How a unicorn is not a myth in the United States and still a species to completely discover in the European Union - The role of equity investment rules and public policy in the growth of unicorns

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How a unicorn is not a myth in the United States and still

a species to completely discover in the European Union

The role of equity investment rules and public policy in the

growth of unicorns

Master Thesis

L.L.M in Law and Finance University of Amsterdam Saranne Bron

Student Number: 12930695 sarannebron@gmail.com Supervisor: Tawnee Hill Date of submission 17th _{of July 2020}

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ABSTRACT

The paper starts with the observation that more unicorns are growing in the United States (US) as opposed to the European Union (EU). In fact, we see that the EU is facing a scale-up financing gap. This can be particularly harmful for the growth of unicorns. The US on the other hand has a plethora of late-stage financing. The JOBS Act in the US eased regulatory hurdles for start-ups and venture capitalists. We think it has specifically promoted the abundance of late-stage financing rounds in the US. The EU has aimed to overcome the equity financing gap by introducing the Venture Capital Fund Regulation (EuVECA) and the use of public investment schemes.

Against this background this paper seeks to answer the following question, to what extent do

the differences between the JOBS Act (Title V and XXV) and the EU Venture Capital Fund Regulation (EuVECA) Article 2 combined with the accompanying VentureEU initiatives account for the abundance of unicorns in the US as opposed to the EU?

Our examination shows that the US rules promote an ongoing funding circle for late-stage financing. Whereas in the EU, the rules promote the pure existence of a solid start-up and venture capital landscape. Causing investment to be most geared towards the early-stage financing rounds. The differences between the continents demonstrated that regulation certainly plays a role in establishing an eco-system that promotes the existence of unicorns. Thus, in part explaining the discrepancy between the number of unicorns in the US and EU. As the EU is behind, we provide for a policy recommendation using government backed lending. The idea of this policy recommendation is derived from the differences between the two continents that have most effect on the growth of unicorns.

Keywords: Unicorns, Venture Capital, Late and Early-stage financing, European Union,

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LIST OF ABBREVIATIONS

AIFMD Alternative Investment Fund Managers Directive EC European Commission

EIB European Investment Bank EIF European Investment Fund EU European Union

EuVECA European Venture Capital Regulation

FAST Act Fixing America's Surface Transportation Act IPO Initial Public Offering

JOBS Act Jump Start Our Business Startups Act NPPR National Private Placement Rules R&D Research and Development

SBIC Small Business Investment Companies SEC Securities Exchange Commission SME’s Small Medium Enterprises US United Sates

VC Venture Capital

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INTRODUCTION

In this era technology has critically reshaped our perception of how business should be done. Technology even modified our perception of magical horses, namely unicorns. The unicorn has become an acronym for a specific sort of private start-up, one that has been valued at an astonishing amount of 1 billion dollars.1

These mythical creatures feed on a plethora of venture capital (VC) and without these investors, willing to gamble on high-risk start-ups, the phenomena would not exist.2_All investors have the same mission, investing in those start-ups that attract millions of users and billions in sales. This high competition between various private equity funds has grown into the outright overflow of enormous amounts of capital, enabling start-ups to develop their disruptive business model with as little disclosure as possible to the public.3_{In the US, this} has translated in an abundance of late-stage finance, capable of sustaining the financing needs of future unicorns.4_{This shows, as over half of the 426 unicorns present in our world today} are based in the US.5_{The figures in the EU are somewhat different, in 2019 the EU had 25} million SME’s and only 33 of them were able to join the unicorn realm.6_{This may well mean} that it is harder for European start-ups to attain the illustrious threshold. In fact, the EU market is characterized by too much demand for scale-up finance in relation to the availability of VC.7

This critical difference between the late-stage funding market in the US opposed to the EU, may explain the existence of more unicorns in the former. The most common explanation for this in literature is given by the absence of a sophisticated European ecosystem supporting the growth of unicorns.

1_{A Lee, ‘Welcome to the Unicorn Club’ TechCrunch} _(November ₂ ₂₀₁₃₎

https://techcrunch.com/2013/11/02/welcome-to-the-unicorn-club/ accessed 5 April 2020

J S Fan, ‘Regulating Unicorns and the new Private Economy’ (2016) Boston College Law Review 57 B.C.L. Rev. 583: ‘Valuations are the amounts that venture capitalists determine that companies are worth. The value

takes into account quantifiable and qualitative factors.’ https://lawdigitalcommons.bc.edu/bclr/vol57/iss2/5/

accessed 10 April 2020

2_{Venture capital is a type of private equity, providing capital to high growth potential start-ups in exchange for}

an equity share.

3_{Ibid 1.}

4_{National Venture Capital Association (NVCA) Pitchbook Data, Venture Capital Monitor Q3, (September}

2019) https://nvca.org/wp-content/uploads/2020/01/Q4_2019_PitchBook_NVCA_Venture_Monitor.pdf accessed 26 April 2020

5_{The Global Unicorn Club, CB Insights (updated daily),}

https://www.cbinsights.com/research-unicorn-companies accessed 1 June 2020

6_{Commission (EC) Annual Report on European SME’s, ‘Research & Development and Innovation by SMEs’}

(2019) Publications Office of the European Union 10.2826/500457 accessed 20 April 2020

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However, the literature surrounding the effect financial regulation can have on the growth of an integrated late-stage funding market and unicorns respectively remains unchartered.

The U.S. legal system is the cradle of the private equity industry.8_{We perceive that} especially the JOBS Act, enacted in 2012, adheres to the specific needs of unicorn companies. The JOBS Act might have created the start-up eco-system rooted on the abundance of late-stage funding. Therefore, we only put our focus on this legislative framework throughout the paper.

The EU recognized that more funding was needed for the start-up economy to flourish. Appropriately, constructive regulation such as the European Venture Capital Fund Regulation (EuVECA) was launched in 2013 to ease regulatory burdens for VC firms. Several public investment schemes were created to attract private fund managers to invest more in the start-up industry, such as the VentureEU fund.9

Keeping these legislative frameworks and the scale-up financing gap in mind, the following research question was formed:

To what extent do the differences between the JOBS Act (Title V and XXV) and the EU Venture Capital Fund Regulation (EuVECA) Article 2 combined with the accompanying VentureEU initiatives account for the abundance of unicorns in the US as opposed to the EU?

We focus this research on federal law and European wide enacted frameworks, for the following reason. The US and EU offer tremendous opportunities in market size for start-ups. However, there might be a difference in how these continents promote the use of this entire market for the benefit of unicorn companies. We want to explore how both the US and EU have reshaped and developed the start-up industry through regulatory frameworks. The difference in the rules might explain to some extent how more unicorns grow in the US market. After analyzing these rules, we do perform a case-study of the Netherlands and California. Showing that when provisions at federal or EU level aim at the growth of unicorns, the rules at member-state and state level will adhere their rules to that growth.

In the end, the goal of this thesis is to explain how regulation can facilitate late-stage funding and how this impacts the growth of unicorns.

