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Investment support for technology-backed or knowledge-intensive businesses

31 July 2015

The Enterprise Investment Scheme (EIS) and Seed EIS vehicles provide a legitimate government-introduced, tax- free capital growth environment for investments held for at least three years. Private investors can also expect a 30-50% income tax rebate on funds invested, alongside additional tax advantages including loss relief. Such tax advantages have proven very successful in encouraging investment into small and medium businesses, including start-ups, across a variety of exciting and innovative technological sectors.

On a quarterly basis, HMRC now publish the statistics associated with this investment activity via SEIS/EIS, which is recorded by processing the SEIS-1 and EIS-1 forms submitted by the recipient investee company – the first step for the private investor in collecting their tax relief.

The latest quarterly figures published by HMRC present the full figures up to the end of 2014. At face value, these are encouraging in regard to new capital coming onto the market, which targets early stage investment into SMEs.

At its core, SEIS/EIS is the provision of a tax-efficient vehicle to encourage investment into young businesses. This is achieved by offsetting increased capital risk of investing into earlier stage enterprise against upfront tax reliefs. In this report, we refer specifically to ‘knowledge-intensive’ or technology-backed businesses.

This article is a brief summary of this data, the trends, and our own experiences of EIS and SEIS at Mercia.

First, the numbers:

Enterprise Investment Scheme (EIS)

  • Since its introduction in 1993-4, around 22,900 have received over £12.2billion;
  • In 2013-14, 2,710 companies raised a total of £1.5billion (compared to 2,465 companies raising £1billion of funds in 2012-13);
  • In 2013-14, companies raised a total of around £0.8billion for the first time under EIS, compared with around £0.6billion for 2012-13.

Seed Enterprise Investment Scheme

  • In 2013-14, approximately 2,000 companies received £0.16billion in total investment, (compared to 1,155 companies raising a total of £0.09billion in 2012-13)
Trends and observations:

1. State Aid

a) A number of European-imposed restrictions under State Aid are being considered, which will likely apply to EIS and SEIS in the near term, to include:

b) A cap of £12m (or £20m for knowledge-intensive businesses) per company in total EIS/SEIS or Venture Capital Trust (VCT) investment received;

c) Restrictions on the age of the business. Businesses cannot be older than seven years (or ten years for knowledge-intensive businesses) at the point that it receives its first EIS investment;

d) A restriction on the use of SEIS or EIS capital, namely that it cannot be used to acquire a trade or existing business.

2. Key observations

In regard to making investments into technology and / or knowledge intensive businesses, there are some important points to consider:

a) Businesses often require regular sector hands-on support, deep industry knowledge and clear guidance, so a generalist investment approach should perhaps be avoided;

b) At the peak of investment spikes, follow-on investments start to outnumber new investments. Therefore, funds, private investors or investment businesses that are able to follow their investment (often on an annual basis) will fair significantly better than those who cannot; and

c) A strong portfolio is essential, with a balance across sectors and stage of business growth key due to sector trends and high failure rates (ranging from 30-70%) associated with this class of investment.

Taking into account the above, the graph below (Figure 1) from HMRC indicates that we are heading for another peak in the flow of capital into this early stage space, which may mirror that of the 1999-2002 period.

In Figure 2 (below), which is also from HMRC, we see the comparison of new investments against the quantum of follow-on investments. In 2001, following a sharp correction in the market, there was a dramatic shift from new investment capital provision to follow-on finance, with many businesses struggling to secure follow-on investment and therefore failing as businesses.

In this current period (2011 to the present) we see a more gradual correction as follow-on investment levels rise to meet the growing number of new investments being made.

Conclusion

Through structures such as SEIS and EIS, successive governments have now created an environment to facilitate the growth of early stage enterprise and the expansion of “knowledge intensive” businesses.

With the changes introduced at the recent budget, and those likely to come through the new State Aid rules, the winners, in our opinion, will be investors (whether private investors, funds or investment businesses) that:

  1. Have good access to strong deal flow;
  2. Are able to pick winners at an early stage;
  3. Have a hands-on approach in order to provide strategic guidance and connections of value to the investee to enable rapid scale. This counters the risk associated with early stage investing;
  4. Have the ability to follow their investment, and therefore mitigate a key financial risk associated with businesses with high growth potential;
  5. Are patient, or have a capital model that rewards investors at various stages of the journey; and
  6. Play a clear and balanced position within the portfolio.

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