How to invest in smaller companies and start-ups - A guide to Enterprise Investment Schemes, Venture Capital Trusts and AIM portfolios
Monday 26th July, 2021
"How can I invest in smaller, newer, growth companies and Start-ups?"
It is probably the dream of every investor to go out and find a brand new start-up that very few other people have access to, buy up some equity in the business and then watch as it goes stratospheric. It's like Captain Ahab's quest for the great white whale, hopefully just a little less self-destructive and fruitless.
Despite the fact that this is often perceived as the preserve of the institutional investor (your Gordon Gekkos of the world), many retail investors have not given up hope of finding a start-up to invest in with the possibility of finding the elusive 10 bagger (10 x original investment) investment or higher. After all, it doesn't take much. I had a friend who invested £15,000 in ASOS, when it first floated on AIM, and watched (firstly with shock and then undisguised glee) as it grew to £250,000.
In the article below, I will look at a number of different investment vehicles which retail investors (that's non-professional investors) can use to gain access to investment opportunities in start-ups and smaller, riskier, growth focussed companies. We will look at Alternative Investment Market (AIM) portfolios, Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCT). We will look at what they are, how they work, and the advantages and disadvantages of utilising them as an investment option.
It is important to note that, although these investments carry large growth potential and tax benefits, they are incredibly risky. It is therefore crucial to take advice before investing in any of these investment vehicles and it is important that you are careful about how much of your portfolio you choose to invest in them.
I am often asked by clients how they can get exposure to smaller, newer companies within their investment portfolio. They are looking for ways to invest in companies that have the ability to be the next big thing and really shoot the lights out with growth that is possibly 10 – 20 times the value of the initial investment.
For the majority of these investors, they already have a portfolio of bog-standard funds holding corporate bonds, equities in listed companies and various other asset classes. These investments make up 90% of their holdings and are producing a fairly respectable, but pedestrian 3% – 6% net of charges per year (annualised over the medium to longer term). However, they want more than this. Their inner Gordon Gekko wants to speculate. They are therefore keen to use 5% or 10% of their available funds to seek out higher returns.
In a world full of investors watching the development of the digital age and success stories such as Amazon, Facebook, Microsoft, Gousto and Zoom to name but a few, everybody is looking for the next big opportunity to get in on at the bottom, and ride that beast to the top.
Supporting the investor’s desire to invest in genuine growth vehicles is the government’s desire to encourage investment in small start-up companies in order to boost the economy and create new jobs. The government acknowledges that any investor putting their money in these types of companies is taking a huge risk. So, in order to reduce some of the downside for investors, the government offers certain tax reliefs, that cushion the blow of a failed investment and make it far more attractive for investors to risk their capital.
The question is, where can investors get this exposure? The start-ups have quite often not been floated on any markets yet and seem to be the preserve of the super wealthy institutional investors and investment angels. Furthermore, these start-ups want millions from their investors, so where do you fit in, with your smaller amount of available investment?
In the article below, I will explore three main options for retail investors to gain exposure to higher risk, growth orientated smaller companies and new start-ups, with incredible growth potential. I will also briefly discuss the tax reliefs on offer from the government to encourage investment.
We will look at:
- Alternative Investment Market (AIM) portfolios
- Enterprise Investment Schemes (EIS)
- Venture Capital Trusts (VCT)
I must stress right at the outset that these are very risky investments into which you should only invest money that you can afford to lose. These are generally used as satellite investments or alternative asset classes that diversify your portfolio further and should not make up the majority of a retail investor’s portfolio.
In order to understand what an AIM portfolio is, we need to understand what the Alternative Investment Market (AIM) actually is. It is a sub-market of the London Stock Exchange that was launched on 19 June 1995 to allow smaller, less developed companies to float shares on a market. The regulatory requirements for a company to float on the AIM market are substantially lower and less arduous than those required on the more mature and established exchanges.
This approach has born substantial dividends with AIM growing from only 10 companies at the start, to 821 companies in 2021. The success of the market is further demonstrated by the fact that there are now international companies listing on the AIM exchange as well.
Now, investing in companies floated on the AIM market is generally regarded as fairly speculative. The reality is that the laxer regulatory regime is in place to let newer companies float, in situations where they would not be allowed to float on any of the more recognised markets. This inevitably means that the companies are less well established and the possibility of the company failing is substantially higher.