8_{M Kenney and J Zysman Unicorns, ‘Cheshire cats, and the new dilemmas of entrepreneurial finance’ (2019)}

Venture Capital, 21:1, 35-50, https://doi.org/10.1080/13691066.2018.1517430 accessed 20 March 2020

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The methodology that will be used in this research follows the functional method within comparative legal studies. We will look how Section 501 of Title V, Title XXV of the JOBS Act and the safe harbors within Rule 144A and Section 4(a) (1½) have facilitated late-stage funding. We examine the same for the EuVECA Article 2, enacted after the Alternative Investment Fund Manager Directive (AIFMD), and the use of fund-of-funds. This forms the basis on which we perform our functional analysis.

The legislative frameworks will thus be analyzed together with academic articles surrounding the working of the regulation in the real economy. Throughout this paper we have also used news articles as we are dealing with quite a novel subject that changes frequently. We use these articles to show examples of the path that unicorns take in the US or EU in relation to the regulatory environment.

In order to provide for an answer, the paper is divided into five sections. In the first section, the unicorn phenomena will be explained. We determine the importance of an abundance of venture capital to trigger the existence of unicorns. In the second section we will research the US legal landscape. Here we will solely focus on the Titles in the JOBS Act having effect on the availability of late-stage funding. In the third section we will discuss the relevant EU wide enacted rules. We will focus on how the EuVECA and the VentureEU public investment schemes could have put a focus on early-stage finance. The comparative section comes next. The main differences between the jurisdictions will be discussed and why these differences are important in light of our research question. After, we will acknowledge the limitation of this research. Section 5 will provide the answer to the research question by summarizing our main findings.

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1. What is a Unicorn company?

The Unicorn, a term venture capitalist use to describe a private company that is valued at or above 1 billion dollars. However, this does not explain how unicorns come to existence. With this Chapter we aim to explain this.

1.1 Unfolding the Definition

Technology is somewhat the reason behind the success of unicorn companies, technology has made the entry barriers in a lot of sectors far lower than it used to be. When looking at the unicorns of this era (Uber, WhatsApp, Snapchat) a common feature is that they are rather dominating the use of the mobile internet. Moreover, their existence has changed our use of the internet.10_{This perspective creates the following hypothesis, that different generations of} start-ups are capable of riding distinct waves of technology and they benefit from the unique opportunities enabled by the technology of that specific wave. 11

The true game changer for the advantageous use of the current wave of technology came with introduction of the smartphone in 2007.12_{New functions and facilities could vastly} be deployed by the use of applications on mobile devices. The applications introduce network effects, where it becomes more valuable with each additional user.13_{High user contributions} seem to be the key to market dominance for the current unicorns. 14

1.2 Environmental Conditions

In this section we want to explore what elements need to be in place to create an environment that supports the growth of unicorns. This will demonstrate which element might cause the difference in the number of unicorns in the US as opposed to the EU.

As we saw in the previous section unicorns build on new technological advances. This shows that the first step towards the right conditions is the need of an overall innovation

10_{Commission (EC), ‘How to Catch a Unicorn An exploration of the universe of tech companies with high}

market capitalization’ (2016) JCR Technical Reports 10.2791/893975 accessed 10 April 2020

11_Ibid.

12_{Ibid.; J.P. Simon, ‘How Europe missed the mobile wave’ (2016) Info Vol. 18 No. 4, pp. 12-32.}

https://doi.org/10.1108/info-02-2016-0006 accessed 10 April 2020

13_{T O'Reilly ‘What Is Web 2.0: Design Patterns and Business Models for the Next Generation of Software’}

(2007) International Journal of Digital Economics No. 65 pp. 17-37. https://mpra.ub.uni-muenchen.de/4580/1/MPRA_paper_4580.pdf accessed 20 June 2020; T O’Reilly and J Battelle, ‘Web Squared: Web 2.0 Five years On’ (2009) Sebastopol O’Reilly Media https://assets.conferences.oreilly.com/1/event/28/web2009_websquared-whitepaper.pdf accessed 20 June 2020

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supportive economic environment.15_{Besides promoting the use of innovation, the} environment also offers the regulatory ease towards small businesses entering the market. The people that are passionate about business, making money and technological novelties are lured towards this environment. This establishes the two other requirements needed to let the supportive economic environment flourish. The first requirement is the access to talent, where the right skilled workers are easily matched with start-ups. 16_{The second condition is strongly} correlated to the first, access to capital. Without the availability of sufficient funding, one can not attract highly sought-after qualified workers in a competitive market. Start-ups, and unicorns respectively, need a finance opportunity that gives the flexibility to the entrepreneurs to develop their ideas. It must offer managerial support and at the same time not demand return in a short period.

This then leads to private equity17_{being a preferred source of finance for start-ups and} scale-ups. Especially VC is popular here, which is a form of private equity. Investors provide VC to start-ups that are believed to have long-term growth potential.18_{In the next section we} will analyze the VC industry in the US and EU.

1.2.1. Sketching the VC Landscape in the US and EU

Commonly the US markets are defined by high levels of interaction between VC funds and firms. The EU market however, is defined by a limited number of investors that have trouble in funding and contracting with each other at reasonable costs.19

15_{Z J Acs et al. ‘The lineages of the entrepreneurial ecosystem approach’ (2017) Small Business Economics}

Volume 49 1-10 https://doi.org/10.1007/s11187-017-9864-8 accessed 20 May 2020

16_{Centre for Policy Studies (CPS), Herding Unicorns: How Britain can create and support the high-growth tech}

companies of the future, (Centre for Policy Studies 2019); Scale-up Europe, European Startup Network ‘A

Manifesto for Change and Empowerment in the Digital Age’ (2017) The Lisbon Council and Nesta https://europeanstartupnetwork.eu/wp-content/uploads/2017/10/Scale_Up_Europe_Brochure.pdf accessed 12 April 2020

17_{Private equity is invested capital not listed on a public exchange. It is composed as funds or individuals that}

directly invest in private companies.

18_{T B. Poser, The Impact of Corporate Venture Capital: Potentials of Competitive Advantages for the Investing}

Company (1st_{edition, Deutscher Universitätsverlag 2012)}

19_{Commission (EC), ‘Action Plan on Building a Capital Markets Union’ COM (468/2) Brussels, 30 September}

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1.2.2. The EU Figures

We will first look at the recent figures of the EU. The graph below shows that VC has reached a new high in 2019 with a total of €10.6 billion invested, backing up over 4,696 companies.20 Figure 1 below also shows that investments in early-stage finance has had dominance over the other investment stages as of 2016. The early-stage investments backed up 2,789 companies, which is more than half of the total amount of companies backed up by VC in 2019.21

As to the investor population, government agencies have been one of the largest contributors to the VC industry in the EU for the past decade. In 2019, government agencies comprised 20% of the amount raised in 2019.

Late-stage investment showed an increase in amounts invested but the total number of investee companies declined. In 2018, 790 companies were backed up by VC investors for late-stage financing and 758 in 2019. This seems in line with the fact that there is just less funding available in the EU VC markets. When there are more companies looking to scale-up, but the same amount of funding, eventually less companies are able to attain a late-stage deal.22_{This dearth of late-stage money has thus forced EU based start-ups to essentially scale} up in a more efficient way, as you have to implement new ideas with less money.

20_{Invest Europe, ‘Investing in Europe: Private Equity Activity 2019 and 2018’ (May 2020)}

https://www.investeurope.eu/research/data-and-insight/ accessed 5 May 2020

21_Ibid. 22_Ibid.

