At Harper James, we specialise in providing legal advice to start-up businesses. Many of our clients want to know about readily available options to attract investment– often through schemes designed to raise capital in order to fund the costs of development, whether that be to acquire premises, build IT infrastructure, or simply for working capital while their business grows its operations.
Equally, for our more established clients looking to scale their businesses, the question of funding and which kind of investor to target is a key concern, particularly in an increasingly volatile market.
- Why you need to know about different types of funding and investors
- Different types of venture capital schemes:
- What about collective investment schemes?
- Background to EIS, SEIS, SITR and VCT investment schemes
- How do the investment schemes work?
- Key criteria for each investment scheme:
- What’s the difference between individual investing and investing via a Venture Capital Trust?
- Conditions imposed on individual investors
- Eligibility criteria to qualify under the EIS, SEIS, SITR or VCT schemes
- If you think your company is eligible under one of the investment schemes, what are the next steps?
Why you need to know about different types of funding and investors
If you want to attract investment by using a readily available investment scheme (such as one of the UK government schemes), it’s very important for founders and CEOs to understand the different types of investment scheme that exist so that they can identify the most suitable investors that may be interested in funding their business. The nature of investment schemes that are popular with investors can vary and one scheme can be very different to another, for example venture capital schemes are different to collective investment schemes.
Venture capital schemes are investment programs that are usually related to investment in new players to the market or small to medium companies that do not have listings on recognised stock exchanges, for example. The schemes themselves are designed to offer certain tax relief incentives to investors that are willing to make investments in companies that have a higher level of perceived risk (on account of being new or small and therefore are not ‘tried and tested’ and do not have endless resources).
Different types of venture capital schemes:
The table below sets out different types of venture capital schemes:
|Type of scheme||Overview of scheme|
|Enterprise Investment Scheme (‘EIS’)||Used by individuals to make investments directly in small to medium businesses.|
|Seed Enterprise Investment Scheme (‘SEIS’)||Used to make investments directly in early stage start-up businesses.|
|Venture Capital Trusts (‘VCT’) scheme||Used as a vehicle for individuals to make indirect investment in small, medium or start-up businesses.|
|Social Investment Tax Relief (‘SITR’)||Used by individuals to make investments directly in certain social enterprises (a social enterprise is an enterprise applying commercial strategies to maximise social impact, typically improvements in financial, social and environmental wellbeing).|
What about collective investment schemes?
Collective investment schemes are regulated by the Financial Services and Markets Act 2000 (‘FSMA’) and are described as arrangements with respect to property of any description, including money, that enable investors (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.
In a collective investment scheme investors’ money is collectively invested in a portfolio of assets. The investment is spread amongst the entire portfolio and an investor is not specifically investing in one business. Investors will be given shares in the portfolio that will make or lose money depending on how much the value of the underlying portfolio rises or falls. This article focuses on venture capital schemes where there can be a much closer relationship between the investor and the business itself.
Understanding what drives potential investors is very important when looking to affiliate your business with an investment scheme such as the EIS & SEIS, SITR and VCT schemes. These schemes offer tax reliefs to individuals who buy and hold new shares, bonds, or assets for a specific period of time.
As well as tailoring your pitch to suit the needs of investors who wish to benefit from the schemes, it is also be possible to target individuals who are not aware of the tax reliefs available and entice them to invest for a potentially greater return than they might receive from traditional investments.
There are however certain requirements that must be met before a company, investor or a proposed investment can qualify for these schemes.
Background to EIS, SEIS, SITR and VCT investment schemes
The EIS, SEIS, SITR and VCT investment schemes were designed to promote growth in the economy by providing tax relief to private investors. In particular, they are geared towards attracting investments into early-stage, small and medium companies, start-ups, and social enterprises and often it will be the growth potential of the specific business itself that attracts investors.
On top of the income tax relief available to investors, any gains from eligible investments are also exempt from capital gains tax (‘CGT’) provided certain scheme conditions are met. What’s more, provided the scheme criteria is met, eligible investments are exempt from inheritance tax.
How do the investment schemes work?
The net effect of these investment schemes is that investors can reduce their capital at risk to less than the amount invested, and this has historically proved to be a huge incentive for investors to use the schemes.
On top of the income tax and loss relief benefits, profits from eligible investments are exempt from CGT as long as the shares are held in accordance with the scheme requirements. For all schemes to benefit from income tax relief the shares much be newly issued and paid in cash. For example, if an angel invests £10,000 into an EIS company, their capital at risk, after the tax relief at 30%, would be just £7,000. If the shares increase in value to £20,000 then the increase in value of £10,000 would be exempt from CGT. Looked at another way, the investor whose shares double in value has almost trebled his or her initial investment. And if the company goes bust, then the investor’s losses, rather than being the £10,000 initial investment, could be reduced by over half, considering the initial income tax relief and further loss relief available.
