EIS guide

7 RISKS AND REWARDS Investments into unquoted small and medium- sized enterprises are deemed high risk. It is important to understand the risks associated with EIS-qualifying investments in a general sense, and we will examine some of those risks here. However, each individual EIS investment opportunity has its own unique risks and, therefore, each opportunity must be individually assessed. Investment risks Statistically speaking, smaller companies fail more often than larger, established companies. The reasons for this include: • They can be more reliant upon a small number of customers; • They have less capital available to withstand a downturn in their fortunes; There is no large-scale active secondary market in unquoted shares and EIS managers do not offer buy-backs. It may be possible to arrange a private sale of shares to a third party, but, at the point of investment, investors should regard themselves as locked in to the shares until the underlying company either lists on a recognised stock exchange, achieves a trade sale, or the company is wound up. (EIS rules dictate that should a company list on a recognised stock exchange within an investor’s relevant three-year holding period EIS relief for that investor will be withdrawn. However, some stock exchanges such as AIM fall outside the definition of a recognised exchange so it may be possible to list on AIM without a withdrawal of relief. This is considered further in the Rules for qualifying companies section). Exit risk As unquoted investments, any gains in EIS-qualifying shares are only ‘attributed gains’ (unrealised) until the investor can exit and realise those gains. There is no active secondary market in unquoted shares, so an exit is most likely to come in one of THREE ways: 1. An Initial Public Offering (IPO) – The company lists on an exchange and shares can be sold on the open market. 2. A trade sale or management buyout – A majority of shareholders agree to sell their shares to another company or possibly the incumbent management team. 3. Voluntary liquidation by shareholders - The company is wound up and the assets are sold, with the proceeds distributed to shareholders. This doesn’t necessarily mean that the company has failed; depending on the remaining assets of the company, the distributions to the shareholders may be worth more than the initial price they paid for their shares. ‘Zombie companies’ There is a risk of an investment continuing indefinitely with no large-scale active secondary market in EIS shares; this is to the extent that described exit routes cannot be achieved at either a gain or a loss. A loss could at least be offset against other gains. Since very few small companies pay dividends and dividends paid from an EIS- qualifying company are subject to tax, there is unlikely to be any income. In this scenario the funds remain tied up indefinitely with little prospect of recycling them. EIS investee companies in this situation are often referred to as ‘zombie companies’. Tax risks A company that issues EIS-qualifying shares must meet a number of different criteria. Some of these criteria apply at the point of investment and some apply for the minimum three-year holding period. If the company changes its activities or structure in such a way that it no longer meets these qualifying criteria during that three-year period, then investors lose their tax reliefs. See the Rules for qualifying companies section on page 26 for more details. Relief will be denied on any shares issued under arrangements that offer investors a protection against the risks of making the investment or which would effectively guarantee (or at least make it likely) that the investor will receive their money back at some point in the future through some mechanism introduced by the provider or the company itself. This would be considered to be part of an arrangement, for the purpose of tax avoidance. However, simply making an investment with the aim of qualifying for relief is unlikely to be viewed as tax avoidance in itself. • They can take a long time to bring new initiatives to fruition and become profitable. These risks can be offset, to some extent, by skilful stock selection and sufficient diversification. Liquidity Although the minimum holding period to qualify for the full income tax relief and tax- free growth is at least three years (note, there is no minimum holding period for Capital Gains Tax (CGT) deferral relief), in reality investors are likely to have to commit their funds for much longer; most EIS investments should be viewed on a five to ten-year investment horizon. Previously, some EIS funds have been positioned as ‘lower-risk’ and some may have had an objective of winding up as soon after the three- year period as possible. But this is still subject to being able to successfully dispose of the qualifying investments without there being any arrangements for this in place from the outset (as required by EIS rules). However, the new risk-to-capital condition (explained on pages 26-27) means that anything structured to be ‘lower risk’ has no longer qualified for new EIS investment since 15 March 2018, when the Finance Act 2018 received Royal Assent. EIS HOLDING PERIOD Potential growth Years 0 1 2 3 4 5 6 7 8 9 10 Statutory 3-year holding period More likely investment horizon EIS investment* * EIS shares must be held for a period of at least three years - from the later of the issue of shares, or commencement of trade if the shares were issued when the company hadn’t commenced trading. Risks and rewards