Nothing ventured, nothing gained

SwiftKey is widely recognised as one of the world’s best keyboard applications for mobile devices. It is currently being used on more than 300m mobile phones and tablets worldwide . SwiftKey’s success is partly due to the fact that the company was backed by venture capital funding from an early stage, which gave two founders with a passion for artificial intelligence the opportunity to build a global business that could scale quickly.

Tech hub

The UK is now an increasingly accommodating place for entrepreneurs, and London is Europe’s largest tech hub. Yet while the sale of SwiftKey has gathered headlines, investors may still be scratching their heads as to how to access this niche corner of the market. After all, it can be hard to know how to access unlisted entrepreneurial companies. But here is where tax-efficient investing offers something special for entrepreneurs and retail investors alike.

Since the mid-1990s, successive governments have supported smaller UK companies through two tax-efficient structures: Venture Capital Trusts (VCTs) and the Enterprise Investment Scheme (EIS). Investing in smaller companies contains higher risks than investing in listed stocks, which is why investors are offered attractive tax incentives.

For VCTs, investors can receive up to 30 per cent income tax relief up-front on investments of up to £200,000 in any tax year, as long as the shares are held for a minimum of five years. Additionally, any dividends earned are tax-free, and there is no capital gains tax to pay when it comes time to sell the shares.

For EIS, the tax reliefs are even more compelling. Investors can still receive up to 30 per cent income tax relief, but this can be on investments of up to £1m, and the minimum holding period is three years. Also, EIS investments typically include full inheritance tax exemption (provided the shares are held for at least two years and are still held at the time of death), capital gains tax deferral (which is eliminated if held until death), and up to 45 per cent loss relief on any holding that falls in value.

VCTs come in all sorts of shapes and sizes, but they are all listed companies in their own right and many seek to offer regular dividends as well as the potential for special dividends. While some choose to invest in specialist niche sectors, other, larger VCTs make a virtue of the fact that holding more portfolio companies offers greater diversification. Some high-profile examples of companies that have benefited from VCT investment include Zoopla Property Group, Secret Escapes, graze.com and LoveFilm. EISs takes a slightly different approach, as they allow investors to invest directly in businesses, but often also focus on specific sectors, such as renewable energy, infrastructure or healthcare services

Many of the smaller businesses that can benefit from VCT and EIS investment are quite different from larger listed companies, whose returns are largely influenced by the day-to-day ups and downs of the stock market. However, smaller businesses can come with their own challenges, including volatility, and are high-risk investments as a result.

VCTs and EISs offer a wide range of different investment mandates and underlying investment opportunities to meet different requirements. That said, the supply of underlying companies that qualify for VCT and EIS investment has been affected by the legislative changes that were announced during 2015.

Investment flows

Governments frequently adjust the rules relating to tax-efficient investments, as a way of directing the inflow of investments into certain areas where it is needed. For example, renewable energy-generating companies have benefited greatly from government-approved tax incentives. So much so that these incentives have been deemed to have done their job. From 6 April 2016, energy-generating companies will no longer qualify for EIS tax incentives. This means there is a limited window of opportunity left for suitable EIS investors to take advantage of this proven opportunity in the current tax year.

As for VCTs, recent legislation changes included the stipulation that funds raised by VCTs can no longer be used for company acquisitions or management buy-outs. In some respects, the rules have been changed to make sure that VCTs focus on funding those companies that need it most. Some VCTs have had to restrict raising new funds while they look at adjusting their operating models. But for those VCTs that already operate at the early-stage end of the market, it remains business as usual. Therefore, this year is likely to be one where investor demand for the VCTs outstrips supply.

It would be remiss to not include inheritance tax as another important component within tax-efficient investing. In August 2013, the Government announced shares listed on the Alternative Investment Market (Aim) could be held in Isas. Many AIM-listed companies qualify for business property relief (BPR). Introduced in 1976, BPR was created to allow small businesses to be handed down through generations without incurring inheritance tax liabilities. Its scope has been widened in subsequent years, so that it is not just father-and-son-enterprises which are able to benefit. Shares that qualify for BPR fall outside the scope of inheritance tax as long as the shares have been held for at least two years, and are still held at the time of death.

VCTs, EISs and investments that offer BPR are high-risk investments. Those that do well achieve their objectives and have the potential to offer significant returns, but they do not all succeed. If your clients are not comfortable with the idea of investing in smaller companies that are not listed on the London Stock Exchange, then such investments are not right for them.

The performance of such investments can also be more volatile, which means that, over time, their value could fluctuate significantly. When it is time to sell there is a chance that the investment will have reduced in value. There are minimum investment limits and these products certainly will not be suitable for everyone.

It is also important that the tax benefits are not allowed to overshadow the risks. Particularly because the tax treatment for investors depends on their individual circumstances and may be subject to change. In addition, the availability of any tax reliefs depends on the investment companies maintaining their qualifying status.

Of course, it is not just the tax benefits that are attractive to investors. For many, it is the opportunity to share in the growth potential of fast-growing, exciting young companies. At a time when global stock markets are preoccupied with concerns over lack of growth, it is worth noting that the majority of the high-growth small businesses in a VCT or EIS portfolio will be less exposed to global market risk than their larger, listed cousins. This means their fortunes are therefore less likely to be influenced by the day-to-day fluctuations of stock markets.

Two decades since they were introduced, billions of pounds of investor capital has been put to good use supporting UK enterprise and smaller companies, from start-ups all the way through to mature names listed on AIM. It is no wonder then that VCTs and EIS have become a critical source of funding for many UK companies, the envy of entrepreneurs outside the UK, and a cherished part of many investors’ portfolios.

Paul Latham is managing director of Octopus Investments

Key points

Since the mid-1990s, governments have supported UK smaller companies through VCTs and EISs.

For VCTs, investors can receive up to 30 per cent income tax relief up-front.

Many invest because of the opportunity to share in the growth potential of fast-growing, exciting young companies.

EIS/VCT comparison