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1.2.3. The US Figures

In the US 2019 embarked a year where deal volume was at $136.5 billion and VC capital raised was at $46.3 billion backing up over 8380 companies.23_{Most of the deal volume is} accumulated within late-stage financing as shown in Figure 4.24

At the end of 2019 however, a decline was shown in the deal count for finance rounds in late- stage companies. Reason for this may be that there has been a disappointing trend in successful IPO’s or the ability to spend money responsibly. 25_{US scale-ups are showing a} trend of Blitzscaling, where hyper growth through large funding rounds is most important. Even without reasonable prospect of profits at that same proportion.26_{This shows a} discrepancy with the EU start-ups that do prepare for early-on profit as large funding rounds are not a given fact. We perceive that the Blitzscaling trend might compromise the efficiency of US future unicorns as hypergrowth has the dominance, instead of a strong business model that can sustain downturns. The importance of this efficiency claim within our research will be discussed at the end of Chapter 5.

However, the VC funds in the US can sustain large losses, they can essentially wait for the valuation of the scale-up to be up and running again. At that juncture, they can sell part

23_{National Venture Capital Association (NVCA) Pitchbook Data, Venture Capital Monitor Q3, (September}

2019) https://nvca.org/wp-content/uploads/2020/01/Q4_2019_PitchBook_NVCA_Venture_Monitor.pdf accessed 26 April 2020

24_Ibid.

25_{Ibid.; For example, WeWork and Zume.}

26_{R Hoffman C Yeh, Blitzscaling: The Lightning-Fast Path to Building Massively Valuable Companies}

(Currency Publishing 2018)

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of their stake for a good price. As the US private equity market is highly integrated, they are able to invest in more start-ups. Through this, money keeps on circling around from start-up to scale-up. 27

With a highly integrated market, smaller VC funds can attract larger VC funds to invest in the promising start-up they have a stake in. The integrated market enables them to contact each other at reasonable costs. In that way, that start-up can scale-up more easily and both small and large VC funds can reap the benefits. This shows the advantages of an integrated market.

The biggest difference between the EU and US market is the fact that the EU does not have an abundance in late-stage finance. This translates in a discrepancy between the EU and US scale-up possibilities. The difference is made even worse by the fact that successful EU firms migrate their business to the US, such as Zendesk and Hackerone.28_{The fact that the US} offers higher late-stage funding rounds is not the only attraction for successful EU start-ups to migrate. The US, and specifically Silicon Valley is home to a wide array of intellectual resources valuable for each future unicorn. The US also offers a different attitude, as there is more capital available and taking high-risk is popular, they are able to grow exponentially without the pressure to show early profit. 29

Right now, it is time to put this into the perspective of regulation. Regulatory frameworks can provide easier access to both the market and to financial resources.

We want to put our focus on whether US frameworks have promoted the abundance of late-stage funding. We will look at EU enacted frameworks to determine whether they have led to a focus on early stage financing.

27_{J S Fan, ‘Regulating Unicorns and the new Private Economy’ (2016) Boston College Law Review 57 B.C.L.}

Rev. 583; https://lawdigitalcommons.bc.edu/bclr/vol57/iss2/5/ accessed 10 April 2020

28_{Hackerone was founded by two Dutch entrepreneurs but moved to Silicon Valley to get more clients and}

became a unicorn there. Zendesk was founded in Denmark, after receiving Series B financing from US VC fund Benchmark, they moved to Silicon Valley.

29_{K K Catina and A Preda, The Sociology of Financial Markets (OUP 2005) p. 166-170: US investors have}

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2. The US Regulatory Framework

In this Chapter we will research the rules enacted in the US capable of having effect on the growth of unicorns.

Regulation has always been a high barrier as regards to entering the market and attaining financial resources for small businesses. In April 2012, the Jumpstart Our Business Startups Act (JOBS Act) was passed, rolling back regulation of the financial sector. Each Title of the JOBS Act aims at key regulatory hurdles in several sections of the Securities Exchange Act, seeking to lower the barriers for small businesses.30_{The higher degree of freedom and} diversity in finance possibilities show the greatest strength of the JOBS Act.31

We know from analyzing the environmental conditions of unicorn companies that the abundance of financial resources is a vital condition. The JOBS Act may thus prove to be fruitful.

Throughout this Chapter we will solely focus on the provisions in the JOBS Act that can contribute to the abundance of late-stage finance. As this encourages companies to stay private longer and causes a more eased path towards the unicorn status.

2.1 VC Fund Exemption Title XXV

In this section we will analyze the exemption of registration requirements for VC funds in the US. The SEC Investment Advisors Act allows VC funds to be exempted from registration requirements.32_{They can become ‘exempt reporting advisors’ and thus relieved from the} regulatory requirements of registered investment advisers.

To fall within the exemption, VC funds must ensure that more than 80% of their investment activities is direct investment in private companies.33_{One concern for VC’s operating in} especially the start-up scene is the fact that they have an increasing portfolio of nonqualifying investments, primarily in the form of secondary market shares. Which, if reaching the limit of 20% would mean that they have to comply with the requirements of the SEC.34_{The third}

30_{T B Knight, ‘A Walk Through the JOBS Act of 2012’ (2016) CATO Institute Paper Number 790}

https://www.cato.org/sites/cato.org/files/pubs/pdf/pa790.pdf accessed 5 May 2020

31_{Martin, Thomas, The JOBS Act of 2012: Balancing Fundamental Securities Law Principles with the Demands}

of the Crowd (2012) http://dx.doi.org/10.2139/ssrn.2040953 accessed

32_{Investment Advisers Act 2011 Section 203(l); Section 202(a)(29) for the definition of private fund.}

33_{Ibid. Section 203-3(l)-1-(2) stating that over 20% in non-qualified investment will trigger registration}

requirements.

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reform of the JOBS Act tried to counter this problem and included Title XXV.35_{The SEC’s} definition of qualifying investment now also includes private secondary market securities.36 VC funds now have the ability to buy more secondary securities from especially those start-ups trying to scale-up their business.37

2.2 Staying Private Longer Title V

Section 501 of Title V of the JOBS Act causes companies to be able to stay private for a longer period. Before this Title was enacted, if a company had 500 shareholders they triggered the registration requirement of the SEC.38_{Right now this is at 2,000 persons or 500} accredited investors.39_{Triggering the SEC filing requirements too soon is disruptive to the} growth of unicorns. The reason for this is the fact that future unicorns have best growth potential when they mature away from the public eye. If promising start-ups are pushed in the public market too early, their platform may not be ready for the close examination of both competitors and analysts. This will compromise their ability to conquer the market.

Start-ups usually cross the registration threshold because they offer employees stock as compensation under certain plans.40_{For start-ups and scale-ups money is tight, the excess in} cash that they do have is used to invest. The stock option plans thus serve to attract employees and incentivize them to perform well.

Title V offers another advantage by not including the stock received under employee compensation plans in the 2,000 threshold. Section 501 of the JOBS Act is the most advantageous towards scale-ups close to reaching the unicorn threshold. Start-ups can attract a higher number of investors and are enabled to implement aggressive growth strategies, in the end this can lead to higher valuations. The money of VC investors has for example

35_{The JOBS and Investor Confidence Act 2018, Title XXV H.R. 6177 this section cites the Developing and}

Empowering our Aspiring Leaders (DEAL) Act

36_{Ibid. DEAL Act 2018 Title XXV Section 2(1)}

37_{Testimony to the Committee on Banking, housing, and urban affairs, ‘On legislative proposals on capital}

formation and corporate governance’ (2019) https://www.banking.senate.gov/imo/media/doc/Corzo%20Testimony%202-28-19.pdf accessed May 12 2020

38_{Securities Exchange Act of 1934 (The Act 1934) Section 12(g)(1) before amendments made pursuant to the}

JOBS Act in 2016 see next.

