Why investors shouldn’t chase tax relief ahead of returns
Private investors face a range of choices when looking to access the upside of private markets investing - in particular the returns that can be generated when investing early in a successful start-up.
The main choice is whether they want to invest directly into businesses (higher returns if they get it right, but higher risk as 90% of startups fail), or via a fund, which will raise a pool of money from investors, and invest across a portfolio of businesses. Funds are typically a lower-risk way of investing in early stage businesses, due to the risk mitigation that comes from investing across a diversified portfolio. The best funds still comfortably outperform the public markets, and have done so consistently across the past 20+ years.
UK investors are likely to be familiar with Enterprise Investment Scheme (EIS) funds and venture capital trusts (VCTs) - both of which offer investors some tax benefits which have driven their popularity as an asset class, especially when offered via financial advisors and wealth managers.
However, the inherent nature of tax-efficient investing means that there are certain limitations placed around the funds themselves. Typically the best-performing VC funds are not tax-efficient funds, but ‘normal’ VC funds - better known as LP/GP funds.
LP/GP funds represent the vast majority of VC funds worldwide. They can expand their portfolios across borders, follow on their initial investment into subsequent rounds and have fewer limitations over what they can invest in. Investors don’t receive tax benefits, but the best funds don’t need tax relief to deliver good returns for their investors.
Below, we walk through the world of EIS funds, how they work and some of the restrictions that investors should be aware of.
What is EIS?
EIS is a tax relief programme designed to encourage investment in small and medium-sized enterprises (SMEs). Through the EIS scheme, businesses can raise up to £10 million per year, and up to £12 million in the company’s lifetime, unless your business is ‘knowledge-intensive’, in which case the £12 million lifetime cap can be exceeded.
Understandably, there are a number of qualifying criteria which businesses must adhere to in order to take advantage of the EIS scheme, as well as limitations on what funds acquired through the scheme can and cannot be used for.
(A full breakdown of the EIS scheme is available here: https://www.gov.uk/guidance/venture-capital-schemes-apply-for-the-enterprise-investment-scheme)
For investors, EIS schemes offer the ability to benefit from income tax relief at 30% of the amount invested per year, with an annual investment cap of £1 million.
While it may seem like a no-brainer to take advantage of tax relief that EIS schemes offer, there are a number of limitations that investors should first consider.
1. Opportunities beyond borders
Critically, EIS tax relief is limited to UK taxpayers who invest in qualifying companies based in the UK. This means that if you are a non-UK taxpayer, or if you are looking to invest in companies based abroad, you are not eligible for the tax relief. This restriction can limit your investment opportunities and may not be suitable for investors who want to diversify their portfolios globally.
2. Control over the purse strings
Another consideration around EIS tax relief is that there are limitations on the sectors of business you can invest in; for example, it is not available in banking and financial services. This means that EIS funds can’t invest into banking & financial start-ups, often some of the highest growth businesses..
3. Think big!
There are also strict limits on the cheque size that investors can provide in line with EIS. While this can be advantageous for individuals looking to invest small amounts, it can be a disadvantage for investors on the other end of the scale. This restricts the ability of EIS investors to access larger rounds, or even follow on into the best performers (the ‘winners’ across multiple rounds is a key part of how VC funds generate better returns).
4. Natural adverse selection
For tax led investors, their priority is maintaining tax-relief benefits which could result in decision-making that fails to align with the management's vision. Some examples include expanding or changing HQ into different jurisdictions, early exit options, selling secondary shares, or diversifying revenue streams into non-EIS compliant activities.
Solely focusing on the benefits from tax-relief schemes brings with it a major disadvantage as it heavily restricts the pedigree of company they can access. With other sources of investment available to those businesses with the product, service or market strategy capable of attracting them, investors through EIS funds can find themselves at the bottom of the pile.
5. Hidden costs
Some EIS funds charge high transaction, annual, referral and board member fees – all of which eat into the company’s cash flow, making it harder for them to grow and succeed. Some of the funds may even include an interest coupon or aggressive share classes on their equity investment. In some cases, these fees can be so high that they negate any potential benefits offered by the tax relief.
Focus on returns, not tax
Of course, tax relief can be a nice bonus, however, it’s not a substitute for thorough research and due diligence. Whilst beneficial in the short term, businesses that secure investment through tax incentivised schemes may end up restricting their potential growth in the long run.
For investors, focusing solely on tax relief may result in investments being tied up in companies that are not a good fit for their portfolio, which could lead to poor returns.
Ultimately, tax relief doesn’t turn a bad deal into a good one. Investors should ensure they have appropriate sourcing, screening and diligence processes in place, or should back proven funds where they are unable to do so. When looking at funds, investors should be aware of the limitations of funds that solely invest via EIS.
Don’t go chasing tax relief; it’s all about the returns.