Raising capital is perhaps one of the toughest challenges that entrepreneurs have to face while developing their startups. Although there are many different ways to finance a startup, some types of funding – such as bank loans and credit cards – are often difficult to access for emerging businesses due to the extraordinary risk early ventures entail. Thus, young companies are usually relying on angel investors to provide that essential initial capital.
Business angels are individuals who invest in startups and buy shares at a low value with the expectation that they will grow in value over time. When they get it right, they can then sell their shares in their winners at a substantially higher price and get a profitable return. Angel investing can be very rewarding but it requires capital, expertise, an existing network, patience and of course a degree of luck.
The UK government acknowledges the importance of business angels to small businesses’ growth and introduced the Enterprise Investment Scheme (EIS) in 1994. EIS was conceived to encourage individuals to buy and hold new shares for at least 3 years by minimising the risks of early-stage investments. With this scheme, if an individual decides to buy shares in an EIS-qualified company, they would be entitled to claim 30% back of their investment through income tax relief as well as other tax benefits such as a capital gains tax exemption – if the investment returns a profit – or a loss relief – if the company unfortunately fails.
Following the success of EIS, the UK introduced the Seed Enterprise Investment Scheme (SEIS) in 2012. This new program supports the most early-stage companies’ development by providing investors with more generous tax benefits when compared to EIS. SEIS offers 50% of an investment back through income tax relief alongside further tax benefits to individuals who buy shares in SEIS-qualifying companies. To this date, SEIS and EIS are the most generous and successful tax incentives for private investors to invest in startups in the world, and have been major drivers of the development of the UK tech ecosystem.
Although the SEIS and EIS schemes were originally designed for individual investors, asset managers in the UK spotted the opportunity to encourage passive investors to support early-stage companies by developing SEIS and EIS funds. These funds are designed for investors who are willing to get exposure to risky and illiquid assets, are eligible to claim the tax benefits, but do not have the time or expertise to select startup companies. Today, there are well over 100 SEIS and EIS funds operating in the UK across various sectors such as life sciences, digital technology, or media and gaming.
Asset Managers usually raise money for SEIS and EIS funds from private sophisticated investors. The managers use their expertise to screen and select the most promising SEIS and EIS-qualifying startups for their funds. After selecting the companies, they handle the investment process and invest monies on the investors’ behalf.
Once all investments are completed, investors receive SEIS and EIS certificates corresponding to the underlying fund investments so that they can claim their tax benefits. Usually, asset managers will provide post-investment support to investee companies to support their growth and protect the investors’ interests.
Besides the tax benefits, the time-saving element, and the fund managers’ expertise, there are other advantages to using SEIS and EIS funds for investors. Perhaps one of the most notable benefits is the diversification effect. Depending on the strategy, asset managers usually can select five up to fifty companies per investment portfolio. This allows the investment risk to be spread across a broader portfolio of companies than the one an individual would have achieved by investing directly in companies.
For companies, these SEIS and EIS funds represent an additional source of capital in addition to angel investors, which explains why the UK is the best market in Europe to raise seed capital for startups.
Although SEIS and EIS funds allow investors to diversify their exposure and to claim generous tax benefits, it is still a risky investment that might result in investors losing a portion of their investment. Investment in early-stage companies involves risks such as illiquidity, lack of dividends, loss of investment and dilution, for which it is good practice to consider it as part of a diversified portfolio. Also, it is worth mentioning that the schemes’ tax benefits are subject to individual circumstances and they are subject to changes. Thus, investors should always seek independent tax advice prior to investing under the SEIS and EIS schemes.
Capital at risk. For professional investors only.
For more information on SEIS and EIS, please read SFC Capital’s article All you need to know about SEIS and EIS.
Sources:
HS341 Enterprise Investment Scheme – Income Tax relief (2020) - GOV.UK (www.gov.uk)
Tax relief for investors using venture capital schemes - GOV.UK (www.gov.uk)