39_{The Act 1934 Regulation D Rule 501(a) definition of an accredited investor; The JOBS Act 2016 Section 501}

amending Section 12(g)(1) of the Act 1934; SEC Proposal, Changes to Exchange Act Registration Requirements to Implement Title V and Title VI of the JOBS Act, (December 17, 2014) Release No. 33-9693

40_{T H Maynard and D M. Warren, Shannon Trevino, Business Planning: Financing the Start-Up Business and}

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enabled Uber to sustain losses for a longer period. Allowing them to continue to operate while providing extremely low costs for their taxi application service. 41

It seems sensible that venture capitalist can wait a significant time to see profit, employees however can not wait for this.42_{The use of private secondary placements become important} here, as this enables employees to sell their shares.

In the next section we will first elaborate on the use of safe harbors that ease secondary private placements. Safe harbors offer some regulatory relief and make certain transactions or companies exempted for requirements in full or part, such as the VC fund exemption.43

2.3 Private Placements under Regulation D

When you sell a security on the private market you have to comply with the registration requirements of the SEC. However, there are safe harbors that relief from this registration. The most important safe harbors for private offerings are found in Regulation D of the SEC. 44_{In light of our research, Rule 144A of Regulation D is most important. As it is} largely used for the resale of restricted securities.The safe harbor of Rule 144A eliminates the high disclosure requirements, which are especially burdensome on the shoulders of small businesses.45_{Securities sold under Rule 144A are also considered ‘covered securities’} pursuant to Section 18 of the Securities Act46_{, and are exempt from state securities law} registration and qualification requirements. Resales pursuant to Rule 144A can be offered to an unlimited amount of qualified intuitional buyers (QIBs).47

Restricted securities pursuant to Rule 144A(a)(3) are acquired securities in an unregistered private sale from the issuing company or from affiliates. These securities are received for most through employee stock benefit plans and in exchange for seed money.

41_{H Horan, ‘Uber’s Path of Destruction’ American Affairs (Summer 2019) Volume III, Number 2}

https://americanaffairsjournal.org/2019/05/ubers-path-of-destruction/ accessed 15 May 2020

42_{K J Mack, O V Mack, et al. ‘Navigating A Successful Private Secondary Offering Through Murky Waters’}

Association of Corporate Counsel (2015) https://www.paulhastings.com/docs/default-source/PDFs/f-mack_nov15-(2).pdf accessed 16 May 2020

43_{J M Bartos and J Bartos United States Securities Law: A Practical Guide (3}rd_{edition, Kluwer Law}

International, 2006) p.70

44_{Regulation D follows the wording of Securities Act 1933 (The Act 1933) Section 4(a)(2) which exempts from}

registration transactions by an issuer not involving any public offering.

45_{See no 28.}

46_{The Act 1933 Section 18(b) exempts covered securities from state law registration requirements.} 47_{The Act 1934 Preliminary Note 1(a) on Regulation D Rule 144A definition of a QIBs.}

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The rule is relatively easy to administer and does not pose many requirements. The only requirement of Rule 144A for sellers who are not affiliates at the time of, and for the three months preceding the sale, is that they have held the securities for at least one year. Notwithstanding, Rule 144A is seen as a viable option for non-affiliates of an issuer to sell their securities. This includes the shareholders that are not an executive officer or a director. Rule 144A thus facilitates the possibility for employees and early investors to sell their securities. Deals involving Rule 144A compromise of larger ticket sizes, here sophisticated investors buy a large amount of the shares of early-stage investors or employees.48

This keeps insiders satisfied, however there must be a solid secondary market in place where the securities can be sold.

2.4 The Secondary Market Pre-IPO

The well-crafted, secondary offering of private company shares enables start-ups and scale-ups to satisfy the liquidity needs of early investors and employees without the risks associated with going public. By delaying the IPO, a company can retain control and privacy over its affairs and continue to grow disruptive ideas away from the scrutiny of analysts and competitors. The private secondary offerings also provide a sense of credibility and confidence for employees, investors and the general public as regards to the management and the long-term viability of the company.49

Another forte of the US secondary market is the fact that just about anyone is able to sell their shares through various intermediaries. Employees or companies can already sell shares in smaller deals through firms such as SharesPost, EquityZen, NASDAQ Private Market and Forge Global Inc. which match buyers with sellers of private shares.

Next to established institutional investors, other investors that would normally not be able to attain share allocations in IPO’s have the chance to form funds specifically aimed at buying private company shares.50_{This thus offers a wide range of potential buyers.}

48_{SEC Division of Economic and Risk Analysis (DERA), ‘Capital Raising in the U.S.: An Analysis of the}

Market for Unregistered Securities Offerings 2009‐2017’ (2018) https://www.sec.gov/files/DERA%20white%20paper_Regulation%20D_082018.pdf accessed 1 May 2020

49_{D Milanesi , ‘The Rise of the Secondary Trading of Private Company Shares in the United States, Europe, and}

the United Kingdom: New Opportunities and Unique Challenges’ (2019) TTLF Working Papers No. 46 https://law.stanford.edu/wp-content/uploads/2019/11/milanesi_wp46_.pdf accessed 15 May 2020

50_{D Belt, ‘Pre-IPO Liquidity for Late Stage Start-Ups’ (2018) A Lexis Practice Advisor Practice Note}

https://assets.fenwick.com/legacy/FenwickDocuments/Pre-IPO-Liquidity-for-Late-Stage-Start-Up.pdf accessed at 9 May 2020

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However, there must be careful management in place to deal with the negative effects of secondary market offerings. Employee trading of private company shares can have a disastrous impact on preserving confidential information, causing distraction within management.51_{Furthermore, the stock option plan form a significant part of the overall} compensation employees receive and provide the majority of the incentive for employees to perform well.52_{Perhaps this provides reason for the divide within companies whether they} allow employees to sell their equity options.

Notwithstanding, this resilience is not quite shown in the transaction volume. Over $4 billion in transaction volume was executed by Sharespost, EquityZen, NASDAQ Private Market and Forge Global Inc. in 2017.53_{The known seller population consists in the largest} number of individuals.54_{This shows that employees and early investors appreciate the} platform for private secondary offerings.

Private shares are unregistered and their trading is thus highly regulated by the SEC, which may hamper the use of secondary offerings. Therefore, in the next section we will research other safe harbors besides Rule 144A that ease this practice. We will look in more detail how the safe harbors contribute to a solid secondary market for liquidity needs in the late-stage.

