While securing investment is crucial for innovative startups, understanding how different investor types and their levels of ownership or control can impact a company’s Small and Medium-sized Enterprise (SME) status is equally important to losing the large range of equity-free public funding.

Highly innovative and fast-growing startups frequently seek investors. The landscape of potential investors is diverse, ranging from individual business angels and venture capital (VC) firms to large corporate entities. Each investor offers a unique set of characteristics, not just in terms of capital but also in their level of ownership, control, and strategic influence on the company. When external investors hold a significant share of equity or voting rights, or have strong influence over key decisions, it can affect a company’s independence. This, in turn, can affect the SME status.

SME status gives companies access to various non-equity, public support programs, funding opportunities, and regulatory advantages specifically designed for smaller businesses. Therefore, while seeking investment is vital for growth, startups must carefully consider both the type of investor and the deal terms to understand how they might affect their SME status and the benefits that come with it.
 

Understanding SME Definition exceptions 

By the SME Definition: “An enterprise may still be considered autonomous, and thus as not having any partner enterprises, even if the 25 % threshold is reached or exceeded by any of the following types of investors:

• public investment corporations; 

• venture capital companies; 

• business angels (but the financial involvement of business angels in the same enterprise must be below EUR 1 250 000).;

• universities; 

• non-profit-making research centres;

• institutional investors (including regional development funds);

• autonomous local authorities with an annual budget of less than EUR 10 million and fewer than 5 000 inhabitants;

One or more of the above investors may individually have a stake of up to 50 % in an enterprise, provided they are not linked, either individually or jointly, to the enterprise under SME assessment.”

The EU has a strict list of who counts as an approved investor, and each category has a clear definition.

But the rules are complicated, and it’s easy to make mistakes. A wrong interpretation can cause a startup to lose its SME status, and the funding or tax benefits that come with it. One common problem involves corporate venture capital (CVC). These are companies that mainly run another business but also invest in startups on the side.

Because investing isn’t their main activity, they don’t qualify as “approved investors.”

So if such a company buys 25% or more of a startup, it can make the startup too large or too dependent on that corporation.

As a result, the startup might no longer count as an SME, simply because the investor’s parent company is big enough to break the “independence” rule.

Another problem comes up when investors are connected to each other.

Even if each one owns less than 50% but more than 25%, their combined shares can still go over the allowed limit.

Also, “linked enterprises” doesn’t just mean companies that directly own shares in each other — it can also include those with the same owners, shared managers, or close business ties that make them part of one larger group.

Implications of investor funding for public funding eligibility

Securing a term sheet from an investor is a big milestone for any startup. However, sometimes, saying yes, even to the eligible investor will mean saying no to the SME status and its privileges. The key issue lies in the investment agreement, specifically the “the concept of control — both legal and de facto. […] 

How is it possible? Due to the SME definition two or more companies will be treated as  linked to each other if  any of the following relationships exist between them:

• “one enterprise holds a majority of the shareholders’ or members’ voting rights in another;

• one enterprise is entitled to appoint or remove a majority of the administrative, management or supervisory body of another;

• a contract between the enterprises, or a provision in the memorandum or articles of association of one of the enterprises, enables one to exercise a dominant influence over the other;

• one enterprise is able, by agreement, to exercise sole control over a majority of shareholders’ or members’ voting rights in another.”

It is quite uncommon for investment agreements to include clauses that may trigger or breach these rules, creating a “linked” relationship between companies. When such a link exists, the investor’s revenues and staff numbers must be included when calculating the company’s SME status, which can easily push the startup beyond the eligibility thresholds.

Below are the examples of most common investment agreement clauses that may be considered giving one enterprise such control:

• “The Investor shall have the right to appoint and remove three (3) out of five (5) members of the Board of Directors.”
• “No appointment or removal of any member of the Board shall be made without the prior written consent of the Investor.”
• “The Investor shall have the right to approve the appointment or dismissal of senior management, including the CEO and CFO.”

Given these complexities, companies aiming to obtain or maintain SME status should carry out careful due diligence on both current and potential investors.

This means looking beyond direct shareholdings to understand ownership structures and the links between investor entities.

A proactive review of investor relationships and contract terms can help prevent the unexpected loss of SME status — and the valuable benefits that come with it.

If you are uncertain about your status, reach us at info@fundingbox.com, we can not give you a legal guarantee, but we are here to help you figure out the most accurate answer!

Stay tuned for our series: SME definition unpacked.

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*We used AI for the research and to polish the text.

Sources: User guide to the SME Definition. Annex to Recommendation 2003/361/EC