For many people, this speculative investment into AIM stocks has paid off. If you had invested £1,000 in ASOS in 2001 when it floated on AIM, your initial investment would have been worth a £162,130 in 2015, equivalent to an annualised return of 45 per cent (Financial Times, “Aim — 20 years of a few winners and many losers” – 19/06/2015). Not too shabby, right?
However, in the same article, the FT highlights that:
- From 1995 to 2015 investors in AIM would have lost money in 72% of the companies invested in
- Over the same period, in more than 30% of cases investors lost more than 95% of their investment
To further highlight the speculative nature of AIM, I have include a picture of the FTSE AIM Allshare Index’s performance over the last 10 years below:
As you can see, describing it as volatile is an understatement. This is a nausea inducing thrill ride, which is not for the weak of stomach.
However, it is also undeniable that there is fantastic growth potential there, and, for the right investor, providing some exposure to this market can really add some fuel to the growth of their portfolio.
It also needs to be remembered that if you are investing in a managed portfolio of AIM stocks provided by one of the recognised investments houses, there is likely to be a fund manager who will have carried out due diligence on the portfolio constituents and will hopefully have weeded out the most ropey companies. This, along with a reasonable level of diversification across industries, may help to reduce a little of the volatility.
What are the tax benefits of investing in an AIM portfolio?
When looking at the tax benefits of investing in AIM, you need to remember that these are shares that are being traded on a secondary market, so the companies themselves are not receiving the money spent on the trading of the shares. There is therefore no real boost to the company itself from large volumes of it’s shares being traded on the market. It does not increase the funds in their coffers or provide greater liquidity to grow.
There is therefore not much motivation for the government to offer tax incentives to encourage investors to invest in a portfolio of AIM stock.
Despite this, there are a few tax benefits:
- Certain AIM shares qualify for Business Relief. This means that after you have held them for more than 2 years, they become exempt from Inheritance Tax (IHT)
- These are generally growth companies that generate little in the way of dividends, as profits are funnelled back into the company to generate more growth. The majority of their return is therefore generated by growth in the value of the share itself, and is therefore subject to Capital Gains Tax (CGT). This can be set off against the investor’s CGT allowance and, if held to death, the capital gain dies with the investor
- The AIM portfolio can normally be held within an ISA. This means that any returns generated by the portfolio will be tax free. However, it also helps when an investor has built up a substantial holding in ISAs, and is concerned about the impact of IHT. ISAs do not shield assets from IHT. However, by switching all/some of the ISA holdings into an AIM portfolio, it may qualify for Business Relief and become exempt for IHT purposes after 2 years
Disadvantages of AIM portfolios
As you can see, there are some minor tax reliefs available and many people take advantage of the ability of AIM portfolios to shield assets from IHT. However, there are also substantial disadvantages and I have listed some of these below:
- AIM stocks are quite frequently very illiquid investments. Often there can be no buyers for a particular share and there is nothing the investor can do to divest themselves of the holding
- They are, as demonstrated, remarkably volatile and high risk. This means that if the investor needs access to the funds during a downturn in the market, they may need to crystallise a substantial loss. There is also no income tax or CGT relief on offer from these investments, beyond the standard allowances
- These portfolios are often quite expensive relative to other investment portfolios. They require experienced fund managers and teams in order to build a portfolio of suitable stocks. These expenses will inevitably provide a drag on your portfolio’s performance
- There are specific requirements for an AIM share to qualify for Business Relief. If a share stops meeting these requirements, it ceases to qualify for Business Relief. It is therefore important to have someone managing the portfolio who can spot when this happens to a holding and deal with it in a timely fashion. In other words, if you are looking to benefit from Business Relief, you probably don’t want to be managing the investments on your own
Enterprise Investment Schemes (EIS)
EIS is designed to encourage private investment into new and rapidly growing British companies, by offering attractive tax reliefs. The investment is made into start-up companies with a high potential for growth, but also a high possibility of failure.
These investments differ from other investments in that the EIS provider does not simply buy shares in the company and stand on the side-line, waiting for the shares to go up in value. Instead, the EIS provider takes an active role in developing the start-up using their own experienced team to assist the start up and give it the best chance of making it.