2.4.1. Applicable Regulation

Besides Rule 144A, the uncodified principle of Section 4(a)(1½) is the most commonly used safe harbor.55

Section 4(a)(1½) covers the private resale of restricted securities to a limited number of investors, that commonly rely on the Section 4(a)(1) registration exemption. Simply put, Section 4(a)(1) exempts transactions by ‘any person other than an issuer, underwriter, or dealer’. Two points need to be proven, that the seller is not an underwriter and that the

51_{D F Larcker, B Tayan, and E Watts ‘Cashing It In Private-Company Exchanges and Employee Stock Sales}

Prior to IPO’ (2018) Stanford Closer Look Series Corporate Governance Research Initiative: ‘In 2017, just under

half of the (44 percent) say they allow employees to sell or pledge their shares, while just over half (56 percent) do not allow this practice.’

https://www.gsb.stanford.edu/sites/default/files/publication-pdf/cgri-closer-look-73-private-company-exchanges.pdf accessed 1 May 2020

52_{S Blank, ‘How to Make Startup Stock Options a Better Deal for Employees’ Harvard Business Review (April}

3 2019) https://hbr.org/2019/04/how-to-make-startup-stock-options-a-better-deal-for-employees accessed 8 May 2020

53_{See no 50.} 54_Ibid.

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transaction does not involve a distribution.56_{Long history of case law starting from the} 1950’s, including SEC v. Ralston Purina (1953) and Doran v. Petroleum Management Corp (1977), have set out that sales by an issuer do not involve a public offering or distribution when the offers are only made to ‘sophisticated investors’. This means that sales pursuant to Section 4(a)(1½) can be made to a larger pool of investors, to both QIB’s and accredited investors.57

As Section 4(a) (1½) is an uncodified common law principle there are some issues as to the legal certainty of the rule. The JOBS Act aimed to tackle this problem and codified a new exemption, Section 4(a)(7) as part of the FAST Act.58_{Section 4(a)(7) provides for a statutory} basis for resales of securities by persons other than the issuer. There is no requirement of a certain holding period. Therefore, investors that have required securities through for example employee stock benefit plans or for exchange of seed money who have a higher interest in selling their securities in a short time period, may find Section 4(a)(7) useful.

The FAST Act does make clear that Section 4(a)(7) does not fully replace the Section 4(a)(1½) exemption. The reliance on this common law principle is not restricted due to the codification and its use is still popular. The securities sold under Section 4(a)(7) are also deemed to be covered securities.59_{Making it easier to resale the securities in another state.}

Notwithstanding, Section 4(a)(7) does impose some more stringent conditions than Section 4(1½) does. The information requirement for companies that do not file SEC reports, is especially seen as a hurdle. This includes an issuer’s recent balance sheet and profit and loss statement for two preceding fiscal years. The use of Section 4(a)(7) may thus be more restricted by management, unless the company has a strategy to target investors in another state.

56_{This is an amalgamation of the requirements found in Section 4(A)(1) and 4(A)(2) of the Act 1933.} 57_{This includes individuals who have an income that exceeds $200,000 in both prior two years.}

58_{The JOBS ACT Fixing America's Surface Transportation Act (Fast Act) 2015 Title LXXVI which amends}

Section 4 of the Act 1933

59_{The Act 1933 Section 18(b); SEC Concept Release 2016 Small Business Forum recommending to preempt}

state registration requirements for all primary and secondary trading of securities sold in offerings registered with the Commission. (2016) Release Nos. 33-10649

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2.6 Case-study California State Law

To offer more ground to the effect of the above discussed rules we will perform a case-study of California state law in this section. We focus on California as it is the leading supplier of internet services. With this case-study we recognize that the entire US consists of different state laws, causing the effect of the federal laws to differ within the states. The state law present in California may well cause an enlarged effect of the discussed rules of the JOBS Act.

2.6.1 Section 16600 Fostering the Innovation Climate

Section 16600 stipulates the ban on employee covenants in California.60_{This section sees a} contract in which anyone is restrained from engaging in a lawful profession or business as void.61 _{The ban essentially facilitates employee mobility and has established an agglomeration} of economies.62_{It has fostered a high velocity labor market where employees can switch jobs} with more frequency. We perceive that this enables more knowledge to be spread, as former employees from existing companies offer advantages to new start-ups or promising scale-ups on the market.63

2.6.2. Section 25102 California Corporations Code

Stock option plans issued to Californian residents can fall under a registration exemption from the federal securities law through Section 25102 of the California Corporations Code.64_This makes the process for employee option plans less burdensome. Section 25102(o) establishes the compensatory benefit plan exemption most used by venture-backed companies. For this section there is only one filling required for the plan and there is no participation limit, thus

60_{California Business and Professions Code 1941 Division 7 General business regulations Sections 16000 –}

18001 Part 2. Preservation and regulation of competition Sections 16600 – 17365; Techno Lite, Inc. v. EMCOD, LLC WL 289084 (2020)

61_Ibid.

62_{Agglomeration economies indicate the advantages of concentrating output and housing in the same area. When}

that area specializes in producing a particular good, the rest of the firms located in that area can benefit from for example a supply of trained workers for that particular good; A Saxenian, The New Argonauts: Regional

Advantage In A Global Economy (Harvard University Press 2007)

63_{M A Lemley and J H A. Pooley, ‘California Restrictive Employment Covenants after Edwards’ (2009)}

California Labor & Employment Law Review, Vol 23, No. 3 https://ssrn.com/abstract=1295606 accessed 30 June 2020; A Chander, ‘How Law Made Silicon Valley’ (2014) Emory Law Journal Vol. 63:639

64_{California Corporations Code Division 1. Corporate securities law of 1968 Title 4. Securities Sections 2500-}

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offering more flexibility. 65_{This avoids high administration and compliance costs for filling} for multiple plans.66

2.6.3. California Research Credit

On federal level, there is a tax R&D Credit, which is a tax program that allows companies to reduce their tax liabilities to the extent that they engage in particular types of R&D activities.67_{All the separate states follow the federal guidelines under Sections 41 and 174 of} the Internal Revenue Code to establish their own Research Credit. California has made some critical alterations and is seen as one of the most beneficial in the country.68

Start-up companies can use a tax credit of 3% of the firm’s overall qualified R&D expenses for the first five years of their operation.69_{This means that start-ups are allowed to} include total qualified R&D expenses rather than only the incremental increase over a predefined base amount of the expenses, as is the case with the federal credit. Unused credit can also be carried forward indefinitely to offset tax liabilities in future years.70_{This is very} fruitful for start-ups as in the first few years they may not have a high amount of profit to fully benefit from the tax credit. However, in the years profit is made the unused credit can be used to offset tax liabilities.

2.7 Interim Conclusion

Overall, the discussed provisions in the JOBS Act have facilitated a promotion of late-stage financing. The rules enacted at federal level have established a uniform framework consisting of provisions beneficial to future unicorn companies.

When looking at California, we see that the provisions of the JOBS Act have a stronger working. The employee covenants ban and the use of Section 25102(o) enable start-up

65_{The Act 1933 Rule 701}

66_{The other subparagraphs in Section 25102(o) stipulate that fillings are needed for each plan to an individual}

employee.

67_{The Economic Recovery Tax Act 1981 (Federal Level); Protecting Americans from Tax Hikes Act 2015}

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68_{California Revenue and Taxation Code Section 23663; R DeVol, K Harris and M Ratnatunga, Milken}

Institute, ‘California’s Innovation-Based Economy: Policies to Maintain and Enhance It’ (2015)

https://assets1c.milkeninstitute.org/assets/Publication/ResearchReport/PDF/California-Innovation-Economy3.pdf accessed 3 July 2020

69_{California Revenue and Taxation Code Section 23609, 23051.5 and 17024.5; Internal Revenue Code (Federal)}

Section 41(c)(3)(B)(ii).

