liability companies as venture capital funds. This entity is today the only Swedish structure that could attract both Swedish and foreign investors to invest in the same fund vehicle.
Swedish limited partnerships cannot normally be used as venture capital funds, since Swedish investors (unless tax exempt) and foreign investors will be taxed on the income derived from the limited partnership.
The most common objective of venture capital funds is to attain a maximum return on investments. The average life of a fund is estimated at three to seven years, with:
An investment stage of three to six months.
Three to five years of value creation.
An exit process of about four to six months.
Normally, the corporate structure of a venture capital fund does not require a licence from the Swedish Financial Supervisory Authority or elsewhere, since it:
Does not typically offer investment services or conduct investment operations under the Securities Market Act (based on Directive 2004/39/EC on markets in financial instruments (MiFID)).
Typically is not structured as an investment fund or as a manager of such a fund under the Act on Investment Funds 2004 (based on Directive 2009/65/EC on undertakings for collective investment in transferable securities (UCITS)).
However, on 8 June 2011 Directive 2011/61/EU on alternative investment fund managers (AIFM Directive) was formally signed. Alternative investment funds (AIFs) are defined as any collective investment undertakings that are not harmonised under the UCITS. The AIFM Directive will apply to all managers of AIFs, Swedish and non-Swedish, irrespective of the legal structure of the AIF and of whether the AIF is closed- or open-ended, provided that certain thresholds are met relating to the total value of the assets under the AIF's management. Under the AIFM Directive, a manager of an AIFM must fulfil certain authorisation standards. It must also comply with certain conduct of business rules, and capital and transparency requirements.
The AIFM Directive entered into force on 21 July 2011 and the member states must implement it within 24 months, that is, at the latest on 22 July 2013. The Swedish government has appointed a commission with the assignment to propose how the AIFM Directive shall be implemented in Sweden. This proposal shall be presented no later than on 30 September 2012. Once the implementation legislation enters into force, those managers of venture capital funds that are considered to be AIFs will have to comply with the applicable rules and requirements, as implemented in the Swedish legislation.
Venture capital funds are not subject to any particular regulations regarding investment companies. However, for the AIFM Directive, see Question 9, and for tax issues, see Question 3.
Different rules apply for the marketing and advertising of venture capital funds, depending on whether the venture capital fund is structured as a private limited company or a public limited company.
A venture capital fund structured as a private company cannot through advertising, on the internet or otherwise, attempt to sell shares issued by the company, unless the offer refers to a sale of shares to no more than ten buyers.
In addition, a private company or a shareholder in such a company cannot, by other marketing activities, attempt to sell such shares by offering shares for subscription or sale to more than 200 people, unless:
The offer is directed solely to a group of people who have previously given notice of interest in such offers.
No more than 200 units are offered.
Shares in private companies offered in accordance with these rules are not subject to the prospectus rules (see below, Public limited company).
Offers regarding shares issued by a public company are not subject to the marketing and advertising prohibitions (see above, Private limited company). However, offers of shares to the public are subject to the prospectus rules in the Financial Instruments Trading Act (based on Directive 2003/71/EC on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC) on the prospectus to be published when securities are offered to the public or admitted to trading, unless the offer is structured as a private placement under one of the exemptions under the Financial Instruments Trading Act.
The most commonly used exemptions are offers:
Solely directed towards qualified investors (as defined in the Financial Instruments Trading Act).
Directed towards fewer than 100 natural or legal persons.
Where each investor commits to make an investment of at least EUR50,000 (as at 1 November 2011, US$1 was about EUR0.7).
Where the nominal value of each offered security is at least EUR50,000.
Where the total amount to be invested during a 12-month period does not exceed EUR1 million.
Swedish limited companies are the most commonly used vehicles for venture capital funds (see Question 7). The owners of any limited company, including venture capital funds, normally protect themselves by a shareholders agreement between the shareholders or a majority of them.
Protection is also given by the articles of association, which is a mandatory document for all limited companies. The articles of association contain basic and fundamental rules that apply to the company. These provisions provide some protection against changes. By law, the articles of association can only be amended by a resolution passed at a shareholders meeting, where a qualified majority of the shareholders present at the meeting have supported the amendment. Sometimes, the shareholders agreement contains a list of items that can be decided only with the support of a qualified majority.
Investors often seek protection relating to the areas in which the fund invests. Further, the investors often protect themselves by stipulating that the funding decisions require the consent of an investment committee, and that key employees are only appointed with the consent of the investors.
Venture capital funds provide the portfolio companies with external financing in the form of equity capital. Sometimes, the investment in equity can be supplemented by investments in convertible loans and/or a combination of loans and warrants.
It is very difficult to assess the value of an early stage company. Most investors like to see a business plan where the objectives are defined, with estimated projected costs to reach the objectives and estimated future revenues.