The investor can choose to invest in an EIS which offers access to a diversified portfolio of EIS qualifying start-ups or they can take a higher conviction route and invest it all in one EIS qualifying company.
The advantage of choosing an EIS consisting of a more diversified portfolio of 8 – 9 start up companies is that all your eggs aren’t in one basket. Another advantage of the diversified approach is that the investment is sufficiently spread to reduce some of the volatility, however, the growth potential of each company means that, if only one out of the companies in the portfolio succeeds, it is possible to end up in profit, despite all the others failing. This is demonstrated by the performance of Gousto (a holding in the MMC EIS) that returned 20 times multiples from the date of initial investment to 2020.
The downside is that your growth potential is slightly watered down by the spreading of your funds across the different companies.
Many of the EIS providers focus on niche areas, such as transformative tech companies, pharma or university start-ups.
The tax reliefs made available by the government for these schemes reduces the downside risk and make these investments far more attractive to investors. These tax incentives can be particularly attractive to high earners, who can no longer claim significant tax relief via pensions due to the Taper Allowance. As a general rule, investment in EIS is limited to £1m per tax year.
No matter what the tax benefits on offer, it is important not to lose sight of the fact that these are very volatile and risky investments. Once the investment is made, it is not possible to simply sell out, and the investor is tied in until there is an exit (successful or otherwise) from the EIS. It is not unusual for the value of these investments (or individual holdings within the EIS portfolio) to fall suddenly to nothing, if the company invested in goes bust.
In addition to the risky nature of these investments, there are also high initial and ongoing charges and often performance fees applied, which can create a drag on the investment performance.
What are the tax benefits of investing into an EIS?
30% income tax relief – your income tax bill can be reduced by 30% of the amount invested into the EIS. This relief can be applied to the tax year in which you purchase the shares, or carried back to the previous year.
Now if you are investing in a diversified EIS with holdings across 8 or more start-ups, it can take quite some time for your tax relief to be realised. The money is invested by the EIS manager, as and when investment opportunities become available. As you can imagine, there is a limited pool of suitable investment options, being fought over by a number of different EIS companies and other investors. Therefore, it can take some time for there to be sufficient investment opportunities to allow the investor to be fully invested. From experience, it takes about 18 months for an investor’s funds to be 100% invested.
In addition to this, you must hold the EIS for more than 3 years to keep the tax relief. In cases where one of the companies invested into performs really well, the EIS provider may choose to exit before three years have passed, resulting in a clawing back of the tax relief on that holding. Now, in reality, that is not the worst thing in the world. The investor is having to pay back a little tax relief, because your investment performed better than anybody expected
Tax-free gains – gains on EIS investments are not subject to Capital Gains Tax (CGT)
CGT deferral – if you owe tax on another gain, for example from the sale of a share portfolio or investment property, you can defer the payment of CGT by investing the value of the gain into EIS-qualifying companies.
Loss relief – if your EIS investments underperform, you can offset any losses against other income or gains.
Inheritance Tax relief – if held for two years, and still held at the investor’s death, EIS investments may be exempt from Inheritance Tax.
As you can see there are a number of tax reliefs available, that make an EIS very attractive, if used properly. However, you mustn’t lose sight of the fact that it is an investment first. If you let the tax tail wag the investment dog, you will end up invested in a ropey EIS with no way out and little benefit.
The disadvantages of an EIS
There are a number of disadvantages to investing in an EIS and I have listed a few below:
- You cannot simply access your investment at any time. Your only way to get your money back is to wait for the EIS provider to exit the company invested in. This may not be a problem if you are invested in a winner, but if you hold a loser, the only thing you can do is sit and watch the value drain away
- These are incredibly volatile and there is a very high level of risk. You may have some downside protection through the loss relief and 30% tax relief, but the purpose of an investment is to show positive returns. If you lose 100% of your money on an investment, it is still galling, despite the ability to claim at least some of the losses back.