70_{Cal. Rev. & Tax. Code S.23609 and see the general overview of California Research Credit}

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companies to benefit even more from Title V and the secondary private placements safe harbors.

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3. The European Framework

After the financial crisis the EU enacted the first pan-European regulation for Alternative Investment Fund Managers (AIFMD) in 2011.71_{The AIFMD posed extensive} reporting and disclosure requirements. These rules showed especially onerous on small businesses and their funding providers.72_{This has caused problems for both the start-up} industry and the VC landscape to grow in Europe. 73

To let this landscape evolve, the EU the regulators have introduced the European Venture Capital Regulation (EuVECA) easing regulatory hurdles for VC funds to enter the market. This would improve access to finance for start-ups. Besides the EuVECA, the use of government co-investment schemes was introduced to aid in solving the equity gap of start-ups. In this Chapter we will analyze both regulatory initiatives and whether they facilitate a growth in unicorn companies.

3.1 Eased Access for VC

We will begin with discussing the EuVECA, which is most aimed at making VC more accessible in Europe.

The AIFMD offers investment fund managers a passport, which enables them to manage or market funds to professional investors throughout the EU.74_{The framework} however poses quite stringent conditions to obtain this passport.75_{To support the existence of} venture capital, an exemption was introduced for VC funds. Avoiding the most cumbersome conditions of the AIFMD but still enables the use of the cross border free pass.76

This exemption sounds promising, the reality however was different. VC funds still faced different costs when they would actually market their investments across the border. Essentially, they were not offered a 100% free pass. This gave reason for the European

71_{Council Directive 2011/61 of 8 June 2011 on Alternative Investment Fund Managers (AIFMD) and amending}

Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 [2002] OJ L 174

72_{F Gannon, P O’Conner, ‘Navigating Through AIFMD A Guide for Private Equity and Venture Capital Funds’}

(2014) KPMG https://assets.kpmg/content/dam/kpmg/pdf/2016/01/navigate-through-aifmd-july-2014.pdf accessed 3 May 2020

73_{Commission (EC) Expert Report for EC by Hoffman ‘Scale-up Companies– is a new policy agenda needed?’}

see https://ec.europa.eu/transparency/regexpert/index.cfm?do=groupDetail.groupDetailDoc&id=26381&no=1 accessed 2 May 2020

74_{AIFMD 2011/61 Articles 31-33} 75_{AIFMD 2011/61 Articles 12-24} 76_{AIFMD 2011/61 Article 26}

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Venture Capital Fund Regulation (EuVECA).77_{The regulation was specifically designed to} facilitate and boost the volume of VC activity. The aim was to tackle the regulatory differences among member states that hamper the growth of deep cross-border investment activity. The EuVECA introduced the EU wide VC passport for regular entrepreneurship funds.78_{This enables fund managers to market their investments in each member-state under} the exact same conditions.79_{It had long been a long detrimental fact that in every} member-state a fund would market their investment they faced new costs and rules.80_{After the} legislations the funds rather had to comply with a uniform rulebook.81

We will now dive into the notion of the VC passport of the EuVECA in more detail. VC funds have to comply with criteria to become eligible for this specific passport. To become eligible, (I) the assets that they manage must not exceed €500 million, (II) they are incorporated on the territory of an EU member-state and (III) at least 70% of the capital in the fund is invested in qualifying investments.82_{Qualifying investments refer to equity} instruments either issued by the portfolio company or acquired in a secondary transaction.83 The profile of investee companies is also under clear scrutiny. They can not be admitted under any (public) stock exchange, must have fewer than 250 employees and their annual turnover must not exceed €50 million or a balance sheet not exceeding €43 million.84_{In other words,} when one investments is made in a company with a turnover of €51 million or 252 employees, the EuVECA passport is invalid. This severely limits the possibility to approach investors across the EU without too much regulatory hurdles.

Another disadvantage was for the VC managers that hold a subthreshold of alternative investment funds (AIFs) in their portfolio. The subthreshold meant that in order to market those (AIFs) across the EU, a VC manager would still have to comply with the national

77_{Council Regulation (EC) 345/2013 of 17 April 2013 on European Venture Capital Fund (EuVECA) [2013] OJ}

L115/1. And Council Regulation (EC) No 346/2013 of 17 April 2013 on European Social Entrepreneurship Fund [2013] OJ L115/18.

78_{EuVECA 345/2013 and AIFMD 2011/61}

79_{AIFMD 2011/61 Article 3(2)(3), EuVECA 345/2013 Article 2}

80_{EuVECA 345/2013 Recital 2 In the absence of such a common framework, there is a risk that Member States}

take diverging measures at national level having a direct negative impact on, and creating obstacles to, the proper functioning of the internal market

81_{Ibid.; Recital 3 It is necessary to adopt a Regulation establishing uniform rules applicable to qualifying}

venture capital funds

82_{EuVECA 345/2013 Article 2} 83_{EuVECA 345/2013 Article 3(b)(i)}

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private placement rules (NPPR) in each jurisdiction into which its funds were marketed.85_In addition, the AIFMD and NPPR mostly block marketing investments to sophisticated investors (high-net-worth individuals). These investors form a substantial target group for venture funds.86_{Therefore, amendments were made to the regulation in 2018, fixing the} foregoing. Ensuring that VC’s are able to market their entire fund across the EU. There will be no requirement to meet the private placement requirements in the different EU member states as would otherwise be the case.87_{The amendments prohibit local member-state} regulators to impose fees on managers that market funds in their jurisdiction with the presence of the EuVECA passport.88

The €500 million threshold of assets under management was also cancelled, effectively broadening the scope of the regulation. Essentially, fund managers that previously crossed the threshold can now profit from the EU VC Label and are more inclined to enter the VC industry.89_{The amendments also eased the close scrutiny on portfolio companies. To} begin, the limit on number of employees in investee companies doubled to 500. Secondly, the registration process was simplified, reducing the accompanying costs.

AIFMD fund managers with asset under management above €500 million are now enabled to register funds under the EuVECA when most of the investments fall within the above criteria. This will enable them to also market funds towards sophisticated retail investors as long as they invest more than €100,000.90_{Notably, if a fund obtains the EuVECA} passport, registration under the AIFMD will be deemed unneeded.

In essence the amendments to the EuVECA proclaim a very easy access for VC funds to enter the market. This is consistent with the aimed promotion of a fully-fledged integrated VC market. However, it seems that eased access in times of economic prosper may well lead to many new small investors not capable of providing the capital throughout all life-cycles. This leads to an overall larger contribution to early-stage investment. 91

85_{Commission (EC) ‘Proposal for a Regulation of The European Parliament and of the Council on facilitating}

cross-border distribution of collective investment funds and amending Regulations (EU) No 345/2013 and (EU) No 346/2013’ COM (2018) 110 final, 12 March 2018.

86_Ibid. 87_Ibid.

