EIS guide

53 52 RESEARCH AND DUE DILIGENCE RESEARCH AND DUE DILIGENCE NATURE OF UNDERLYING INVESTMENTS It is important to understand: • The nature of proposed underlying trades • The investment stage • The industry sectors they are in • The risks they are exposed to • The level of returns they can generate and how they are generated • How quickly they return to cash or how liquid they are • The manager’s experience investing in the proposed trades. Advisers should also evaluate the anticipated deal flow and deal pipeline for the fund and assure themselves that the manager is able to deploy the funds they raise in line with the proposed investment strategy. The EIS rules generally restrict companies that can receive EIS funding to smaller companies that have been trading for seven years or less (ten years or less for KICs - although a KIC also has more flexibility regarding when this ten-year point starts - see page 31 for more information on KICs). In commercial terms, this means that the companies in an EIS portfolio are all ‘early stage’. But, within this classification, there are various stages of fundraising depending on the development stage of the investee. The funding stage definitions are not fixed, but are typically: Seed: Seed rounds are among the first rounds of funding a company will receive, generally while the company is young and working to gain traction and build a product from an idea. It is likely to be pre-revenue. Some Seed rounds may also include SEIS investment (see page 40 for more on SEIS). Series A: The company may have some established revenues and is typically pre- profit. At this stage, it is seeking to identify the commercial viability of its product or service (product-market fit). Series B: The company may be making small profits but is looking to scale and has growth aspirations outside current revenue streams. Therefore, the funding round is an indicator of risk, with earlier stage funding likely to be higher risk, but lower cost. This brings the opportunity for higher returns, but also greater potential for losses. It is not unusual for EIS managers to diversify across funding stages. Some also reinvest in the same company at a later stage as it develops and proves its value. It is also worth noting that follow on investment, by any party, can dilute the shareholding of earlier stage investors if they are not prepared to invest in the new round of funding. EIS shares can’t have anti-dilution rights. Consequently, each time equity investment is taken by the company, new shares are issued. As a result the total number of shares in issue increases, meaning that an existing shareholder who does not invest in the new round (which would increase the number of shares they hold) will hold a smaller percentage of the new total number of shares. Nevertheless, if the company is doing well, even without participation in follow on rounds, the smaller percentage of the company held by the shareholder should have a larger value than before the investment round. This is because the price of shares in new funding rounds is likely to rise as the company becomes more successful and this valuation is applied to the business as a whole. EIS Funding Stages £10K Concept and seed stage Start-ups Early-stage Later-stage £50K £100K £500K £1m £2m £5m £10m £100m Amount Invested IDEA GENERATION IDEA EVALUATION PRODUCT DEVELOPMENT/ LAUNCHING EXPANSION & MARKETING PROFIT GENERATION Seed • Grants • Business Angels • Venture Capital • Banks Series A • Publicly backed Venture Capital • Private Venture Capital • Banks Series B • Private Equity • Private Venture Capital • Banks The level of diversification across underlying investments varies, but advisers should assure themselves that it is in line with both the investment objective and is commensurate with the nature of the underlying investments. As a general rule, the riskier the underlying investments are, the greater the level of diversification should be. However, some research suggests that beyond a certain point diversification can go too far and that the additional costs incurred do not bring any additional diversification benefits. Advisers need to be confident that the fund is not overly-diversified. “A trade is not a qualifying trade if it consists, at any time in the relevant period, of certain activities, or if such activities amount, in aggregate, to a ‘substantial part’ of it.” HMRC