Key criteria for each investment scheme:
The table below sets out an overview of some of the key criteria for each of the schemes:
|Maximum amount that the entity can raise||Annual limit: £5 million per company/ group or £10 million for shares in a knowledge-intensive company. Lifetime limit is £12 million per group or £20 million for a knowledge-intensive company.||£150,000 per company and its subsidiaries in any three-year period.||Lifetime limit is £1,500,000 for entities up to seven years old. For entities older than seven years, there is a formula to calculate the maximum amount the enterprise can raise based on the value of the tax reliefs, less any state aid already received in the three-year period.||The VCT’s investment when added to all VCT, EIS and SEIS investments made in that company must be not more than £5million (or £10 million for knowledge-intensive companies) in any 12-month period ending with the date the relevant holding is issued. £1 million investment limit applies if the investee company (or one of its qualifying subsidiaries) is a member of a partnership or joint venture, the qualifying trade was carried on by the partnership or joint venture and the partnership or joint venture include at least one other company. The investee company must not raise more than £12 million (£20 million if a knowledge-intensive company) in total from relevant investments.|
|Maximum income tax relief available||30% up to a maximum per investor per year of £1million or up to £2million if amounts over the first £1million are invested in a knowledge intensive company.||50% up to a maximum per investor per year of £100,000.||30% up to a maximum per investor per year of £1million.||30% up to maximum per investor per year of £200,000. Income tax relief is only available on an issue of new shares. A subscription for shares will not attract income tax relief if the investor sells shares in the VCT and the subscription and sale are within six months of each other, or if the subscription was conditional on a buyback of the shares or vice versa (except in some cases in the context of a merger or reconstruction).|
|Tax relief on income from dividends||No||No||No||Yes, provided that in the year of acquisition the market value of the qualifying shares did not exceed £200,000, or if the limit is exceeded, the dividends in respect of the first shares acquired up to the limit are exempt.|
|Capital Gains Tax: Initial Investment||100% exemption for gains on EIS investment.||50% of investment, capped at £50,000. Exempt from tax.||100% exemption for gains on SITR investment.||Deferral relief is not available for investments in shares issued after 5 April 2004.|
|Capital Gains Tax: Other reliefs||Deferral of CGT. Gains exempt from CGT when shares sold if Income Tax relief has been received and shares have been held for at least 3 years. CGT on other asset disposals can be deferred where the gain is re-invested into shares in an EIS qualifying company.||Gains exempt from CGT when shares sold if Income Tax relief has been received and shares have been held for at least 3 years. The tax reliefs are only available once the company has either spent at least 70% of the SEIS monies raised or has been actively trading for at least four months.||Deferral of CGT if investors invest their gain in a qualifying social investment. Gains exempt from CGT when shares sold if Income Tax relief has been received and shares have been held for at least 3 years||Investors in VCTs are also exempt from CGT on any chargeable gains arising on the disposal of the VCT’s shares – so you will not have to pay any CGT on any profits when you sell your shares. The dividend tax relief and exemption from CGT on disposals apply to both new issues of shares as well as the acquisition of existing shares.|
|Other Tax Reliefs, Allowable Losses||Relief is given for allowable capital losses on disposal of the shares against income of the tax year of disposal (or of the previous year) or chargeable gains.||Relief available for capital losses against income||Relief available for capital losses against income but not on loans||No relief is available.|
|Type of investment||Ordinary shares (or shares that can convert to another class of shares in the company) but not preference or redeemable shares.||Ordinary shares (or shares that can convert to another class of shares in the company) but not preference or redeemable shares.||Ordinary shares. Unsecured debentures. Neither shares nor debt must offer more than a reasonable commercial rate of return. The loan or debt must not be secured on any assets and interest must be at a reasonable commercial rate. No part of the loan can be repaid within 3 years of the investment.||The VCT’s ordinary shares must be listed in the Official List of the London Stock Exchange or any other EU regulated market. A listing on AIM is not enough.|
|When can relief be claimed||Up to 5 years after 31 January following the tax year in which the investment is made||Up to 5 years after 31 January following the tax year in which the investment is made||Up to 5 years after 31 January following the tax year in which the investment is made||Up to 4 years after 31 January following the tax year in which the investment is made|
Knowledge-intensive companies: an exception to some of the limits in the schemes is made for companies that qualify as knowledge-intensive companies. These are companies that (a) create intellectual property and expect the majority of business to be generated from this intellectual property within 10 years or (b) have dedicated 20% of its employees that have a relevant Master’s or higher degree to carry out research for at least 3 years from the date of investment.