88_{EuVECA 345/2013 Article 16(2)}

89_{EuVECA 345/2013 Article 2(1)(b); Meaning they can also freely market their funds across Europe.} 90_{EuVECA 345/2013 Article 6(1)(a)}

91_{M Corrales, M Fenwick and N Forgo}_{, Robotics, AI and the Future of Law (Springer 1st ed. Singapore, 2018)}

81-85; G Duruflé, T Hellmann and K Wilson ‘From Start-up to Scale-up: Examining Public Policies for the Financing of High-Growth Ventures’ (2017) Saïd Business School Research Papers Issue 04 2017 https://www.bruegel.org/wp-content/uploads/2017/04/WP-2017_04.pdf accessed 4 May 2020

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3.2 Public Policy and the Rise of Venture Capital

Favorable regulation towards VC and an EU wide passport for investment funds are not enough to help Europe bridge the financing gap for start-ups and scale-ups. This so-called equity gap has been a prone problem in the EU, especially after the crisis. Therefore, the use of government support and public funds has provided for additional aid to fill this gap, aiming for more fertile conditions for new start-ups. While aiding towards the needed supportive ecosystem, government agencies have become the main investors in the start-up scene after the global crisis.92_{The governmental support was at the ultimate high of 30% right after the} crisis in 2010 and in 2019 their contribution was at 19%, which is less but still a significant amount.93

The support through public VC funds triggered the existence of a great number of new start-ups. However, in light of our research we perceive that a too heavy reliance on public support is not the solid base for a successful entrepreneurial ecosystem. The governmental support was the appropriate answer right after the financial crisis in 2008, however as the EU moves forward, the dependence on public funding in equity markets needs to lessen. It is far better to let market forces develop the right ecosystem on their own. The importance of this argument will be shown in the Chapter 4.3.3.

3.2.1 Government Co-Investment

When public support in the area of private equity was first commenced with, it was in the form of direct public investment. It soon showed that this approach did not attain real growth for start-ups backed up by VC investment. After these companies were backed up by public VC funds, they failed in attaining private VC funds for their following financing rounds. As the return demanded from public funds is lower it discouraged private investors focused on generating higher returns to invest. This direct public investment was also at first geared towards early-stage financing. After the crisis the promotion of new businesses and

92_{M Fenwick, I Skultetyova and E P M. Vermeulen, “Venture Capital” is Not the Answer to Europe’s}

Innovation Challenge (2018) TILEC Discussion Papers No 10. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3133588 accessed 29 May 2020

93_{Scale-up Europe, European Startup Network ‘A Manifesto for Change and Empowerment in the Digital Age’}

(2017) The Lisbon Council and Nesta https://europeanstartupnetwork.eu/wp-content/uploads/2017/10/Scale_Up_Europe_Brochure.pdf accessed 12 April 2020; Invest Europe, ‘Investing in Europe: Private Equity Activity 2019 and 2018’ (May 2020) https://www.investeurope.eu/research/data-and-insight/ accessed 5 May 2020

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jobs was important.94_{However, it established a larger problem in attaining late-stage} financing.

There was a need of a more hybrid approach of private and public funds towards promoting the existence of VC backed start-ups and eventually scale-ups. This hybrid approach would also need a holistic approach, where the equity gap in every stage of finance is addressed. 95_{The effort to beef up allocation of capital through a public-private partnership} created the existence of the ‘fund-of-funds’. 96

The working of these specific fund-of-funds is as follows. The fund takes participation in varied funds operating as a limited parent. There is no direct investment from the fund-of-funds companies, but interests are taken in other VC fund-of-funds that, in turn, do invest in businesses. This consequently addresses the need for a more hybrid approach, where private VC funds in the end perceive to have more control in the actual investment.97

Evidence showed that the VC funds with a fund-of-funds contribution do not only attract more private capital but they also invest larger amounts per company on average.98 Therefore, the fund-of-funds might tackle a part of the equity gap, trying to leave more in the hands of the private VC funds and see if the market can grow more on its own. Whether this became reality in our eyes will be discussed in Chapter 4.2.

3.2.2 The VentureEU Fund-of-Funds

In 2016 VC funds in Europe had an average size of €56 million, while US counterparts had an average size of €156 million. This difference in size is also reflected in the amount invested. In the EU €6.5 billion is invested in start-ups, whereas €39.4 billion in the US.99

94_{Commission (EC) Annual Report on European SME’s, ‘Research & Development and Innovation by SMEs’}

(2019) Publications Office of the European Union 10.2826/500457 accessed 20 April 2020

95_{R Aernoudt, ‘Executive Forum: the scale-up gap: and how to address it’ (2017) Venture Capital, 19:4,}

361-372 https://doi.org/10.1080/13691066.2017.1348724 accessed 22 May 2020; J Vervaeck ‘Analysis Of The Belgian Scale-Up Gap The Financing Of Scaling Companies’ (Dissertation Ghent University 2018)

96_{Fund-of-funds are pooled investment funds that invests in other types of funds. Essentially the fund-of-funds}

invest money in for example other EU based private VC funds, who then in turn invest in emerging companies.

97_{H Kraemer-Eis A Botsari S Gvetadze and F Lang, European Investment Fund, ‘VC Survey 2018: Fund}

managers market sentiment and views on public intervention’ (2018) EIF Research and Market Analysis Working paper 2018/48 https://www.eif.org/news_centre/publications/eif-wp-48.pdf accessed 8 May 2020

98_{Commission (EC), ‘Final report Assessing the Potential for EU Investment in Venture Capital and Other Risk}

Capital Fund-of-Funds’ (2015) Centre for Strategy and Evaluation 10.2777/997836 accessed 12 May 2020

99_{Commission (EC), ‘VentureEU: Pan-European Venture Capital Funds-of-Funds Program and Factsheet}

VentureEU ecosystem’ (2018) Press Releases VentureEU fund 10 April 2018 https://ec.europa.eu/commission/presscorner/detail/en/MEMO_18_2764 accessed 10 May 2020

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In light of fixing the foregoing, the pan-European Venture Capital fund-of-funds (VentrueEU) program was set up in 2018 under the initiative of the European Investment Fund and the European Commission.100

The EU has pumped €410 million into this program with a total target of €2.1 billion to be present in the fund-of-funds. This amount will then aim to catalyze €6.5 billion readily available to be invested in start-ups.101_{VentureEU consists of six funds, managed by} professional experienced fund managers and not by the EIF itself. 102_{The managers are under} the supervision of the European Commission and the European Investment Bank.

The fundamental purpose is to use public money in a smarter way. This will attract a substantial amount of new private investors. Those that previously would not invest in EU VC funds due to the absence of an appropriate vehicle. This tries to tackle the low population of institutional investors in the EU VC market. A survey performed by one of the fund managers, Axon Partners Group, has confirmed that European long-term financial investors are not highly active in VC or even private equity as a whole. Among the European institutional investor respondents, less than 10% had an allocation to private equity of 5% or more. 103

The fund thus tries to bridge the gap between large institutional investors and smaller VC funds. The fund-of-funds aim to provide for the appropriate vehicle for these investors., this will provide access to larger amounts of capital. The fund also works on a pari-passu basis, meaning that public and private investors invest on the same terms and conditions.104

3.3 Case-study Dutch Law

To offer more ground to the landscape of both the EUVECA and the VentureEU fund-of-funds we will perform a case-study of the Netherlands. As this is a member-state that fosters innovation and has a very favorable tax climate. 105_{By performing this case-study we aim to}

100_Ibid. 101_Ibid.

