Startups are an alluring asset class for many investors.
Strong returns, portfolio diversity and the adventure of guiding founders towards success are all possible by backing entrepreneurs.
There is also the opportunity to support innovation and to help shake up markets where disruption is long overdue.
In the UK, however, a further benefit of startup investment exists. Angel investors can reap the rewards of tax breaks aimed at encouraging startup investment.
Governments have long recognised the value of a healthy startup climate in aiding economic growth.
A cornerstone of efforts to nurture one in Britain is the Enterprise Investment Scheme (EIS), which rewards those willing to support early stage businesses.
The EIS was launched in 1993 as a means of generating more of the vital funds needed to fuel enterprise. It has since encouraged over £10bn of private investment into upwards of 20,000 early stage firms, according to government figures.
Under the scheme, companies are permitted to raise up to £5m of investment per year – to a maximum of £12m in their lifetime
Individual investors can inject up to £1m per year into EIS-qualifying startups. This rises to £2m if at least £1m that year is invested in ‘knowledge intensive’ companies – which the government says face the “greatest difficulties in accessing growth investment”.
Such backing may be crucial on the journey to commercialise entrepreneurial ideas and scale them up. Cash-intensive processes such as research and development, proving the concept and marketing it to customers could be otherwise impossible without external investment.
For the investor, as well as limiting their tax liability, EIS helps to mitigate the risks of startup investment. Like all forms of investment, there is a chance that a healthy return may not be forthcoming – although there is also the possibility of lucrative returns if a winner is picked.
Tax breaks effectively reduce the amount of funds the investor has riding on the success of the startup, without reducing their stake in the business. In other words, it softens the blow if things go bad – but maximises the rewards of investing in a successful startup.
Through EIS, if an additional rate taxpayer invested in a startup that did not deliver returns, the worst they could expect would be a 38p loss on every £1 invested.
Collectively, then, various tax incentives make a compelling case for adding EIS investments to your portfolio in 2019. They include:
Income tax relief - tax relief of 30% can be claimed against the maximum £1m-per-year of EIS investments you choose to make. This is the equivalent of a £300,000 per year tax reduction – or £600,000 if you are married and choose to double up your investments with your spouse. EIS investment, therefore, is an ideal vehicle for investors looking to reduce large income tax bills, while also putting their wealth to good use.
Capital Gains Tax (CGT) exemption and deferral - if shares in the startup are held for a minimum of three years, and income tax relief was claimed on the investment, any gain is not subject to CGT. In fact, in a typical startup, the shares may be held for several years, meaning CGT exemption could be enjoyed for much longer that three years. Furthermore, CGT payments can be deferred if the gain is invested into an EIS-qualifying company. In this instance, gains accrued from the sale of any kind of asset can be invested. However, the investment must be completed either one year before or three years after the gain was made.
Loss relief - in the event that a loss is realised on your investment, loss relief applies under EIS rules. As with other types of investment, your loss can be considered a capital loss and deducted from your CGT liability for the year of the loss, or carried forward.
A major draw of EIS investment, however, is that losses can also go against income tax liability. This will be applied at your marginal rate of income tax; 20% basic, 40% higher or 45% if you are an additional rate taxpayer. This compares favourably to offsetting CGT. The basic and higher rates of CGT are 10% and 20% respectively – or 18% and 28% respectively for gains made from selling property.
‘Carry back’ facility - this EIS feature enables you to apply your EIS investment to the preceding tax year if the £1m limit for relief had not been surpassed that year. For example, if you invested £2m in EIS companies in 2017/18, you could carry back £1m to the previous tax year if you had no EIS investments in 2016/17.
No inheritance tax - EIS investments can be passed onto beneficiaries free from inheritance tax should the investor pass away after holding the investments for at least two years.
Given the tax implications of EIS investment, and the wider benefits of backing startups generally, it is highly appealing to investors.
Many make their first EIS investment after selling their business, property or shares; enabling them to defer CGT on any gains made. Some may have been affected by reductions to annual pension contributions and are looking for a new long-term outlet for their wealth.
Others may have withdrawn a tax-free lump sum from their pension – which is now possible from age 55 following the reforms of recent years. EIS investment offers them a good starting point into enterprise investment and possibly a new career as a business angel. By reinvesting their tax-free lump sum through EIS, they receive a double-whammy of tax relief.
Aside from the tax breaks themselves, there are various other characteristics of EIS which make it worth considering this year.
Among them is its longevity. While government initiatives can come and go with the changing of ministerial personnel or political winds, EIS has been in place for decades, and shows no sign of being discontinued in the foreseeable future.
Another attraction is the fact that there is no limit to the number of companies you can invest in per year. Commonly, startup investors will back multiple firms to continually strengthen and diversify their portfolio. Through EIS, as long as the annual investment amount is not exceeded, you can back as many enterprises as you wish.
This, and the many other benefits of EIS investing, makes it an exciting prospect for those hoping for a successful 2019 on the investment front.