Knowledge-intensive companies must spend 10% a year for 3 years or 15% in one of 3 years of the business’ overall operating costs on research, development or innovation. If the company is more than 3 years old, this budget will need to be in place before the investment is made. If the company is less than three years old this budget will need to be implemented for the 3 years following the investment. Knowledge-intensive companies can raise higher limits of investment of up to £10 million a year or £20 million in the lifetime of the company and its group, including any other amounts received from other venture capital schemes or state aid.
What’s the difference between individual investing and investing via a Venture Capital Trust?
The EIS, SEIS and SITR schemes are designed for private individuals wanting to invest directly in small and social enterprises. Some investors prefer to spread their risk and choose instead to invest via a Venture Capital Trust (VCT) that itself invests in eligible smaller businesses, thus offering access to a larger portfolio.
Under a VCT, individual investors buy shares in a quoted company (the VCT), who uses those funds to buy the shares of (or lend money to) unquoted companies. The VCT passes the tax relief available onto the investor, who also benefits from CGT relief on any gains, as well as tax-free dividends.
The VCT must be approved by HMRC and must meet a variety of conditions during the relevant accounting period in which the application for approval is made, including:
- Having ordinary shares listed in the Official List of the London Stock Exchange or admitted to trading on an EU Regulated Market (not AIM).
- The VCT cannot be a close company (the definition of close company is complex but it is essentially a UK resident company with five or fewer participators, or any number of participators who are directors and either have control of the company or have rights to receive the greater part of the assets of the company available for distribution on a notional winding up).
- The VCT must get most or all of its income from shares or securities and must distribute at least 85% of its income from shares or securities.
- The VCT must not have more than 15% of the value of the VCT’s total investments in any one company.
- At least 80% of the investments made by the VCT are in eligible companies carrying on a qualified trade.
Conditions imposed on individual investors
Investors looking to benefit from the EIS, SEIS, SITR and VCT must meet certain criteria. The following table summarises the conditions that need to be met by individual investors in each of the EIS, SEIS, SITR and VCT schemes.
|Shareholding duration||Must hold shares for at least 3 years||Must hold shares for at least 3 years||Must hold shares for at least 3 years||Must hold shares in the VCT for at least five years to qualify for income tax relief|
|Restriction on Investor shareholdings||The investor and its associates must not hold a stake in the company of more than 30% of ordinary shares, rights to assets if the company is wound-up or voting rights and must not otherwise control the company or any of its subsidiaries.||The investor and its associates must not hold a stake in the company of more than 30% of ordinary shares, rights to assets if the company is wound-up or voting rights and must not otherwise control the company or any of its subsidiaries.||The investor and its associates must not control more than 30% of the social enterprise’s ordinary shares or debt capital, rights to assets if the company is wound-up or voting rights and must not otherwise control the company or any of its subsidiaries.||The VCT must not be a close company (see above).|
|Limitations on investor connections with company||The investor cannot claim Income Tax relief if it (or its associates) are employees, paid directors or partners of the company or its subsidiaries. The definition of associates can include relatives, business partners and trustees of settlements where you are the settlor or beneficiary. It does not include business angels. Investors that already hold shares in the company (or its subsidiary) will only qualify if those shares were either shares for which an EIS, SEIS, SITR compliance statement was issued or were founder shares.||The investor must not be an employee of the company but can be a director (paid or unpaid).||The investor must not be an employee, trustee or partner of the social enterprise or its subsidiaries. The investor can only be a paid director if they have never been involved in the social enterprise’s business or have never controlled more than 30% of the social enterprise. Investors that have previously invested in the enterprise (or its subsidiaries) will only qualify for relief if those investments were either investments for which an EIS, SEIS or SITR compliance statement was issued or were founder shares.||N/A|
Eligibility criteria to qualify under the EIS, SEIS, SITR or VCT schemes
Naturally, your business or social enterprise will need to meet certain criteria if it is to be eligible as a qualifying investment under the schemes.
General requirements include needing to have a permanent establishment in the UK and not being listed on a recognised stock exchange at the time the investment is made (so an AIM listing is permitted). You company cannot be controlled by another company, must carry out a certain type of trade (called a ‘qualifying trade’) and must plan to spend the investment money it receives under the scheme on a qualifying trade.