102_{These six funds are: Aberdeen Standard Investments, Axon Partners Group, Isomer Capital, LGT, Lombard}

Odier Asset Management, and Schroder Adveq chosen through an application process.

103_{Commission (EC) and Axon Group, ‘Participation of Institutional Investors in European Venture Capital’}

(2019)ttps://www.axonpartnersgroup.com/wpcontent/uploads/2019/06/Participation_of_Institutional_Investors_i n_European_Venture_Capital.pdf accessed 13 May 2020

104_{See text no 100; Commission (EC) ‘Commission Staff Working Document for Guidance on State aid in}

European Structural and Investment (ESI) Funds Financial instruments in the 2014-2020 programming period’ SWD (2017) 156 final 2 May 2020

105_{Commission (EC), ‘Effectiveness of tax incentives for venture capital and business angels to foster the}

investment of SMEs and start-ups Final Report’ (2017) Working Paper No 68 https://ec.europa.eu/taxation_customs/sites/taxation/files/taxation_paper_69_vc-ba.pdf accessed 4 July 2020

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show that the focus on early-stage finance is also imminent at member-state specific incentives for start-ups.

One major advantage in Dutch tax law is the flexible approach to losses. Here losses can be carried forward nine years and carried back for one year. 106_{Meaning that you can deduct the} loss from a previous year from taxable income if profit is made in coming years. Another general advantage is the 30 percent income tax exemption for international workers which can be used for up to 5 years.107

3.3.1 Specific Tax Incentives for Start-ups

The Innovation Box

Under the “Innovation Box” regime108_{, companies can elect to have qualifying profits from} patents and research and development (R&D) taxed at a corporate income tax rate of 7% instead of 25%. Start-ups might have trouble realizing enough profit to actually benefit from this rule right away. However, when profits are reached start-ups can both use the favorable tax rate from the Innovation Box and the carryback ruling.

Research and Development Promotion Act (WBSO)

The Research and Development Promotion Act (WBSO) offers a payroll deduction for employers that engage in certain R&D activities.109_{For start-ups, the reduction is currently at} 40% of the accompanying payroll costs or other investment expenditures of the R&D activity.110_{The WBSO also offers a share option program here, start-ups can withhold wage} tax and national insurance contributions on 75% rather than 100% of this share option plan issued to employees for a maximum period of 3 years.111_{The issuance of share option plans} by means of the WBSO have the highest tax burden.112_{The employer has to withhold wage} tax and pay social premiums on the value. Therefore, in the Netherlands it is more customary to establish a special purpose vehicle, a Stichting Admnistratiekantoor (STAK), that issues the

106_{Wet Inkomstenbelasting 2001 Article 3.150 and 152 this stipulates the carryback ruling.} 107_{Wet Inkomstenbelasting 2001Article 2.6}

108_{Wet Inkomstenbelasting 2001 Article 12b}

109_{Wet Vermindering Afdracht Loonbelasting en Premie voor de Volksverzekeringen 1996 Article 1(1)(p) and}

23; Netherlands Enterprise Agency, ‘The WBSO 2019 Manual Commissioned by the Ministry of Economic

Affairs and Climate Policy of the Netherlands’ (2019)

https://english.rvo.nl/sites/default/files/2020/02/Manual_WBSO_2019.pdf accessed 5 July 2020

110_Ibid. 111_Ibid.

112_{As it is seen as normal salary it will be taxed under Box 1 in the Dutch system which represent the highest tax}

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shares to the participating employees in the option plan.113_{Through this, taxes are far lower} as it is seen as investment income.114

3.3.2. Government Co-investment Schemes

The Dutch public-private partnership Techleap.nl, which is similar to the VentureEU fund, aims at boosting VC investment in the Dutch innovation hubs. 115

Techleap.nl established that fund managers in the Netherlands face high administrative and commission costs. These problems relate to the young VC market of the EU, where firms can not operate or share best practices with each other at low costs. This highlights the importance of an integrated market and we demonstrate this with the following example. The pool of private investors for seed capital is perfectly organized in the Nordics. They have become known for their national business angel networks. The Netherlands is somewhat lagging behind in that area. 116_{However, if there is an EU wide integrated VC} market, this might not be a problem. Nordic business angels can be incentivized to set up a fund in the Netherlands as they can contact the Dutch VC funds at reasonable costs and hear about promising start-ups to invest in.

3.3 Interim Conclusion

Throughout this Chapter we have witnessed an opposite growth facilitation as to the US. The EU Regulatory provisions and policy initiatives were fore most promoting growth in early-stage of financing. This has led to the overall fragmented nature of the VC supply across all funding stages, from start-up to scale-up, in the EU. When looking at member-state level, namely the Netherlands, it confirmed that outcome further. The rules are dominantly geared towards attracting more start-ups to the Netherlands, such as the WBSO and the Innovation Box. There are less long-term incentives.

113_{I M Meeuwenoord,’Share Options as an instrument to attract & retain talent for Dutch startups’ (Dissertation}

University of Twente 2014)

114_{Investment income is taxed in Box 2, which does not require wage tax and social premiums to be withhold.} 115_{Techleap.nl is a non-profit organization, funded by the Dutch Ministry of Economic Affairs and Climate}

Policy, aimed at accelerating the Dutch tech eco-system.

116_{Dealroom.co, Techleap.nl and CBR, ‘Startups: job growth engine in the Netherlands; The Dutch tech}

ecosystem’ (2019) https://blog.dealroom.co/wp-content/uploads/2019/09/Netherlands-Employment-Report-vFINAL.pdf accessed 6 July 2020; Techleap.nl, ‘Empowering Dutch Leaders in Tech 2020 Action Plan’ (2020) https://issuu.com/techleap/docs/techleap.nl_2020_action_plan______public__single_p?fr=sNGJhNjcyODgyMg accessed 6 July 2020

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4. The Comparative Analysis

In this Chapter we will first elaborate on how the US framework has promoted late-stage finance and the growth of unicorns respectively. The EU framework however lagged in promoting late-stage financing. Therefore, we will discuss a policy recommendation that will more support the growth of unicorns. Hereafter we will perform our functional analysis showing the difference between the two continents. The Chapter will end by acknowledging the limitations of this research.

4.1 The US Secret Sauce117

For the effect that the discussed US rules have on the growth of unicorns we have created a Venn Diagram, shown on the next page.118_{The three rules combined represent a strong core} that leads to an ongoing funding circle in the late-stage and a higher growth of unicorns. As VC funds can hold a larger number of secondary shares, they can invest in more start-ups able to reach the unicorn status. After, we see that start-ups are enabled to attract a higher number of investors while still staying private. On top of that, start-ups can benefit of the use of employee benefit plans even when they scale-up. As employees and early investors have the chance to sell their shares on the secondary market, inside pressure to file for an IPO is reduced. The secondary market also enables VC funds to buy large bulks of shares from those start-ups believed to have growth potential. Increasing the possibility to become a unicorn as the VC investors will provide for both more funding and managerial support.

117_{Secret sauce is the specific strategy that accounts for the success of a start-up.}

118_{The Venn Diagram enables to see the relationship between three objects, or in this case, three rules derived}

How a unicorn is not a myth in the United States and still a species to completely discover in the European Union - The role of equity investment rules and public policy in the growth of unicorns