Milestones are often defined based on such predictions. These milestones can then be used to trigger additional capital funding, at valuations already agreed between the investors and the founders at the outset of the initial investments. The valuation is always subject to negotiations between the founders and the investors, and if applicable, earlier investors and new investors.
Venture capital funds carry out due diligence on potential investee companies. Principal areas are:
Key employment contracts.
Founders and key employees, and their earlier experiences and reputation.
Material customer and supply contracts.
Intellectual property rights (IPRs).
Litigation.
Licences and permits.
Tax issues.
The main legal documents are a shareholders agreement between the owners and a subscription agreement (an investment agreement) between the company and the investors. Sometimes, these documents are supported by representations and guarantees from existing shareholders.
In addition, the issuance of shares must be made in accordance with certain procedures stipulated by the Companies Act. These procedures require that the shares be issued through a resolution passed at a shareholders meeting. At that meeting, certain formal documents must be presented.
The subscription agreement and the legal documents required by the Companies Act offer a certain degree of protection. If the factual circumstances presented in these documents prove to be wrong, the documents can be held against the company, the board of the company and other parties who have endorsed them.
The shareholders agreement offers protection in relation to how the company is run, financed and eventually disposed of. Typical protections for the investors relate to:
Their entitlements to influence major decisions of the company.
The key employees' and founders' non-compete obligations.
Issues relating to anti-dilution and exits.
Preferred shares are very often taken by a fund.
As a holder of preferred shares, a fund has preferential rights to dividends (distributed in the ordinary course or in connection with liquidation), normally up to an amount corresponding to the invested funds plus, sometimes, added interest.
Board representation and veto rights on certain matters are commonly covered in the shareholders agreement. In addition, the investors sometimes ask for certain kinds of information to be provided to them on a regular basis.
Generally, the articles of association contain pre-emption rights and/or right of first refusal. The shareholders agreement often contains additional provisions to supplement the sometimes lacking provisions in the articles of association. These additional provisions often relate to bad leavers and valuation of shares in case of breach of contract.
Both drag-along and tag-along rights are commonly used.
The technique varies, but investors normally require rights that enable them to impede further issues of shares if they do not accept the terms of the issuance. As a result, investors can normally ensure that the company does not issue shares to new investors at unfavourable terms. Commercially, a new investor often requires existing investors to participate in a new round of funding.
All issues of shares are subject to the approval of the shareholders at a general meeting. Therefore, to issue shares, all shareholders must be summoned to a general meeting, and certain legal formalities must be complied with. Following a resolution to issue new shares, the decision is registered at the Companies Registration Office.
The shareholders can empower the board to decide on a share issue, to facilitate the procedure. This authorisation is decided at a general meeting. Thus, the power to issue new shares still vests in the shareholders.
In addition, the law provides various methods for the procedure of issuing shares.
Normally, the costs are covered by the investors themselves, that is, the costs are covered by funds from the investment. Often, the target company pays for consultants and other expenses.
Various forms of stock option programmes are commonly used. The technique varies, but the programmes are normally based on warrants that entitle the holder to subscribe for shares in the future at a fixed strike price. Normally the exercising period is no longer than three or four years.
If the stock option is considered to be a security, the benefit (that is, the market value of the option minus any consideration) is taxed as employment income (up to 58% plus payroll tax for the employer) upon the acquisition. The value increase thereafter is taxed as capital income (30%).
If the obtained stock option is not to be considered as a security but an employee stock option (that is, the holder is entitled to subscribe for securities at a fixed price in the future), the benefit is taxed as employment income when the stock option is being exercised or transferred. A later sale of acquired shares is taxed as capital income.
The classification of a stock option as a security or employee stock option depends on the terms of each stock option. The decisive element is any restriction of the holder's right to dispose of the stock option. A stock option which gives an unconditional entitlement to payment or delivery and which can be transferred freely at market value should normally be considered a security.
If a stock option programme is used, the entitlement to obtain ownership of the warrants only matures if the founder is still active in the venture at the fixed future dates. Sometimes, the entitlement to ownership relates to certain milestones being accomplished. The reversed method is also sometimes used, that is, a founder is required to surrender his shares at a discounted price if he leaves.
Key personnel are generally impeded from competing with the venture during an agreed period of time after leaving, and cannot use or disclose confidential information.
Buyback is the preferred exit option, where the venture capital funds try to sell the portfolio company back to the founders. Liquidation and bankruptcy may be used in extreme cases.
Trade sales are the most common option. Initial public offering (IPO), secondary sales and partial exits are also possible. The choice of exit is primarily based on the:
Expected return on investment.
Expected length of the exit process.
Requirements for warranties and escrows.
Available exit opportunities.
The most common buyers are trade buyers, other private equity funds or buyers through an IPO.
It is now not unusual for a private equity fund to sell to another private equity fund, which may have a different geographical scope and larger financial resources to help the company through its next development phase. In this way, a company can be financed by private equity for an extended period of time.
An exit strategy is often contained in the shareholders' agreement.
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