Qualifying trades include most trades but there are a number of exceptions which include (but are not limited to) conducting more than 20% of its trade in coal, steel, gas or other fuel production; dealing in land, shares, commodities, futures, securities or other financial instruments, leasing or letting activities (except for some ship chartering activities); legal or financial services; farming; operating hotels or nursing homes; property development and banking, insurance, debt or financing services.
It is therefore important to make sure that you research what a qualifying and non-qualifying trade is before your business applies for a scheme. There are also some specific qualifying trade requirements as part of the individual schemes, for example legal and accountancy activities are permitted under the SITR scheme whereas they are not under the EIS scheme.
In addition, the following table is an overview of some of the criteria your business must meet to be eligible for specific investment schemes:
|Type of Entity||Unquoted company (or group of companies if you’re a parent company) and it has not been more than 7 years since the company’s first commercial sale (or 10 years from that date that its annual turnover exceeded £200,000, for a knowledge intensive company). The company must not be controlled by another company and must have control of its subsidiaries during the applicable three-year investment period. There must be no arrangements in place for its shares to become quoted. This age limit can be waived in certain limited circumstances including where the company has already received qualifying investment under the EIS (or one of the other schemes) within the seven-year period.||Unquoted company (or group of companies if you’re a parent company) that is less than 2 years old at the time of investment and your company has not previously carried out a different trade and there must be no arrangements in place for its shares to become quoted. The company must not be controlled by another company and must have control of its subsidiaries from incorporation up to and during the applicable three-year investment period.||Unquoted company that is a registered charity, community interest company or community benefit society. There must be no arrangements in place for its shares to become quoted. The company must not be controlled by another company and must have control of its subsidiaries during the applicable three-year investment period.||A VCT is a company whose shares are listed in the Official List of the London Stock Exchange or on any European Union Regulated Market. It invests in unlisted companies that must not have been trading for more than 7 years since the company’s first commercial sale. This age limit can be waived in certain limited circumstances.|
|Does the entity satisfy the risk to capital condition?||The Finance Act 2018 introduced the risk to capital condition which is a principles-based test, that is satisfied if acting reasonably and regarding all the circumstances existing at the time of the share issue, the company has objectives to grow and develop its trade in the long term; and there is a significant risk that there will be a loss of capital of an amount greater than the net investment return (this being the total income, capital growth and upfront income tax relief). The condition needs to be satisfied first before the other scheme criteria are applied.||The Finance Act 2018 ‘risk to capital condition’ applies.||The Finance Act 2018 ‘risk to capital condition’ does not apply.||The Finance Act 2018 ‘risk to capital condition’ applies.|
|Assets held by entity at the time of invest-ment||No more than £15 million in gross assets pre investment and £16 million gross assets immediately after investment.||No more than £200,000 in gross assets.||No more than £15 million in gross assets pre investment and £16 million gross assets immediately after investment.||No more than £15 million in gross assets.|
|People||Less than 250 employees (or less than 500 if it is a knowledge intensive company)at the time of investment in the entity.||Less than 25 employeesat the time of investment in the entity.||Less than 250 full-time equivalent employeesat the time of investment in the entity.||Less than 250 employeesat the time of investment in the entity|
|Trading Activity||The company must carry on trade on a commercial basis with a view to profit.||The company must carry on trade on a commercial basis with a view to profit and must exist for the purpose of carrying on one or more new qualifying trades. The company must not have been actively trading more than two years before the investment.||The company must be engaged in a qualifying trading activity, as for EIS and SEIS (can be via a controlled subsidiary if the funds are invested in the trading subsidiary). Be a charity or carry on a trade on a commercial basis with a view to profit.|
|Other||The company must not be in financial difficulty. The company must deploy the money raised within two years from the issue of the shares.||Must not have already had investment through EIS or a VCT scheme. The company must not be in financial difficulty.||The company must not be in financial difficulty.||“Enterprises in difficulty” are not eligible for investment under the VCT scheme.|
If you think your company is eligible under one of the investment schemes, what are the next steps?
This article provides an insight into some of the various investment schemes available. If you feel that you would like to pitch to investors, or ensure that your company qualifies under a particular scheme, why not contact our corporate solicitors who have experience advising on these schemes. You might also find our additional advice on financing your business via investment useful.
Just as you would on any approach to a bank for lending purposes, it’s vital to draw up a detailed business plan with revenue and growth projections so that you can demonstrate to the investors why they should invest in your business.
It’s also possible under each of the schemes to apply to HMRC for ‘advance assurance’ so that potential backers can have confidence that the various reliefs will apply. Again, it is advisable to seek legal advice first so that you make this application in the correct format.