'The outlook for investing in venture capital is exciting'

The number of announced equity deals via crowd-funding platforms grew from just eight deals in 2011 to 573 deals in 2021.

It seems growing numbers want to back companies in their formative years, to play a part in helping them grow, and to take on more risk with a portion of their wealth to reach for higher returns.

Accordingly, the advised market has seen plenty of interest from clients who want to diversify their portfolio and target high growth by backing new ventures.  

At the same time, the current outlook for investing in venture capital is particularly exciting. 

The best time to invest in a decade? 

This might surprise you but, just like diamonds, billion-dollar companies (or ‘unicorns’) are renowned for taking shape under pressure. 

For example, some of the most successful venture capital-backed businesses, like AirBnB, Zoopla, and Uber were formed in the wake of the 2008 global financial crisis. 

Investors must be patient for returns.

As the global economy once again faces fresh challenges, we are seeing many of the same trends appearing that helped to create these great unicorns: existing businesses are spending less on innovation, there’s a growing pool of available talent due to company layoffs, and there’s less competition to invest in the best entrepreneurs.

While slowing global growth can be tough on any business, if you look closely, there are some opportunities to unearth tomorrow’s success stories. 

In this environment, managed portfolios of Enterprise Investment Scheme (EIS) investments have come into their own. 

Backing companies from day one to success or failure

EIS is an established route that facilitates investment into early-stage companies while providing for tax relief to mitigate some of the risks involved. They support investment directly into the shares of one or more qualifying companies near the start of their growth journey.

Investors must also be patient for returns. The investment is illiquid and exits should be expected only once each company has had time to significantly develop and attract a purchaser. EIS is, therefore, all about investing in a portfolio of companies with significant growth potential. 

As the global economy faces fresh challenges, we are seeing many of the same trends appearing.

This is a different investment to a venture capital trust, another tax-efficient investment that invests in early-stage companies. This functions more like a fund; it will already be invested across a large portfolio of early stage and maturing companies, with more being added each year and successful maturing businesses being sold. 

VCTs typically pay out growth as a dividend each year rather than allowing growth to accumulate, and investors can sell VCT shares back to the VCT or in the secondary market, subject to liquidity, after the minimum five-year holding period has been met.

An EIS portfolio will typically offer a more unfettered return as the portfolio is much more concentrated, both in size and stage of company journey, so while a client will feel the failures more sharply, the successes will feel more pronounced. A VCT on the other hand, offers a blended return that nets losses against successes within the VCT vehicle itself.

Early-stage companies have the potential to grow significantly. 

And it is worth noting that the shares of unquoted companies can also fall or rise in value more sharply than shares in larger, more established companies.

This is why the tax reliefs available are important. 

How EIS tax reliefs work

Clients can claim 30 per cent income tax relief on the amount they invest in EIS-qualifying companies. They can claim relief against income tax due for the tax year they invest into each company, or they can choose to carry back relief to the previous tax year.

When an EIS company is sold from an investor’s portfolio, any growth in value is 100 per cent tax-free. This is especially valuable, because early-stage companies have the potential to grow significantly. 

Since there is an opportunity for high growth, EIS-qualifying companies also have a high risk of falling in value, including to nil, meaning investors may not get back the full amount invested.

This is a very beneficial suite of reliefs for investors looking to target high growth from early-stage companies.  

Loss relief can reduce the impact of companies that fall in value. Investors can claim relief on their “net loss” – the amount of money invested in the company that has lost value after the benefit of income tax relief has been taken into account. This loss can be offset against capital gains or income tax.   

Importantly, because EIS reliefs are based on investments in individual companies, loss relief is available on companies that have failed, even if an investor holds a portfolio that has delivered a positive return overall.

An equivalent is not available for VCT investors, where losses and gains made on portfolio companies offset within the VCT itself, producing a net return. 

Combined with tax free growth and income tax relief, this is a very beneficial suite of reliefs for investors looking to target high growth from early-stage companies.  

While not applicable to a large swathe of clients, some EIS investors also choose to make use of CGT deferral. When a client has realised a gain elsewhere and invests the gain in one or more EIS-qualifying companies within a certain window of time, CGT can be deferred until those companies are sold.  

Tax treatment depends on individual circumstances and tax rules could change in the future. 

EIS shares also qualify for relief from inheritance tax. If the client passes away while holding the shares, provided they have held them for at least two years, they can be left to beneficiaries free from IHT. If a gain was deferred when an EIS investment was made, that liability is also wiped out on death of the investor. 

It’s important to remember that tax reliefs depend on portfolio companies maintaining their EIS-qualifying status. The same is true of VCTs, which must maintain their respective qualifying status.

Tax treatment depends on individual circumstances and tax rules could change in the future. 

Investing in EIS at tax year-end

One of the attractions of investing in an EIS portfolio is the ability to carry back income tax relief to the previous tax year.

For a typical managed EIS portfolio, relief can be claimed in the year that money is invested into each individual EIS company, or the previous year. But this can make offsetting income tax from the prior year difficult when investing in an EIS portfolio at the end of the tax year because funds will be deployed over the subsequent months.   

However, investing in a knowledge intensive EIS fund gives clients a solution to this problem. 

It’s best explained with a scenario: 

Chris wants to mitigate a prior year income tax bill Chris is in his late forties. He’s self-employed and a high earner, although his income can fluctuate from one year to the next.

It’s important to remember that tax reliefs depend on portfolio companies maintaining their EIS-qualifying status.

In fact, Chris often doesn’t know what his tax bill will be until his accountant has finished preparing his tax return.

He has a diversified investment portfolio and is an experienced investor. Over the years Chris has made it clear he’s open to being adventurous with a portion of his portfolio, and he’s happy to take more risk to target significant growth. 

Tax year-end is approaching and Chris wonders if there are any opportunities available that would allow him to offset an income tax bill from the previous tax year, while also supporting his wider planning objectives. 

Chris meets with his adviser, Helena. She considers Chris’s needs, goals, and appetite for risk, before suggesting a potential investment that could work for him.

Helena explains that one of the benefits of investing in companies that qualify under the EIS is the ability to carry back income tax relief to the previous tax year. 

Chris could invest in a knowledge intensive EIS fund, which would give him access to a diverse portfolio of early-stage companies with high growth potential. Helena is aware that this will likely be a restricted mass market investment, so she is conscious of the new requirements when issuing this financial promotion to Chris.

Importantly, the relevant date for income tax relief when investing in a knowledge intensive fund is the date the fund closes, rather than the date each underlying investment is made.

So Chris could invest close to tax year-end, once his income tax bill for the prior year is known, and still claim relief against the prior tax year.

His investment would provide him a single certificate, which he could use to claim up to 30 per cent income tax relief, creating either a rebate or allowing him to offset tax yet to be paid. 

Jess Franks is head of investment products at Octopus Investments