ICFC had undertaken many name changes since its formation and in the early 1990s the business was known as 3i (three i’s, with iii standing for investors in industry), but it was still state-owned. Privatising the business had proved difficult over the years, as investors were unsure about investing in what was seen as a risky option. However, the government took the plunge in June 1994, pricing the shares at 272 pence, a price that seemed a fair val- uation given that the net asset value of the business at 31 March 2004, the year end, had been 315 pence. The first day of dealings had been fixed for 18 July 1994 and soon the price of 3i plc’s shares moved above 300 pence, allowing the company to join the FTSE 100 on 19 September 1994 (Coopey et al.).
As ICFC had originally discovered, the big disadvantage for those offering venture capital was that there was no secondary market, so the investments could be realised only through a trade sale or flotation on the main stock exchange. To alleviate these problems, the Conservative government helped to set up the Unlisted Securities Market (USM) and the Business Start-up Scheme (BSS). Under BSS, high-rate tax payers could reduce their income tax liability, but the restrictions placed upon it to avoid mere tax avoidance made the scheme virtually unworkable. Accordingly, it was replaced by the Business Expansion Scheme (BES) where both income tax relief and capital gains tax relief were available.
This government action spurred on the venture capital industry and it led to the formation of the British Venture Capital Association in 1983. This organisation has hundreds of members who over the last 20 years or so have invested over £60 billion to help start-up, expand and buyout over 25 000 companies (BVCA directory 2004/5). In addition, there is also an European Venture Capital Association with members providing equity and other capital in the United Kingdom and rest of Europe.
Over the last 20 years, the tax incentives available to those investing in venture capital, or private equity, and the capital markets have changed. The BES has been replaced by the EIS and VCTs, while the USM closed down to be replaced by the AIM.
to new ordinary shares in such companies. The shares must not carry any preferential rights to dividends or to the company’s assets on winding up, and they must not carry any rights to be redeemed.
Only shares issued by companies carrying out a qualifying trade or carrying out research and development or oil exploration leading to a qualifying trade will qualify for relief. Most trades qualify, but the following trades do not:
• Dealing in land, in commodities or futures in shares, securities or other financial instruments
• Financial activities such as banking, money-lending, insurance, debt- factoring and hire purchase factoring
• Dealing in goods other than in the ordinary trade of retail or wholesale distribution
• Leasing or letting assets on hire, except in the case of certain ship- chartering activities
• Receiving royalties or licence fees, except in the case of the exploitation of an intangible asset created by the company or its group
• Providing legal or accountancy services
• Property development
• Farming and market gardening
• Holding, managing or occupying woodlands, or other forestry activities or timber production
• Operating or managing hotels, guest houses or hostels in which the com- pany carrying on the trade has an interest or which it occupies under licence or any other form of agreement
• Operating or managing nursing homes or residential care homes in which the company carrying on the trade has an interest or which it occupies
• Providing services to another company in certain circumstances where the other company’s trade consists, to a substantial extent, of excluded activities.
(Source: Revenue and Customs Website (2006/2007).)
Subject to the investment being made in a qualifying company issuing qualify- ing shares, then income relief at the rate of 20% will be given on investments from £500 to £400,000 in any tax year. This is the relief for 2006/7, but may be varied each year.
from ‘capital gains relief’ on the EIS investment, ‘capital gains tax deferral relief’
on other investments, together with other tax benefits.
All these tax relief sound good, so what is the catch? Well, the catch is that there is no tax relief of any description if the investor is connected with the company. You are deemed to be connected to such company if you are a director, partner or employee of the company or are entitled to receive any money from the company apart from goods or services provided on a genuine commercial basis. If, as an individual, you supplied secretarial, managerial or other ‘outsourcing’ services, you would be deemed to be connected. You are also deemed to be connected if you hold more than 30% of the equity of the company or can effectively influence the way the company is run by virtue of voting power, assets held or loans given.
