The Good, The Bad And The Ugly Of VCTs And EISs by SensibleInvesting.TV
“There’s some serious wealth destruction there that at worst could have left you with less than 20p in the pound. You’d have more fun setting fire to £50 notes.” – Monevator – ‘The Investor’ on VCTs
Is the tax tail of VCT and EIS investment wagging the investment dog?
When it comes to considering the role of Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs), this is the question that needs to be asked and answered. Tax breaks need to be very carefully weighed against the material risks of owning minority stakes in small, unquoted company investments. Are they ever appropriate for investors?
VCTs and EISs represent tax-advantaged opportunities to invest equity capital into very small and often very early stage – or even start-up – privately held businesses. The words ‘equity’, ‘privately held’, ‘small’ and ‘early stage’ immediately point out some of the risks, which we cover in more detail later. There is a certain human appeal towards potentially investing in the next Google or similar tech start-up, or owning a share of a biotech firm commercialising some aspect of research for the good of mankind. Intuitively, one knows that this is a risky, dice-rolling business and that for every winner there are bound to be some losers and some also-rans. But the tax breaks afforded by HM Government, for both of these schemes, risk clouding the due diligence that these investments deserve.
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It is a mistake to think that these tax breaks are altruistic in nature. Their purpose is to encourage the supply of capital to these companies in the hope that they will employ more people – who will pay income tax, make NI contributions (individual and company) and pay VAT on goods bought with their wages – and that they will generate higher corporate earnings on which corporation tax can be charged. The tax breaks are provided to improve the risk-return relationship that potential investors in these companies face. It is estimated that somewhere in the region of 35% to 50% of money invested in early stage businesses would not have been invested in the absence of EIS.
Capital raising metrics
By way of background, it is worth noting that there are over 5 million SMEs (companies with fewer than 250 employees) in the UK, accounting for 99% of businesses and around 50% of total private sector turnover. Companies with fewer than 10 employees account for 95% of all UK businesses.
EISs were launched in 1993-1994 as an evolution of the Business Expansion Scheme that went before them. Since they began, they have raised over £10.7bn for 21,000 small companies, with an estimated £1 billion raised in 2013/2014 for around 2,400 companies5. This compares to around £22bn of retail investments into UK mutual funds6 in the 12 months to October 2014. The peak of EIS capital raising was in 2000/1 at the height of the technology boom. Today’s level of fund raising is almost comparable to the previous high. Since 2006, around 60% of all investment has been made into companies operating in London and the South East.
EIS investors have the opportunity to invest either directly into share issues of qualifying firms or via a pooled arrangement – somewhat erroneously described as a fund – which tends to be a collection of investments held by the manager and managed on behalf of the pool of investors. The investments are held in a nominee name with the individual investors remaining as the beneficial owners. This makes access to the tax reliefs easier.
The VCT scheme was first introduced in 1995. VCTs are similar to investment trusts, raising capital by the sale of shares in the trust, which is then invested into qualifying trading companies. VCTs must be listed on a UK stock exchange and will trade at a premium (rare) or discount to the Net Asset Value (NAV) of the underlying portfolio companies. They are managed by professional fund managers. Total funds raised from 1995-6 to 2013-4 were £5.5 billion, with record funds raised in 2000-1 of £450 million. In 2013-14, funds raised were £440 million, via 66 funds, out of 97 funds in existence7. This is around half of the funds raised for EIS in 2012/13.
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