At Harper James, we specialise in providing legal advice to start-up businesses. Many of our clients want to know how to raise funding to grow, for example, they may need to acquire premises, build IT infrastructure or just need working capital while their business expands.
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.
In this article, we explore the different types of investment scheme, and which one might be suitable for your business.
- Why you need to know about different types of funding and investors
- Different types of tax-advantaged venture capital 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 in venture capital investment schemes
- Eligibility criteria for your company 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
The UK has a variety of investment schemes that are designed to help small business attract funding. If you’re the founder or CEO of a start-up looking for finance, it’s a good idea to understand the different types of investment schemes so that you can identify which might be the best fit for your business, and what type of investor might interested in funding it.
Venture capital investment schemes are designed to attract investors in start-ups and unlisted SMEs. They offer tax relief to investors who are prepared to provide funding to businesses with a higher level of perceived risk (on account of being new or small).
Understanding what drives potential investors is very important if you’re looking to attract funding via venture capital investment scheme such as the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS), Social Investment Tax Relief (SITR) and Venture Capital Trust Investment scheme (VCT). These schemes offer tax reliefs to individuals who buy and hold investments 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’s 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.
However, there are certain requirements that must be met before a company, investor or a proposed investment can qualify for these schemes.
Different types of tax-advantaged venture capital schemes:
The table below sets out four different types of venture capital schemes:
|Type of scheme||Overview of scheme|
|Enterprise Investment Scheme (EIS)||Designed to attract direct funding by investors in small and medium-sized businesses.|
|Seed Enterprise Investment Scheme (SEIS)||Designed to attract direct funding by investors in early stage start-up businesses.|
|Venture Capital Trust scheme (VCT)||Designed to attract indirect funding by investors in small, medium or start-up businesses via a trust.|
|Social Investment Tax Relief scheme (SITR)||Designed to attract direct funding by investors in certain social enterprises, for example, a business designed to facilitate improvements in financial, social or environmental wellbeing.|
Background to EIS, SEIS, SITR and VCT investment schemes
These investment schemes were designed to promote growth in the economy by providing tax relief to private investors. They’re geared towards start-ups, SMEs and social enterprises. It’s the potential for rapid capital growth that attracts investors, plus the tax advantages that are tied to the schemes that have the net effect of reducing the level of risk.
On top of the income tax relief available to investors in these schemes, any gains from eligible investments can also be exempt from capital gains tax (CGT) provided certain scheme conditions are met. What’s more, provided the scheme criteria are 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 the amount of their capital that’s at risk to a sum that is less than the amount invested. 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.
To benefit from income tax relief, the shares must be newly issued and paid for 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 their 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 bearing in mind 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 your company can raise||Annual limit: £5 million per company/group or £10 million for investment in a knowledge-intensive company (see below). |
Lifetime limit is £12 million per group or £20 million for a knowledge-intensive company.
|£150,000 per company/group in any three-year period.||Lifetime limit of £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.
|Not more than £5million (or £10 million for knowledge-intensive companies) in any 12-month period (including any other VCT, EIS and SEIS investments made in that company). |
No more than £12million over your company’s lifetime (or £20million if yours is a knowledge-intensive company).
|Maximum income tax relief available to investors||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.
|Tax relief on income from dividends||No||No||No||Yes, under certain circumstances.|
|Exemption from Capital Gains Tax: Initial Investment||100% exemption for gains on EIS investment.||50% of investment, capped at £50,000.||100% exemption for gains on SITR investment.||100% exemption for gains on VCT investment.|
|Capital Gains Tax: Other reliefs||Yes||Yes||Yes||No|
|Other Tax Reliefs, Allowable Losses||Relief available for capital losses against income.||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 allowed||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 or unsecured debentures. Neither shares nor debentures 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.|
Note: A ‘knowledge-intensive company’ is a company whose costs of research and development or innovation are at least 15% of its operating costs in at least one of the previous three years, or at least 10% in each of the previous 3 years (the 3 years ending immediately before the company’s last accounts); and either:
- it is engaged in intellectual property creation that is expected, within 10 years, to comprise the greater part of it or its group business; or
- it has employees with a relevant master’s or higher degree who are engaged in research and development or innovation and who comprise at least 20% of its total full-time equivalent workforce
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.
