EIS guide

Research and due diligence Performance information Small, unquoted businesses are illiquid, hard to value and managers can be reluctant to disclose valuations of the businesses that they might be looking to sell in the near future. Consequently, performance information is limited. Assessing and comparing the performance of EIS funds, or the track record of the fund managers, can be challenging. The best indication of (good) past performance is a track record of successful exits, but not all of the managers are in a position to evidence this yet. Investors and advisers should not expect to find the kind of in-depth quantitative information that is used when researching stock market-based funds. The lack of past performance information is an additional risk of investing in EIS funds. The changes in EIS rules announced in the Autumn 2017 Budget also introduced the possibility of some managers that previously focused entirely on EIS investments targeting low risk, capital preservation strategies, having to pivot their activities. This means it is important to review the relevance of their track record to their current investments. Other risks of funds The risks of funds are broadly the same as those described on pages 6 and 7. The skill, experience and operational expertise of the fund manager should reduce some of the risks, as should the additional diversification that can be achieved. Additional risks for funds include sufficient deal flow for the manager to deploy the funds raised in accordance with their stated investment mandate. If there is not sufficient deal flow, there is a temptation for the manager to invest in opportunities that do not fit the mandate, that are more risky than deals they would normally invest in or at higher valuations (making it harder to earn returns). Researching funds Advisers cannot rely solely upon a provider’s marketing literature for their research and due diligence. The FCA has said: “Advisers can rely on factual information provided by other EEA- regulated firms as part of their research and due diligence. However, they should not rely on the provider’s opinion, for example, on the investment’s risk level.” The expectations of both the regulator and the courts of what advisers are required to do by way of due diligence are set very high and it is clear that advisers owe a non-delegable duty of care to their clients. As well as assessing whether an EIS investment is suitable for a client, advisers must also assess the range of offers available in the market, and select the most appropriate investments for their clients. In assessing EIS offers, there are a number of areas advisers need to cover and they should document their assessment of each of them to create a thorough research and due diligence process on record. In April the European Commission launched a consultation to inform its ”fitness check” evaluation of the State Aid regulations and the various guidelines applying to venture capital schemes such as EIS, including the Risk Finance guidelines. Here were our recommendations: Abolish the age restriction on eligible recipients for VCT/EIS funding and replace with a gross assets test of £20 million to determine eligibility Justification: The age of a company is not a robust indicator of whether or not it has the capacity or knowledge to scale up its production and therefore neither is it an indicator of its ability to secure bank financing. If this first recommendation above is not adopted, then: Redefine the definition of a first commercial sale as being the end of the accounting period in which a company’s annual turnover first exceeds £200,000 Justification: This is the test for knowledge intensive companies, but all companies developing a new product or geographic market will undertake sample test sales before making a general entry to market. A company may also not keep adequate paperwork during the first years and months of development to assess when it begins to trade and has its “first commercial sale”. Therefore this concept should be interpreted flexibly so that the same turnover test can be used for all companies. Abolish the financial hurdle imposed on the entry into a new product or geographic market Justification: The exception to the basic age limit for companies entering a new product or geographic market requires a risk finance investment which is higher than 50% of their average annual turnover in the preceding five years. This is unduly restrictive and is interpreted as requiring that expenditure on each newmarket should exceed 50% of 5-year average turnover. This penalises an SME that has a business plan to enter two or more newmarkets rather than one. For example, a biotech company with only one new cure to alleviate pain might qualify for VCT/ EIS funding whilst another with two new cures for different ailments might not. This is clearly nonsensical and is inconsistent with an overriding aim to stimulate growth in new risky market entries which commercial markets won’t finance. The European Commission intends to adopt changes based on the “fitness check” in the first quarter of 2020. However, how and to what extent these changes might apply to the UK as it exits the European Union remains to be seen. Whether or not these changes are adopted at a European level, however, they remain in our view sensible options that could be adopted by the UK government going forward. EU CONSULTATION: “FITNESS CHECK OF STATE AID RULES” Thought Leadership SENIOR PARTNER, RW BLEARS ROGER BLEARS 48 SUITABILITY