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How do you decide which companies to invest in via EIS?
The Enterprise Investment Scheme (EIS) was launched in 1994 to encourage more private funding for new businesses.
It has since helped to leverage over £18bn worth of startup investment.
The scheme allows investors to receive tax relief on up to £1m of funds injected into businesses in any tax year – or £2m if those companies are considered ‘knowledge-intensive’.
The headline benefit is an income tax break worth 30% of the value of your investment applied in the year of investment, or the previous one.
An exemption from capital gains tax also applies on profits earned from shares owned for three years or more. Capital gains can also be deferred by putting them into an EIS-compliant startup.
There is also zero inheritance tax to pay on shares held for at least two years, while investors benefit from loss relief to protect against the collapse of their investee. If the business fails, you receive relief valued proportionally in line with your income tax bracket.
The latest annual figures, for 2016/17, show that almost 30,000 investors claimed income tax relief through the scheme. A total of £1.8bn was raised for 3,470 companies that year.
And choosing which opportunities you invest in through EIS is partly dictated by the basic rules of the scheme.
Firstly, the business must not be listed on any exchange and its operations must centre around a qualifying trade. The majority of trades do qualify, but if more than 20% of operations involve ineligible trades, you will not be able to claim EIS tax breaks.
These trades, shown here, include farming, running a hotel or nursing home, legal or financial services, and energy generation. Coal or steel production, property development and leasing activities are also on the list of non-qualifying trades.
The company must also have a permanent UK base, no more than 250 staff and less than £15m in gross assets. Investors with a connection to the business, either financially or through employment, will not be able to claim income tax relief through the scheme. Companies must meet EIS criteria both at the time of investment and also for three subsequent years.
Furthermore, any monies raised through EIS must be used to expand the business, and not to purchase another company’s shares, trade or certain assets. These rules are designed to ensure that only businesses offering a high growth opportunity to investors are EIS-eligible.
With so many opportunities standing within the EIS parameters, however, choosing which one to invest in can be hugely challenging.
Select wisely and you will not only mitigate your income tax bills, but also diversify your portfolio and enjoy potentially strong returns.
You may also wish to play an active role in helping to guide the enterprise beyond its goals as a seasoned business expert.
If you find the selection process overwhelming, or simply want a fast-track into tax efficient startup investing, you could invest via a managed EIS fund.
But if you are keen to go it alone as a business investor, there are various approaches to help you choose from the many available opportunities.
Initially, you may decide to seek an opportunity in a sector you know well. Perhaps you are keen to share your expertise to disrupt the established order in this particular industry. Alternatively, you may be drawn to a high growth industry that has piqued your interest. Aside from the financial benefits, business investment can be a vehicle to pursue more interesting or meaningful work – possibly after exiting your own business. You may therefore seek to back businesses involved in solving world problems through innovation.
But whatever factor is top of your agenda when you look for EIS-qualifying startups to add to your portfolio, there are some fundamental considerations.
Crucially, is the management team capable of realising the business plan? As an investor, some degree of instinct is required as you weigh up the people behind the business. Since yours is likely to be a long-term investment, you must of course click with the people you back - but there are also many characteristics to look out.
Is the team adequately skilled? Does it have strong market knowledge? Will it respond quickly and flexibly to unexpected setbacks? Is the team harmonious? Will the founders take your advice on board?
Analysing the business model is also absolutely key to your assessment of the opportunity. Investors use many different tools to test startup business models from every angle. As a sophisticated investor, you may have devised your own system. It is worth noting that startup business models are not set in stone. They will invariably change – either through minor tweaking or more sweeping adjustments. As an investor you are looking for signs of potential, but also evidence that the model is robust and likely to function smoothly.
Also vitally important is the market opportunity. In a study of 101 failed startups, CB Insights found ‘no market need’ was the most common reason for failure.
The management team must be able to demonstrate clear market demand, whilst your own research into the market opportunity will help to ensure that the true picture is not being sugar-coated in the hunt for investment.
Another good indicator of market demand is the momentum in the business. Early sales, web traffic, enquiries, positive focus group responses and beta testing results can all serve as indicators of market need for the product or service.
The money factor must also be questioned before you invest.
Is there enough cash flow in the business to keep it in hot pursuit of its targets? Does the business have a clear plan to maximise the impact of your investment? Are further fundraising events that will dilute your share on the horizon? Money, and the other pre-investment considerations mentioned here, are often termed the ‘5 Ms of startup investment’ (you can read more about them here).
In summary, as an investor you must choose opportunities that are aligned with the ambitions you have for your portfolio – and possibly your career if you intend to become an active and engaged business angel.
Becoming a startup investor can be a steep learning curve, with various associated risks, but the benefits of EIS, alongside the many advantages of enterprise investment, can undoubtedly make it a journey well worth embarking upon.