In the process of negotiating terms, it was slipped into conversation that the accelerator actually invests double the amount requested into the business (artificially inflating the business valuation and potentially creating some pretty big burnrate questions for future investors), which is paid directly to the accelerator on receipt of funds as a service charge.
This service charge is apparently there to facilitate the other "free" mentorship, office space and introductions that the accelerator offers.
It seems like this is a bit of a tax fiddle from an SEIS (Seed Enterprise Investment Fund) perspective, as all they are doing is draining the fund to essentially pay themselves, exposing very little risk, but obtaining a decent equity share in a new start up business. This also eats into the £150k of available SEIS funding, as a chunk of it is not invested at all, just leaving through the backdoor to pay the accelerator.
Is this commonplace and is anyone aware of other accelerators doing the same thing?
The one we went through got most of their fees via "highly recommended" legal and accounting service kickbacks, which charged far higher than market rate monthly retainers, for doing absolutely nothing in some cases. Lawyers and accountants who stood to benefit were literally partners at the fund... We decided to stick with our own accountant, and the accelerator got extremely upset at us for doing so. Some shockingly unprofessional, threatening, vague emails and lots of criticism for not choosing their accountants.
You are correct that the people running these funds will get paid no matter what, and will have absolutely no financial incentive to make you succeed. Quite the opposite. Ours in particular has done a lot to minimize their work, drag out anything they're required to do over months, and get rid of companies as quick as possible after their investment.
These can still work out, just know that these aren't the tier #1 funds that we're used to hearing about. Founder beware.
Writes off £50k of your SEIS allowance as a business, which as I'm sure you know is like gold dust for the first £150k, as 50% of the investment can be written off against investors income tax, then a further 30% if the company fails.
If the company succeeds, the investors pay no capital gains on sale of shares.
To answer your question, some of them take equity and others take cash. Either way, you're getting screwed. Unless, of course, you just keep finding investors to pour money into it. If that's your objective, the price is usually worth it.
Edit: I didn't mean to say that all accelerators are worth it, but I disagree with the sweeping generalization that all accelerators are screwing their companies.
Whatever reason the accelerator is doing it for (whether good or bad for them) is bad for the company if it's losing some of it's allocation without seeing the money. A lot of early stage investors won't touch a non-SEIS deal.
Edit: Also for every YC/Techstars/500 there's a 100 "incubators" that overcharge and underdeliver.
That is extremely not the case, too often. Many times it's the equivalent of used car salesman / real estate broker type sales people - who are good at selling themselves to people with money and love to squeeze the most out of negotiations just for fun, with no clue or regard for the tech startups. Wish I was exaggerating.
Specifically because of the way that it burns the SEIS allowance.
I would be tempted to call HMRC and explain what the accelerator are doing, that they are using the investment incentive as a service charge for themselves, and to ask them to clarify whether or not this is allowed and the degree to which it creates an issue for your company.
https://www.gov.uk/report-an-unregistered-trader-or-business
That page is aimed much more at the "cash in hand" trader, but they'll take reports on anything.
You don't have to know that it's tax evasion to make a report.
"We invest $100k in exchange for 7%, and charge a $25K program fee for a net $75K investment."
Not quite sure why some accelerators do this.
Their explanation: http://www.quora.com/What-is-500-Startups-business-model
Important to understand: they've got one brand but two entities, the investment fund and the accelerator. The accelerator is designed to take in $X per year in revenue and pay out $X in expenses, for a net profit of zero or slightly negative. (Having more than slightly negative is tax inefficient. You get to book the implicit tax value of the loss as a carryforward asset but you would have no way to ultimately realize it since the accelerator is designed in this model to never actually make significant amounts of money.)
"But isn't it equivalent if you just give them $75k." No, not equivalent. This manages to teleport revenue through time from the eventual carry into the present, pays for present cash expenses, and gives that revenue favorable tax treatment.
How exactly it's favorable tax treatment is a great question for a tax lawyer. Here's my layman's understanding: you can deduct expenses from capital gains prior to taxing them but they have to have a certain level of connection with the gains, and it is possible that "general administrative expenses of our operation" don't have that level of connection. Shuffling those expenses into the accelerator makes them clearly deductible against the accelerator's ordinary income, since the accelerator looks like any money-comes-in-money-goes-out IT business. The program fee is clearly revenue. Their rent is clearly an expense. If revenues equal expenses than their revenues are taxed at, effectively, 0%.
"Tax optimization on $25k doesn't make sense" would be a sensible objection until you remember that 500 Startups operates at industrial scale and that this is suddenly $3 million in revenue a year.
n.b. 500 Startups would, eventually, pay whatever the normal capital gains taxes are on the carry (and/or ordinary income tax if the law is ever changed to make it less favorable), in accordance with the standard treatment of investments under US tax law. It's not an avoidance strategy, it is a temporal optimization strategy.
Edit to add: Above explanation is purely "My best understanding of the matter as someone who had no hand in putting this together." based on my inexpert understanding of standard US principles of taxation and their public statements about it.
(The more comes from the fact that a lot of times this is convertible note with a discount, and the discount also provides a bump in pro-rata rights. See http://www.bothsidesofthetable.com/2014/10/12/the-authoritat...)
So this isnt just tax optimization, but investment/equity optimization as well. That said, smart founders should probably value their involvement in the accelerator as an valuation multiplier: if it isnt, they shouldnt join one.
I personally consider it deceptive for any incubator to ask a participant to pay for things the incubator positions as free support (i.e. use of "our" office space). And it is perfectly valid to call out any business as predatory when its behavior seems purposefully structured to confuse customers about how much they are paying and what they get for it.
How is that multiple even close to right? Everyone I've ever talked to says 5-10 is more realistic, and the push-back you get grows exponentially as you approach 10.
Only you know if it's a deal you can stomach.
