The Enterprise Investment Scheme (EIS) and venture capital trusts (VCTs) are growing in popularity among investors looking to put money into small, early-stage businesses with the added sweetener of a tax relief.
In the 2021-22 tax year, there was a 39 per cent increase in funding going to companies that raised money under EIS. VCTs raised £1.08bn in the 2022-23 tax year, the second-highest annual total on record.
These schemes gained a new lease of life in the Autumn Statement, when chancellor Jeremy Hunt extended the sunset clauses providing tax relief on them until 2035.
But EIS and VCT investments are not suitable for every investor, as they require more advanced knowledge and risk appetite. How should investors make the best use of them?
What are the tax benefits?
EIS investors can claim 30 per cent income tax relief on investments up to £1mn, or £2mn if at least £1mn is invested in knowledge-intensive companies.
Capital gains tax relief can also be claimed on 100 per cent of the amount invested. If EIS shares are sold at a loss, the amount can also be set against your income, excluding any income tax relief already given. EIS investments must be held for at least three years to claim the full tax reliefs. They are also not included in estate value calculation for inheritance tax.
VCT investors can claim 30 per cent income tax relief on investments up to £200,000 a year. Profits are exempted from capital gains tax when shares are sold, but relief for capital losses against income is not available. VCT investments must be held for five years to benefit from income tax relief.
VCTs tend to pay dividends, which are tax free. EIS companies rarely do, and when they do they are liable to tax.
However, investors in such schemes are not always just seeking tax relief, as the EIS and VCTs offer the chance to gain high returns by backing tomorrow’s company success stories.
“Even among more established investors, I think there’s an element of wanting to back small, fast-growing businesses and hoping you pick the next Amazon,” said Nick Hyett, an investment analyst at broker Wealth Club.
Returns targeted by EIS fund managers can vary from approximately 1.3 times to more than 10 times money invested, according to Wealth Club. VCTs often target a dividend of 5 per cent per year.
Data on EIS performance is rarely publicly available, but of 16 EIS funds tracked by Wealth Club that raised money in the 2017-18 tax year, the total value of investments is £1.74 per £1 invested, not including tax relief and including fees. Of that, 40p has been returned to investors in cash.
In the 10 years to September 2023, the 10 largest VCT managers delivered an average net asset value total return of 81.4 per cent, assuming dividends are reinvested, Wealth Club said.
Where are the best opportunities?
EIS investors can put money directly into companies or managed funds. Direct investments are more appropriate for people with a high level of expertise, who can scout out good opportunities. In funds, a manager takes responsibility for those tasks.
“We always suggest investing in a portfolio . . . to mitigate risk rather than putting all your eggs in one basket,” said Madeleine Ingram, a director at Calculus Capital, an EIS and VCT fund manager. “Professional fund managers often have structures in place when it comes to things like due diligence and getting to know the business and management team, which tends to determine whether the company succeeds or fails.”
Popular sectors include business to business software, healthcare and net zero technologies.
Software is relatively capital light and can be sold in infinite numbers at minimal cost, while the path to approval for healthcare devices tends to be faster compared with drug discovery.
“Investors can typically find managers who have, if not a portfolio that’s wholly invested, one that has a bent towards a particular type of investment or investment theme,” said Richard Stone, chief executive of the Association of Investment Companies.
On the other hand, retail and consumer products are relatively more capital intensive and often require high marketing expenditure. They can be subject to pressure as discretionary spending levels change with the economic climate.
The higher interest rate environment has challenged some company valuations. Since EIS and VCT companies are growth stocks which promise returns in the future, they have struggled to compete with relatively less risky, high-yield investments such as gilts.
However, according to Hyett, times of market stress can be an ideal moment to invest in venture capital.
“Companies are now chasing money rather than money chasing companies,” he said. [Fund managers] tend to have a much stronger hand in the negotiation with a company. There is also a pipeline of experienced founders starting or leading businesses, as technology companies have laid off staff.”
What are the risks?
Since investments into EIS and VCT target relatively unproven companies, there is a higher risk they will fail.
“Investors need to understand and be prepared for the risk that some of these investments may go insolvent,” said Kieron Launder, chief investment officer at Growthdeck, a private equity investment platform. “It is also likely that this will happen earlier than successful exits, meaning the psychological journey for EIS investors may be harder.”
Tax reliefs are only attached to new shares, which means someone buying them from the original owner or subsequent owners will not benefit.
Investments into EIS and VCT are also more illiquid, meaning that shares are harder to sell.
“Investors should be aware that you can’t get your money back easily,” said Christiana Stewart-Lockhart, director-general of the Enterprise Investment Scheme Association. “This is patient capital that is intended for the investment to be for a minimum of three years but typically five to 10 years.”