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SME investment via tax efficient EIS scheme continues to rise – but policy shift towards start-ups could dampen future investor demand

21 October 2016

  • Lack of tax breaks for lower risk later-stage businesses should not deter investors if deal is good quality in its own right

Investment in SMEs through the tax-efficient Enterprise Investment Scheme is continuing to rise – but a policy change last year shifting EIS’s focus towards early stage businesses could dampen future investor demand, says Connection Capital, the specialist private client investment business.

New figures show that the amount of funds raised by small businesses under the EIS grew 14% to £1.82bn in 2014/15 from £1.59bn in 2013/14, having risen steadily in the past few years (see graph). The number of companies raising funds increased 15% to 3,265 last year from 2,840 the previous year.

However, Connection Capital says rule changes implemented last autumn mean that most established later-stage businesses, which tend to be less risky than early stage investments, no longer fall within the scope of the scheme.

Investors can now only benefit from generous EIS tax breaks by investing in companies which are less than seven years old, except in very restricted circumstances*. EIS offers 30% income tax relief for investments held for three years up to £1m per year, tax-free capital gains and zero inheritance tax after two years.

Claire Madden, Managing Partner at Connection Capital says, “Private investors have shown a strong appetite to invest in SMEs in recent years, but now the EIS landscape has changed significantly. More than ever, investors need to weigh up the opportunity value against the tax advantages.”

“With the tax planning season upon us, this will be a key consideration.”

“While plenty of early stage EIS qualifying venture capital deals will still be available, this category, by its very nature, also has a relatively high failure rate.”

“Those who want to invest in less risky, more established companies, which are running profitably, with a visible track record and clear growth prospects, are finding that these are now far harder to come by with EIS tax breaks attached.”

“EIS was set up to help ambitious small businesses access vital funds for growth in order to maximise their potential, create jobs and contribute to economic prosperity. Now a large swathe of well-run, successful SMEs could struggle to get the backing they need to expand or develop, simply because they’ve run a viable business for a few years.”

Connection Capital cites one of its recent investments, a company called 23.5 Degrees, which qualified for EIS when the deal took place last summer, as an example of a business that would no longer do so today, putting its chances of securing investment at risk. The company is a Starbucks franchisee and the £5.6million of growth capital invested by Connection Capital clients was used to finance expansion of the company’s store portfolio and provide working capital for roll-out. The business is going from strength to strength and now has 37 sites, employing c500 staff.

Lack of tax breaks for lower risk later-stage businesses should not deter investors

However, Connection Capital says that the lack of tax breaks should not deter private investors if the investment proposition is sound in its own right.

“A good investment stands on its own merits – regardless of tax incentives,” says Claire Madden. “Our experience is that if investors are offered a good quality deal in a strong business with the potential to achieve growth and deliver real returns, then lack of tax breaks won’t hold them back.”

For example, several of Connection Capital’s investments to date have been management buy-outs, a type of deal which has never qualified for EIS. These opportunities are invariably heavily in demand from its private investor/family office client base.

One of its recent investments, the £14m MBO of a high-spec portable accommodation hire business called Carter Accommodation Ltd in October last year proved so popular that clients committed £5million of funding in the space of just ten days. This spring, only seven months later, Connection Capital clients provided a second tranche of capital to enable the company to meet surging demand, which was even stronger than its most ambitious forecasts.

Claire Madden says, “By shifting the focus of EIS onto start-ups and very young businesses, private investors who are aiming to mitigate their tax position could now be exposed to a much greater degree of risk. Later stage investments may no longer have those tax breaks as a selling point, but they could prove highly attractive for a whole host of other reasons.”

She adds, “Apart from anything else, EIS is not the only tax break out there. Recent changes to Entrepreneurs’ Relief could prove advantageous to private investors, who may find that Capital Gains Tax is payable at a lower rate when shares are sold.”

This year’s Budget announced extensions to the scope of Entrepreneurs’ Relief to include long-term investors in unlisted companies. This means that they could now pay CGT at 10% when they sell their stake, provided they have held it for three years, up to a lifetime maximum of £10million.

Amount of EIS funds raised by SMEs - last 5 years

* 10 years for “knowledge-based” businesses. Companies that have raised this kind of investment before are exempt from the 7/10 year rule. There is also an exception to the rule if the business has never raised risk finance investment before and if funds raised are at least 50% of the company’s average annual turnover, taken over the previous five years.

 Russell O'Connor
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