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The Enterprise Investment Scheme (EIS) is a vital component in stimulating UK economic growth through tax-incentivised investment
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The Enterprise Investment Schemes (EIS) has been selected by the government as a vital component of its efforts to stimulate economic growth through tax-incentivised investment in smaller, privately-held businesses.
The immediate need to support the economy hardly needs highlighting; we’ve been through one of the deepest recessions for almost a century and the prospect of a much-feared double dip cannot be discounted.
So just how effective might EIS be in assisting a recovery? And, perhaps more importantly for investors, what are the risks and the rewards?
For the answer to the first question it is worth looking at the work of the National Lottery-funded National Endowment for Science, Technology and the Arts (Nesta), which has a remit to support and develop innovation in the UK economy by various means, including investing directly in businesses.
Of particular note, three reports it has produced, the Vital 6 Per Cent, Vital Growth and Siding with Angels, consider the importance of small, fast-growing businesses to the UK economy.
To boil them down – and drastically oversimplify the findings – they highlight that some 6 per cent of innovatory UK businesses with the highest growth rates have been responsible for generating half of all new UK jobs. The third report, Siding with Angels showed that investment from business angels – which can include funding through the EIS – is hugely important to the development of these small, fast-growing businesses.
There can be no doubt that the economy needs these businesses now more than ever and yet they find investment particularly hard to get in these difficult times. The traditional sources such as banks or venture capital are, respectively, either reluctant to lend or have more pressing concerns keeping existing investments afloat than to put money into new ones.
What this means is that there is now a great opportunity for EIS investors to fill this investment vacuum and potentially reap some very healthy returns in the process.
Investing in small businesses – among which technology start-ups form an important part – is historically seen as high risk. But the Government’s desire to encourage private investment into the sector has led it to increase the upfront tax relief available through EIS and to take other steps to increase its attractiveness and minimise potential investment loss.
One of the key aspects of the EIS that mitigates risk is loss relief. For higher rate taxpayers this can mean a maximum loss of 35 pence in the pound once initial 30 per cent income tax relief has been taken into account and the remaining 70 per cent loss is offset against income tax at the 50 per cent rate. Such a government-backed guarantee to limit an investor’s losses is incredibly valuable, particularly when coupled with the highly attractive upside to EIS investing whose gains can be capital gains tax free.
For instance, it is not unheard of for EIS-qualifying companies to deliver tenfold returns or better to investors. While this is by no means an everyday occurrence, it serves to demonstrate the attractions of EIS investments in today markets, when most mainstream investments are struggling (and you will find no loss-relief in stock markets) and cash is paying next to nothing.
Based on my own experience from many years of investing in start-ups, particularly technology companies, the economic climate and paucity of funding available to small businesses could mean now is an extremely good time to invest through an EIS.
This is because there is a strong element of linkage between the position in the economic cycle and the returns you might receive from investment in a start-up.
Research into mainstream venture capital funds has shown that investments made during tough economic times tend to deliver higher returns when they are eventually sold. While the data is venture capital fund specific (there is far more reporting data for these than EIS) it is not a stretch to extrapolate that the same will be true of EIS investments because there is a significant amount of crossover in the type of companies in which they invest.
There is some irony here, in that when the economy is in better shape it is far easier for small businesses to raise money from banks, venture capital and angel investors.
But, with funding not being generally available from these first two of sources, angel and EIS investors benefit from seeing more and better quality opportunities.
Well-connected EIS investors are being presented with a steady stream of interesting and potentially very attractive investment companies. The lack of alternative funding from traditional sources also means that they can negotiate better deals with these companies – in essence get a bigger percentage of a business for the same or a lower price than at other periods in the economic cycle. The timing also means that when these businesses come to be sold or floated, typically three to five years later, they tend to be valued more highly because of the higher growth environment and so the return on investment is greater.
Of course, it is difficult to tell exactly where we are in any given economic cycle, but times are clearly very tough and there is no doubt that even the most promising businesses are finding it hard to get the funding they need.
But in spite of the general economic malaise, many large companies, particularly in the technology sector, are sitting on large cash reserves. Apple, for example, has an $80bn (£51.7bn) potential war chest, so the future potential for innovative businesses to be acquired up by larger companies looks very promising.
Companies such as Apple – though there are many more you may not have heard of - have the resources and capacity to defend such patents against competitors who infringe them. For example Apple and Samsung are currently slugging it out in the courts with each accusing the other of patent infringement.
In spite of the economic environment – or to an extent because of it – the outlook for investment in EIS-qualifying companies is very good. This is not a low risk sector, but with the government committed to reducing the downside more than at any other period since EISs’ began, and the rewards are so potentially great, your clients may well be thanking you in a few years’ time if you take a closer look today.
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