However, there is one exception to the above rules and these are those that are applied to ‘business angels’. A business angel is defined by Revenue and Customs (EIS Income tax relief, capital gains tax exemption and loss relief, chapter 3) as ‘an individual who provides managerial, financial or entrepreneurial advice to small companies.’
To qualify as a business angel, the individual must not have been connected to the company prior to the investment made or been involved in carrying on the trade, and subsequently has become a director who receives or is enti- tled to receive remuneration. Such a person may make further investments within 3 years of the original investment. This means that apart from a recog- nised business angel all investors who are entitled to tax relief are ‘betting blind’.
One objective of this book is to look at things from the perspective of the ordinary investor. In this context, an ‘investor’ is defined as a person who has an interest in a particular company either through buying ordinary shares in it or by being an employee in the company or by providing goods or services for the company. For each type of investor, the ultimate risk is the same. The shareholder risks losing his investment, the employee risks losing his job and consequently his earnings, while the supplier risks losing money through not being paid for goods and services provided.
In respect of the EIS a potential investor may receive a prospectus. Such a prospectus will be written by experts and will be very cleverly worded. All the information that are needed to make an informed decision will be there; it will likely be accurate but not usually in a format that will be easily understandable.
For example, the prospectus might say:
The company is forecasted profitable for 2009 and is rated at 11 times estimated 2010 earnings PBIT (profit before interest and tax). We consider the valuation as attractive based on the forecasted growth.
We now have to read between the lines. The expression ‘forecasted profitable’
means that at the date of the prospectus, the company was not profitable.
The 11 times earnings may seem attractive because in our mind we have the word ‘earnings’ and the fact that some quoted companies in the sector are trading at 27 times earnings. But the word ‘earnings’ means profits avail- able to ordinary shareholders, that is, profits after interest and tax, but before dividends.
Obviously, the example prospectus does not give a clue as to what the interest and tax might be, so the only assumption that can be made is that it will be consistent with the like for like ratio for the quoted company. If you then examine the accounts of a quoted company (for example), you might find that the price/earnings (P/E) ratio, if it were based on ‘earnings PBIT’ rather than on ‘earnings’, falls to 11.5, very similar to our ‘attractive’ valuation. But, the quoted company is both profitable and quoted whereas the company in the prospectus is not profitable and its shares will be illiquid. So we must apply appropriate discounts of 40% for not being profitable and 25% for being illiquid. These discount percentages are, of course, based on ‘judgement’ and other percentages might be equally valid. The point, though, is that some discounting must be applied to take account of the additional risks being taken on.
Now by applying a discount of 40% and 25% to the 11.5 times valuation of the quoted company, assuming that the information in the prospectus is accurate, we can have a rating of 5.2 earnings. We are asked to pay 11 times earnings, but if we discount this for the 20% tax relief we will be getting, then we are being asked to subscribe at 8.8 times, for something realistically valued at 5.2 times.
The conclusion is that the proposed investment is not such a good idea when analysed properly.
Anyone reading an EIS prospectus should trawl it carefully to see how the
anything but. It must be remembered that there is nothing illegal or dishonest in this, as the information will be accurately supplied in the prospectus. It is simply a case of ‘caveat emptor’, let the buyer beware.
Another ruse that can be used in raising capital for EIS companies is that the directors are to be paid a ‘success fee’. Again the exact details will be shown in the prospectus and the effect needs to be calculated. In one prospectus where the directors paid the same price for their shares as the general public, their proposed success fee had a dramatic impact. If they were successful, they would receive a compound return of 153% over 5 years, while ordinary investors after tax relief would receive a compound return of a staggering 6.8%
over the same period.
The message is that investors considering investing in the EIS need to tread very carefully. Each prospectus needs to be examined in great detail, for in addition to the risk of losing the value of the investment, there is another trap lurking. It is at least arguable that if an investment is made that turns out to be extremely imprudent, then Revenue and Customs might reject the concept of tax relief, because one of the conditions of allowing relief is that
‘the subscription is made for bone fide commercial reasons and not for tax avoidance purposes’. This leads to the first of the investment rules, but before we do, we need to define ‘rules’ in this context.