- Like many of these more niche products, they are pretty expensive (for good reason) and the charging structures can be quite complex and hard to understand. This will obviously impact performance. As always, investors don’t mind paying fees when they are making money, but it can be a bit of a kick in the teeth, when the investments simply aren’t performing
- It can take an incredibly long time to get invested and for all the tax relief to get claimed. As mentioned above, you can easily wait 18 months before funds are fully invested
- The government can change the tax treatment of these investments at any point in the future
Venture Capital Trusts (VCT)
VCTs are very similar to EISs in that they offer exposure to small companies and start-ups with high levels of growth potential. In order to encourage investors to invest in these vehicles, the government once again offers a number of tax benefits.The VCTs themselves are publicly listed on the London Stock Exchange and can (theoretically) be traded. In reality, the market for VCTs is pretty illiquid and it is difficult to find buyers.
Similar to EISs, the underlying companies are small and volatile with great potential for returns, but an equally high potential for failing. The VCT tends to be more diversified than an EIS, with investments spread across far more companies, so (notionally) less volatility.
As mentioned above, these vehicles can be traded on the open market, but there is not much liquidity. As a result, the VCT providers generally offer a share buyback scheme, where they agree to purchase the shares back from the investor at a discount to Net Asset Value. The discount is normally 5% - 10%.
As with an EIS, the set-up costs for a VCT can be pretty chunky. Before you baulk at the costs, it is important to note that this is a niche product and the companies being invested in need to meet certain requirements to qualify for the reliefs. A lot of work and research goes into choosing and maintaining the underlying investments, hence the higher initial costs.
What are the tax benefits of investing into a VCT?
Income Tax credit – There is a 30% Income Tax credit on investments of up to £200,000 each year when you buy shares in a new VCT share offer, but you need to have paid at least as much tax as the rebate and must hold the shares for at least five years to retain the tax relief
Tax-free dividends - There is no Income Tax to pay on dividends from VCT shares. The dividends from a VCT can actually be really substantial and can provide a decent tax-free supplementary income in retirement, alongside any pension or rental income that is also being paid.
For Example (Dividend Payments, History & Dates - Mobeus Income & Growth 4 VCT plc (MIG4) (hl.co.uk)), the dividend yield for the Mobeus Income and Growth 4 VCT PLC is as follows:
2020 – 8.7%
2019 – 28.8%
2018 – 10.6%
2017 – 27.6%
2016 – 9.3%
I had a client who was asset rich and concerned that his income from these assets would result in him being an additional rate taxpayer. However, we managed to wrap all his investments into Offshore Investment Bonds and ISAs over time. He does not currently draw down upon these, but rather lives off the income provided by a number of VCTs he built up using his bonuses from employment. Thanks to some good financial planning he is a non-taxpayer despite his considerable wealth.
No Capital Gains Tax - You won’t be liable to Capital Gains Tax when you sell your VCT shares
The disadvantages of a VCT
You may spot a trend with the disadvantages across the three investment vehicles. For a VCT there are once again a number of disadvantages. These include:
- There is a very serious lack of liquidity for these investments. If you desperately needed your funds or wanted to remove them from that particular investment, the lack of liquidity would mean that you would probably have to allow the provider to buy your shares back at a discount to Net Asset Value. Furthermore, this is not a quick process and generally requires consent from the VCT board which meets infrequently.
- These are risky investments and you can see the value of your investments fall substantially. The 30% income tax relief does provide some downside protection, however, you cannot offset your losses against Income Tax or CGT, as you can with an EIS. In addition to this, VCTs do not qualify for Business Relief and therefore still form part of the investor’s estate for IHT purposes
- These are also often very expensive, due to the niche nature of the investments
- The government can change the tax treatment of these investments at any point in the future
At the end of the day VCTs, EISs and AIM portfolios are just an additional tool in the investor’s bag. They will be suitable in some circumstances and completely unsuitable in others. However, when used properly with reasonable research and as part of a clear investment strategy, they can make a large difference and play an important part in acting as another asset class within an overall well diversified investment portfolio.
The tax reliefs should be treated as an ancillary benefit. If nothing would have persuaded you to invest into such a risky investment without the associated tax reliefs, this is a strong indicator that the investment is likely to be unsuitable for you, even with the tax reliefs included.
This is a very complex area, and if you are considering investing into these types of vehicles it is crucial that you take some sort of advice to help you understand all the advantages and disadvantages, as well as how the investments work.
If you have any questions, please don’t hesitate to give us a call.