This article first appeared in Shares Magazine.
Napoleon famously dismissed us as a ‘nation of shopkeepers’, believing this made us an easy target for conquest. In fact, the UK is a nation of smaller companies, and the trailblazing entrepreneurs at the helm are leading the charge to get our economy back on its feet. Now is the time for savvy investors to help write the next chapter of the UK’s growth story, says John Thorpe, Business Line Manager for Enterprise Investment Schemes at Octopus Investments.
As the UK makes encouraging progress along the road to recovery, emerging growth figures are pointing toward a positive picture for this year. In 2013, the UK was the fastest-growing major European economy and is set to retain this position in 2014, according to PwC. Meanwhile, GDP growth is expected to be in the range of 2-3%, topping pre-recession levels for the first time in the fourth quarter of this year. New businesses are being registered at a record rate, with more than 250,000 start-ups in the first four months of this year alone. This suggests that 2014 will see a substantial increase on the half million launched in 2013 and the 484,000 registered in 2012 (1).
In the fight to generate growth, one sector of the economy is establishing itself as a formidable force: the nation’s backbone of smaller companies. A staggering 99.9% of private sector businesses in the UK are small or medium-sized – in other words, they employ fewer than 250 people (2). And behind them stands an army of entrepreneurs.
Smaller companies with big potential
Sophisticated investors have been quick to recognise the lucrative investment opportunities represented by some of these smaller companies – and the entrepreneurs who lead them. The Enterprise Investment Scheme (EIS) has given them a way to support burgeoning businesses with high-return potential.
Introduced by the government in 1994, the EIS was designed with one key objective – to encourage investment in the smaller private companies that are so critical to the UK’s economic well-being. A traditional EIS focuses on achieving long-term capital growth by investing in companies with the potential for high growth, which are privately owned or listed on AIM.
With an EIS, the investor holds shares directly in the various companies in their portfolio. This differentiates them from more mainstream investments like venture capital trusts (VCTs) and unit trusts, where they have shares in the overall fund, rather than the underlying holdings.
Total EIS investment since the launch of the scheme has passed £10 billion (3). High-profile companies that have used EIS backing to grow from start-ups to household names in a few short years, include Secret Escapes, graze.com and Zoopla, whose IPO in mid-June valued the company at £919 million.
Five impressive tax incentives for investors
The incentive for investors, alongside the possibility of impressive returns, is a range of generous tax incentives. As long as they keep the underlying holdings for three years, investors can claim 30% upfront income tax relief on EIS investments of up to £2 million. The relief can relate to income in both the current and previous tax years, with a maximum claim of £300,000 for each year. The holdings also qualify for 100% inheritance tax relief after two years, as long as an investor still has the investments at the time of their death.
In addition, investors can defer capital gains tax (CGT) due on another separate investment by investing the gain into an EIS. 100% of the CGT is deferred for the life of the EIS investment. This means that if they still have their EIS shares when they die, the CGT won’t have to be paid at all. Investors in an EIS can also expect tax-free growth, with no capital gains tax on any rise in value of the portfolio’s holdings.
One of the most compelling benefits offered by an EIS is loss relief. Each individual holding is assessed separately for loss relief, so if its net value after upfront tax relief has fallen at the time of sale, the investor can use the losses to reduce their overall tax bill – even if the overall value of the portfolio has gone up. There is further flexibility in the fact that the loss relief can be claimed against either other capital gains or income tax, whichever is better for the investor.
Find the best opportunities with a specialist provider
Even for highly capable investors, taking a DIY approach to EIS investing can prove prohibitive in terms both of time and cost. For most people, the most efficient and cost-effective option is to choose a specialist EIS provider to build and manage their portfolio for them. Using their expertise, the provider seeks out and manages the underlying investments within the portfolio and looks out for the right time to sell. Each time an investment is sold within the portfolio, the proceeds can be reinvested, and the investor can claim more income tax relief.
Alongside these tax benefits, the high-return potential of an EIS holds an obvious attraction for experienced investors. But, in common with any highly speculative investment, it comes with risks that should not be underestimated.
Investing in small and early-stage companies is inherently risky. In many EIS portfolios, some of the holdings will fail, but investors pin their hopes on the successes outweighing the losses. It may also be difficult for investors to withdraw their money if they need to. The manager could take a couple of years to choose the right investments for the portfolio in the first place, and it may take even longer to find the ideal time to sell them, particularly when unquoted companies are involved. This is why investors in a growth-focused EIS need to be comfortable making a long-term commitment of at least five to seven years.
Playing a profitable part in the UK’s growth story
The long-overdue recognition of our entrepreneurs is good news for British business and great news for investors. Those with foresight and vision are tapping into the high growth potential of the UK’s robust base of smaller companies – and the entrepreneurs who lead them. There’s never been a better time to be an entrepreneur in the UK, and many investors are now seizing the opportunity to play their own part in this growth story.
Investing in an EIS is a serious, long-term commitment, and the risks of losing money should never be underestimated. However, for informed investors who understand the potential pitfalls, EIS investing can deliver tax-free capital growth, protect income from taxes and provide increased diversification within a broader investment portfolio.
This article is issued by Octopus Investments Limited which is authorised and regulated by the Financial Conduct Authority for use by journalists in their professional capacity and should not be relied upon by retail clients. The value of investments, and the income from them, may fall or rise. The information in this document should not be construed as offering investment or tax advice.
(1) StartUp Britain
(2) Department for Business, Innovation & Skills
(3) £9.7B as at 5th April 2012 – HM Revenue & Customs Enterprise Investment Scheme Statistics, published December 2013