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Managing Risk in EIS – Examining the Baby and the Bathwater

In the FCA’s view, EIS investing has always been high risk. But, the reality is that many offerings have focused on the investor tax benefits much more than the companies EIS was originally designed to assist.  The government has decided this was detrimental to the main aim of EIS – to encourage investment into early stage, smaller, younger UK companies with high growth potential.

Consequently, in the last nine months it has taken measures to prevent investment structures that provide a low-risk return from qualifying for EIS.In the FCA’s view, EIS investing has always been high risk. But, the reality is that many offerings have focused on the investor tax benefits much more than the companies EIS was originally designed to assist.  The government has decided this was detrimental to the main aim of EIS – to encourage investment into early stage, smaller, younger UK companies with high growth potential. Consequently, in the last nine months it has taken measures to prevent investment structures that provide a low-risk return from qualifying for EIS.

This has undoubtedly shifted the risk profile of some sub sectors of EIS investing. But, as EISA Director General, Mark Brownridge put it in the EISA’s recent report, EIS; New Landscape, New Opportunities, there is, “a very real danger of the baby being thrown out with the bathwater.”

The changed risk profile certainly demands full and proper understanding by the investor  community, particularly in relation to those managers that have been forced to pivot their investment activities to comply with the new regulations. But EIS remains a crucial funding mechanism for emerging businesses – around 30,000 have already benefited from over £16 billion (HMRC) of investment.

Beyond this, with careful consideration, EIS also continues to offer interesting opportunities for a broad range of investors with differing goals and risk/reward sensitivities.  Increasingly, this is likely to include those looking for CGT shelters and pension alternatives as a result of tighter restrictions on pension contributions.

 

Generous reliefs remain

For a start, the recent changes have solidified EIS as a legitimate scheme, giving certainty to everyone involved. With personal tax investigations becoming one of the fastest growing revenue streams for HMRC in the last two years (UHY Hacker Young) and growing scrutiny of what it considers as tax avoidance, the government has again demonstrated its support for the scheme.

There has been no erosion of the generous tax reliefs on offer (subject to investors holding EIS qualifying shares for the required time periods). The rationale is to compensate for the additional risks and costs of involvement in start-up or SME firms and the consequent downside protection of the reliefs available is still substantial:

  • 30% income tax relief
  • Capital Gains Tax deferral for gains invested into EIS qualifying companies
  • Capital Gains Tax exemption for profits from the sale of EIS qualifying shares
  • Loss relief allowing any losses (less the income tax relief already received)
  • Likely Business Relief qualification with potential 100% IHT saving on EIS qualifying shares

 

So, what has changed?

An investment must now meet the following requirements to be eligible for EIS investment:

  • The company in which the investment is made must have objectives to grow and develop over the long term
  • The investment must carry a significant risk that investors will lose more capital than they gain as a return (including any tax relief).

The upshot is that capital preservation strategies are no longer allowed. Consequently, companies employing structures where asset backing, such as a pub owning the freehold, or contract backing, such as a film-production company with distribution contracts already in place, are now highly unlikely to be eligible for EIS. HMRC is using a “principles-based test”, applying a ‘rounded’ approach, to assess the level of risk to capital on a case-by-case basis.

Of course, the EIS market has not just focused on capital preservation strategies and there are plenty of opportunities to invest in EIS qualifying companies which have had no assets to pledge as protection to investors, nor pre-agreed income streams. Mark Brownridge again: “If you understand risks you can mitigate them and improve your chances of success.”  And the managers with long term involvement in growth-focused EIS investing understand the risks and that their activities can be a critical contributor to their success or failure.

 

Many risks can still be minimised

Putting all your eggs in one basket by investing in a single company can be a big issue. It might be a winner, but it might not, leading to total loss other than loss relief. Good EIS managers actually plan success by expecting some failures among their investees. Of course, they target companies that fit a considered investment strategy and have been reviewed against a rigorous selection process, after in depth due diligence, as the aim is for a significantly improved success rate. But the reality and the statistics cannot be ignored; smaller, younger companies are more prone to failure.

Experienced managers mitigate this risk by building diversified portfolios of EIS-qualifying companies to spread risk and improve the chances of good overall returns. This can be achieved by varying the sectors, geographic regions, managers or maturity stages of the investee companies.  This last method balances early-stage investments that have high potential but are higher risk with later-stage investments with a higher valuation but lower risk.

 

The right manager, the right risk mitigation

So, choosing the right investment manager is a key risk mitigator, although the selection process is only one of the factors to look at. As well as track record, including successful exits, the experience and expertise of the investment team are important. Not only do these affect the investment selection and beyond, they also inform the size and quality of the deal flow the manager has access to. EIS investment managers rely heavily on contacts, often developed during their careers. A good reputation can also open doors and attract opportunities. The more deals viewed, the greater the likelihood the best deals will be identified and the better the likely quality of the deal that is eventually invested in.

The level of ongoing involvement with the investee company is an indicator of how much influence a manager has on the specific risk that applies to that company. HMRC advance assurance gives a stamp of approval that a company and investment structure appears to meet EIS-qualifying criteria, based on the information provided to HMRC. But, it doesn’t guarantee the company will not, at some point, fall foul of qualification by undertaking activities that break the rules. Proper monitoring of what investee companies are doing is vital to reduce or remove the potential for a company to become ineligible for EIS, leading to clawbacks of the tax reliefs.

 

Specialist Support

Beyond monitoring, the provision of specialist business support to help nurture an investee company can be invaluable. Early-stage businesses can be easily distracted by the volume of day-to-day operational challenges. Expert input into prioritising the strategies that will drive value creation may not be accessible to the investee company unless an investment manager can deliver it. And managers with board presence and the ability to set and access key metrics to compare progress against strategic milestones can also introduce an important degree of accountability.

Many early stage EIS managers recognise that managing these investments is an active process. What’s more, the close working relationships that can result, put them in a great position to identify companies with positive metrics that are ready to scale.

There is no lack of companies with ambition to grow and the new rules seek to incentivise innovation and entrepreneurship. Indeed, it’s worth remembering that EIS has not been singled out and punished with the new regulations.  Instead, it has been identified as a crucial driver of SME prosperity with the potential for impressive investment gains, the reality of substantial tax reliefs and the considerable advantage of seasoned and sophisticated early stage EIS managers.

Oxford Capital is an experienced venture capital investor and our EIS opportunities can be accessed here.

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