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How to invest in EIS investment opportunities as a first-time investor
There are two overriding benefits of becoming an Enterprise Investment Scheme (EIS) investor.
Firstly, it is highly tax efficient and secondly, it enables you to add startups to your investment portfolio – which brings many advantages, including diversity, balance and potentially strong returns.
Before you consider the how and how much of EIS investing, it is important to reaffirm the why. With any EIS investment, there can be a long journey between the initial outlay and the exit event that, hopefully, delivers you a healthy profit.
Fortunately, there are a number of incentives that should keep you motivated in the interim. The big one is the income tax break you receive, which is the equivalent of 30% of anything you invest, up to a maximum of £1m per year per person (more so if your investment is into knowledge intensive companies).
Beneath this headline-grabbing tax break, other HMRC-approved incentives exist, too. There is a ‘carry back’ facility, meaning EIS investments can be treated as though they were made in the preceding tax year, thus reducing your income tax liability for that period.
Also, any gains made from your shares after holding them for at least three years are exempt from capital gains tax (CGT), while gains made from any other disposal can avoid CGT by being invested through the EIS.
Furthermore, your EIS shares can be transferred to a loved one free from inheritance tax. EIS investments are also protected through loss relief, which allows you to claw back some of your investment should the startup fail.
This is calculated by applying your income tax bracket – for example, 40% as a higher rate taxpayer – to the amount of your ‘at risk’ capital. Essentially, this is the amount you invested minus the value of the income tax relief you received.
Aside from tax breaks there are, of course, numerous benefits of investing in startups.
Enterprise investing opens your portfolio up to the possibility of exponential returns – with the caveat that startups can be relatively risky by nature.
If all of the elements of startup success are in place, including the finely tuned business model, the market opportunity and the people to execute the plan, a lucrative exit may well await.
Every investor wants to meet a future billion-dollar unicorn that could turn five or six figures into seven or eight.
These are exceptionally rare, but startups do present an opportunity to enjoy significant returns. Gains on startup investment can vary wildly between companies, but an often-quoted study puts the average return rate at 2.6 times the invested capital in 3.5 years from investment to exit.
This research was conducted by experts at Willamette University and the University of Washington. It involved 539 individual angel group investors who have experienced more than 1,130 exits.
Startup investment is also an advisable way of diversifying investment portfolios, by adding an extra asset class on top of others such as stock and property. Backing firms in a range of sectors and at various stages on their growth path lessens the portfolio’s exposure to potential market and wider economic downturns.
Beyond financial gains and stability, other attractions of startup investment include the sheer fulfilment of sharing your industry experience and expertise with up-and-coming entrepreneurs. Also, working with a range of firms as a serial angel investor can make for a hugely enjoyable career. Your investment may also be helping to create jobs and find innovative solutions to global problems.
If all of the above has you eager to get started in EIS investing, what now?
First, an obvious question…
Is the startup you are interested in actually eligible for EIS investment (and have they secured Advanced Assurance for the scheme)?
To qualify for EIS, the company must have a UK base and not have assets worth over £15m, or £16m after the investment. They must have a full-time workforce of no more than 250 and should not be listed on any public markets, or have any plans to join one.
There is also a stipulation that your capital must be spent within two years of investment or, if later, the trading start date. It should be used to grow or develop the business, not buy all or part of another business.
Crucially, certain trades are not eligible for EIS investment. These can be checked with HMRC here, but include financial services, exporting energy and leasing activities.
Another notable rule is that you can invest up to an extra £1m over the standard £1m EIS limit by backing ‘knowledge intensive’ businesses. This is to encourage growth in sectors considered vitally important to the UK’s economic future.
Meanwhile, it could be that the company actually falls into the eligibility category for the Seed Enterprise Investment Scheme (SEIS). If this is the case, and you are determined to invest, you should consider pursuing SEIS rather than EIS, for SEIS takes the 30% income tax break of EIS and raises it to 50%.
Since investors can make up to £100,000 worth of SEIS investments per year, the £50,000 boost is ideal for high earners looking to reduce hefty income tax bills. Like EIS, SEIS is also favourable in terms of CGT liability.
SEIS companies must have traded for less than two years and have no more than 25 employees. Clearly, as SEIS is for early stage firms, there may be more potential risk attached to them than EIS investments.
You’ve found an interesting, EIS-eligible opportunity - what next?
Any potential investment should be carefully considered before you take the plunge.
You must assess the business from all angles to test its credentials and how realistic its plans are.
Initially, ask yourself whether this business is really a good fit for you. Are its exit plans and the time they are likely to take to deliver aligned to your goals as an investor? Are you interested enough in the firm’s products or services to keep you enthused as an investor for the long haul? Startup growth plans often take longer than expected and you may be involved as an investor for several years.
Also, do you think you would get on well with the management team over time? This is difficult to predict, but you should at least respect the people you are investing in at the outset.
There are many approaches to weighing up startup opportunities, but the universal rule is that you must be thorough in your research before you invest.
A good starting point is the ‘5 Ms of startup investment’, which many investors follow as a rough guide to spotting startup successes and covers management team, business model, market opportunity, money and momentum.
What happens after the investment?
How regularly you monitor the progress of your investments depends on how involved you wish to be as an investor. You may be speaking to the entrepreneurs every week, or perhaps merely in quarterly shareholder meetings.
Aside from assuming the general role of an active, reasonably engaged or silent investor, you must also manage the tax implications of your EIS investments.
Shares must be held for at least three years to benefit from income tax relief. If you sell them before that - for example, if a successful exit is achieved - HMRC must be informed and some tax relief may need to be repaid.
Assuming the investee has been trading for four months and the investment has been processed, the company must send you an EIS3 form to complete. Your claim can be made through the Self-Assessment process.
The gains you make beyond that, as the startup progresses, are entirely dependent on your investment terms and the quality of the business, and although startup investment often carries greater risk than other assets, the potential rewards can undoubtedly be particularly appealing.