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In this section, we will look at the
investment case for purchasing unquoted
equities in smaller companies as an
asset class without considering the tax
advantages – we’ll cover those
when
we discuss the EIS benefits. The reason
for this is most seasoned commentators
suggest that the tax benefits should be
secondary – the tax tail should not wag
the investment dog – so we wanted to
start by considering smaller companies
as an asset class and then examine how
the tax relief tilts the risk/reward ratio.
#1 THE POTENTIAL FOR SUBSTANTIAL
CAPITAL GAIN:
Smaller companies that
do go on to be the giants of tomorrow
will, of course make huge capital gains for
investors. Around 10% of investments into
smaller companies return greater than
10x capital (of course, picking out these
investments and avoiding the failures is vital
and we discuss some investment strategies
that can help with this in
sections).
Listed equity investments rarely achieve
such high returns, particularly in the mid-
cap and large-cap sections of the market.
#2 DIVERSIFICATION:
There is no doubt
that small companies are somewhat
wedded to the business cycle and there
are more successes when the economy
is doing well. However, as unquoted
investments that may be in companies
that are at different stages of development
or working in non-mainstream activities,
smaller company investments are not
highly correlated to the stock market and
can provide some diversification benefits
by offering the prospect of returns that are
not correlated to the mainstream markets.
#3 IT’S A BUYERS’ MARKET:
Venture
Capital funds are usually looking to make
investments of greater than £2m, and
banks are very reluctant to lend to small
businesses at the moment. This means
that a section of smaller companies are
starved of capital. Therefore, for business
angels who are prepared to invest, it is
very much a buyers’ market. Britain is a
very entrepreneurial economy (perhaps
counter-intuitively, research suggests
that entrepreneurial activity has actually
increased during the recession) and
there are hundreds of thousands of small
businesses in the UK. There is no shortage
of deal flow and investors can take their pick
from a very wide range of opportunities.
#4 IT’S INTERESTING AND EXCITING:
Investing in smaller companies can be
about more than just financial returns.
Certainly for investors who choose to
invest directly rather than through a
fund manager, supporting new and
interesting ventures or companies in
sectors where they have a personal
interest can be much more engaging
and rewarding than the more abstract
concept of stock market based investing.
#5 IT SUPPORTS THE UK ECONOMY:
Of course all investment should support the
economy – one of the theoretical functions
of the stock market is to enable the
efficient allocation of capital. But in reality
stock market investing often supports
companies whose activities (and spending)
are largely overseas and do not directly
benefit the UK economy; or it supports
companies who are already very well
capitalised. And a significant percentage
of the investment may be used to pay for
the long chain of intermediaries that sit
between investors and the stock market.
Conversely, investing in smaller companies
supports a vital and dynamic part of the
UK economy. According to the House of
Commons, there are some 5,000 SMEs,
accounting for over 99% of UK businesses
and some 50% of the total turnover in
the private sector (approx. £1,578bn).
Companies with fewer than 10 employees
account for 95% of all UK businesses.
Whereas most investors and advisers
think of ethical investing as either
screening out ‘non-ethical’ companies
or investing in a social enterprise or
environmental business, it can certainly
be argued that there is an ethical side
to investing in smaller businesses – it’s
giving something back and supporting
an important part of the UK economy.
THE RISKS OF SMALLER
COMPANY INVESTING
The most obvious risk when investing
in smaller companies is a company
failure. According to research by
NESTA, whereas one in ten investments
return 10x capital, approximately five
out of ten return less than capital.
We contacted HMRC to see if they could
supply more information on how EIS
qualifying companies performed.
They confirmed that through research
of the Companies House database at
least 94% of all companies receiving EIS
investment in the tax year 2011/12 were
still active in November 2013 – this is, of
course, not an indication of performance
and too small a sample to be significant, but
it does hint that EIS qualifying companies
are not here today, gone tomorrow start-
ups. However, this statistic shouldn’t be
surprising; new EIS companies would
have received a cash injection during
this time period and would be expected
to still be in business at this point.
There are two ways to mitigate the risk of
total failure. One is by being an outstanding
stock picker who rarely backs a loser – this
is possible but notoriously difficult! This
is one of the main reasons why advisers
and investors delegate to investment
professionals – for example, a manager with
specialist knowledge of start-ups and small
companies. The other is to be systematic
and diversify investment across a portfolio
of smaller companies in the expectation
that the returns from the winners will more
than offset the losses on the failures.
The other risk is really down to the position
of a small shareholder of unquoted
equities. This is not a powerful position
and investors may have very little influence
on matters of great importance to their
investment – such as rights issues, the
timing of a listing or the sale of the
company. For direct investors, this risk can
only really be mitigated by carrying out due
diligence and developing confidence in the
management team. For investors in funds,
the expectation is that the fund manager
will take a large enough position to exercise
some influence over the management
and look out for investor interests.
The final risk is one of frustration really
– perhaps nothing very interesting will
happen and investors will find their capital
is ‘stuck’. If a company does not manage
to reach a stage where a profitable exit
from the investment is possible, but does
stay in business and investors cannot
sell their shares, then the investment
is essentially in limbo: not necessarily a
bad investment and still holding out the
possibility of success one day, but the
capital cannot be taken out and recycled
into other opportunities. This is a further
risk with unquoted, equity investments.
WHY INVEST IN SMALLER COMPANIES?