Conditions the VCT must meet
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:
- The VCT’s ordinary shares must be 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 a small number of shareholders/directors).
- The VCT must get most or all 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 must be in eligible companies carrying on a qualified trade.
Conditions imposed on individual investors in venture capital investment schemes
Investors looking to benefit from the EIS, SEIS, SITR and VCT must meet certain criteria as set out in the table below:
|How long must investors hold their shares||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 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, 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 can’t 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 or business partners but doesn’t 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 for your company to qualify under the EIS, SEIS, SITR or VCT schemes
Your business or social enterprise will need to meet certain criteria if it’s to be eligible as a qualifying investment under the schemes.
Usually your company needs to have a permanent office in the UK, and not be listed on a stock exchange (AIM excepted).
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 common types of businesses, but there are exceptions such as energy production, land deals, legal and financial services, farming and financial services.
Make sure you understand what constitutes a qualifying and non-qualifying trade before you apply to be qualified for investment. There are some differences between the various schemes, for example, legal and accountancy activities are permitted under the SITR scheme whereas they aren’t under the EIS scheme.
Here is an overview of some of the criteria your business must meet to be eligible for specific investment schemes:
|Type of business||Your business must be a company that isn’t quoted on a stock exchange, and you must be a new company, meaning you started trading less than seven years ago (or 10 years if yours is a knowledge intensive company and sales were more than £200,000). |
Your company must be truly independent of any other company, and with no plans in place for a quotation.
|Your business is an unlisted company less than two years’ old at the time investment is made, your company hasn’t previously traded, and you’ve no plans to become listed. |
Your company is truly independent of any other company.
|Your company is not listed, is a registered charity, community interest company or community benefit society. |
You’ve no plans to list the company and it’s truly independent of any other company.
|The VCT is listed on 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 seven years since the company’s first commercial sale. This age limit can be waived in certain limited circumstances.
|Does your business satisfy the ‘risk to capital condition’?||Does your business have the objective to grow and develop its trade in the long term, and is there is a significant risk that there will be a loss of capital of an amount greater than the net investment return?||Does your business have the objective to grow and develop its trade in the long term, and is there is a significant risk that there will be a loss of capital of an amount greater than the net investment return?||N/A||Does your business have the objective to grow and develop its trade in the long term, and is there is a significant risk that there will be a loss of capital of an amount greater than the net investment return?|
|Limit on the assets your business owns at the time of investment||Your business must not hold more than £15 million in gross assets before the investment is made, and more than £16 million immediately after investment.||Your business must not hold more than £200,000 in gross assets.||Your business must not hold more than £15 million in gross assets pre investment and £16 million gross assets immediately after investment.||Your business must hold no more than £15 million in gross assets.|
|People||Your business must employ fewer than 250 employees (or fewer than 500 if yours is a knowledge intensive company).||Your business must employ fewer than 25 employees at the time of investment.||Your business must employ fewer than 250 full-time equivalent employees at the time of investment.||The business must employ fewer than 250 employees at the time of investment.|
|Trading Activity||Your business must carry on trade on a commercial basis with a view to profit.||Your 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 qualifying trades. |
Your company must not have been actively trading more than two years before the investment.
|Your company must be engaged in a qualifying trading activity, be a charity, or carry on a trade on a commercial basis with a view to profit.||N/A|
|Other conditions||Your company can’t be in financial difficulty and must use the money raised within two years from the issue of the shares.||Your company can’t have already received investment through EIS or a VCT scheme, and not be in financial difficulty.||Your 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.
You can apply to HMRC for ‘advance assurance’ so that investors will know that your company qualifies. Take legal advice to ensure that your application is in the correct format.