Startups are an exciting proposition for seasoned investors.
Although often bringing with them higher levels of risk than other asset classes, they can potentially deliver exponential returns that far outstrip return rates of other asset classes.
And unlike other investment options, they also give investors the chance to have an influence on the outcome of their investment, by sharing expertise and advising on growth plans.
What's more, there are also wider incentives, such as supporting innovation, creating jobs and fixing environmental and social problems - and here in the UK, investors willing to back startups can also be rewarded through various tax schemes and incentives.
The Seed Enterprise Investment Scheme (SEIS)
Encouraging investors to back early-stage enterprises, the SEIS offers some extremely generous tax reliefs.
Investors in an SEIS-qualifying startup will receive 50% of their investment back through income tax relief. Up to £100,000 per year can be invested in a single firm or across multiple enterprises. This means it is potentially worth £50,000 at the outset.
Then, should that startup successfully grow and reach a liquidity event - such as a takeover - after at least three years, any return on your investment is free from capital gains tax.
You can also benefit from capital gains reinvestment relief, by putting any capital gains from any form of investment into an SEIS-compliant startup.
Protection against potential losses also enhances the attractiveness of SEIS to investors, as if shares are sold at a loss, the impact on your portfolio can be softened through loss relief.
Given that you will already have received 50% of your investment back in income tax relief, with this in mind SEIS could be seen as a relatively low risk way of investing in startups.
With other attractions including carry-back relief – whereby your earned income tax deduction can be applied to a previous year - to be eligible for SEIS investment, startups must have traded for no more than two years, have fewer than 25 employees and net assets of under £200,000.
The Enterprise Investment Scheme (EIS)
The older sister of the SEIS, EIS offers tax relief on up to £1m of investment into businesses per tax year, or £2m if at least £1m of this is invested into companies deemed ‘knowledge-intensive’.
Its associated tax breaks cover:
- Income tax relief equivalent to 30% of your investment, applied in the year you invest or the previous year
- Exemption from capital gains tax on profits earned on shares held for at least three years
- Loss relief, in the event that the company you invest into fails. This is valued at your income tax bracket - such as 40% for a higher rate payer - multiplied by the amount of capital at risk after income tax relief is factored in.
- A referral on capital gains tax if you reinvest any gains into an EIS-eligible company
- Exemption from inheritance tax on shares owned for at least two years
To be eligible for EIS, companies must meet several criteria both at the time of investment and for three subsequent years.
When the initial investment is received, they must have assets worth less than £15m and fewer than 250 employees. They must also be unquoted, or listed on the AIM or NEX Growth markets, and there can't be any arrangements in place to go public on a major stock exchange.
At the time of the investment and for three years after that, the business must remain independent, carry out a qualifying trade and have a permanent UK base, even if its main trade is in export markets.
There are also stipulations that money raised through EIS must be used to expand the business, and not for the acquisition of another company’s shares, trade or certain assets.
Tax breaks through Venture Capital Trust (VCT) investments
A VCT invests in, or lends money to, companies – including startups - not listed on any stock markets.
Since they are directed by a fund manager, they are a means of investing in a number of enterprises without having to find and carefully research each individual opportunity.
Investors subscribe to new shares when VCTs are launched - or buy them from other investors in more established VCTs.
Investors in newly issued VCTs are eligible for income tax relief worth 30% of the value of their investment, which can be up to £200,000 per tax year. This is not applicable for buyers of existing VCT shares.
VCT shares must be held for at least five years to retain the income tax relief, while any dividends received are income tax exempt.
An added incentive is the exemption of capital gains tax on profits generated by selling VCT shares, regardless of how long those shares were held, assuming the entity continues to operate as a VCT.
Social investment tax relief (SITR)
Many startups are driven by a desire to solve environmental or social challenges. They are often categorised as social enterprises and can offer various tax incentives to investors.
Thanks to the UK government’s SITR scheme, investors into eligible businesses can deduct 30% of their investment value from their income tax liability.
This can be applied in the tax year of the investment, or the previous year, but investments must be held for at least three years to retain this relief.
In line with other schemes, capital gains tax bills may also be deferred by investing the gains into a SITR-eligible organisation.
There is also no capital gains tax to pay on any gains on the investment, although income tax is applicable to dividends and interest on the investment.
Organisations with fewer than 500 employees and gross assets worth under £15m that have a “defined and regulated” social purpose may be eligible. Many startups, including those set up as community interest companies, will fall into this category.
Figures published in 2018 show that only a modest amount of investment has been made through SITR recently – making it something of a hidden gem among those investors that have taken advantage of the scheme.
The data shows that just £1.8m was invested into 25 entities through the scheme in 2016/17. Hopefully this figure will grow in 2019, for the sake of both tax efficient investors and the greater social and environmental need.
Investing in startups for tax efficiencies
One of the most important points to note about tax efficient investing in UK startups is investors shouldn't do so for the tax reliefs and incentives first and foremost. You should always invest in a company because you believe it is the right option for your portfolio.
The available reliefs and incentives are undoubtedly appealing and beneficial, and can all help to minimise losses, but your focus must be the same as with any investment - to complete your in-depth due diligence and believe your investment is being made with the intention of seeing the agreed return at some point in the future.