EIS Industry Report 2018/19

44 45 Assumed performance over a given period for investment spread across ten portfolio companies Fail (3 companies) x3.0 return (4 companies) x7.0 return (2 companies) x24.0 return (1 company) Cost of initial investment £30,000 £40,000 £20,000 £10,000 Less income tax relief at 30% £9,000 £12,000 £6,000 £3,000 Net of tax relief cost £21,000 £28,000 £14,000 £7,000 Exit proceeds after performance fees £0 £106,400 £117,200 £194,000 (Loss relief on net of tax cost) £8,400 £0 £0 £0 Net tax-free (loss)/profit* £8,400 £106,400 £117,200 £194,600 Total return £456,600 (+457%) The J-Curve effect In general, investors in venture capital funds will find out first about the losers before the winners materialise. Investments in EIS portfolios frequently go through a J-curve effect. In a typical VC portfolio, most of the returns are from 20% of the investments, i.e. if there are 10 investee companies in a portfolio, the two winners will drive the performance for the rest of the portfolio. 44 It’s almost inevitable that companies in the portfolio will reduce in value, or completely fail. In the early years of a VC fund, portfolio valuations tend to decrease as investments are made and fees are incurred. The performance improves as the better companies are revealed and exits are achieved. Which investors are suitable? As discussed earlier in this report, the barrier to entry for open EIS funds in the mainstream market is rather high, with the average minimum subscription being over £18,000. Regardless of the regulatory environment, this places EIS as a vehicle suitable only for HNWIs and sophisticated investors with an appropriate tax ’capacity’ (i.e. the capacity to benefit from the upfront income tax relief, as well as the tax capacity to subsequently claim loss relief in the most efficient manner should an investment fail). Even with the tax relief available, these investors will also be more likely to be in a position to stomach a loss. That being said, there is no shortage of potential clients for EIS managers. According to Capgemini’s 2018 World Wealth Report, there were 575,000 HNWIs resident in the UK in 2017, holding approximately £1.6trn in wealth. 45 Liquidity risk The majority of available EIS investments are unlisted, which means they are highly illiquid. If an investor sells their shares within the three-year holding period, they will lose the tax reliefs associated with investing in an EIS company. This should be a serious consideration for investors, as in most cases, they will have to wait for the investee company to be exited before seeing any of their capital returned. Further, those EIS investments that are ‘listed’ can only be listed on AIM or the NEX, which are junior markets and can be more volatile and bear greater liquidity issues compared with senior markets. Tax risk Although it is unlikely that there will be wholesale changes to the reliefs on offer for EIS, unexpected changes to legislation can happen. EIS is funnelling capital into genuine growth businesses which generate cash and employment for the UK economy - so changes are unlikely to be on the immediate horizon. Should any changes be announced, they are unlikely to be ‘retrospective’ in nature. However, it’s worth noting that HMRC can revoke the EIS qualifying status of an investee company if the company no longer complies with the relevant conditions. Further, an investor themselves can breach EIS conditions (by becoming ‘connected’ with the EIS company during the relevant three-year period, for example). If the conditions are breached, the investor can lose their tax relief. Therefore, it is prudent for investors to retain enough cash to be able to pay their income tax and CGT liabilities in full, rather than assume that the tax reliefs will continue to be available. Delays in deploying capital Although not a direct risk, investors should be aware that they may not have immediate access to tax relief upon engaging in an EIS offer. Investors (in most circumstances) will only be eligible for tax relief when the investment manager has deployed their capital. They must wait to receive a form EIS3 (or form EIS5 for HMRC ‘approved’ funds) for each underlying investment in the EIS portfolio to claim the tax reliefs. A form EIS3 for each EIS investor is issued to the company by HMRC when the company submits (and HMRC have processed to their satisfaction) a form EIS1. A form EIS1 can only be submitted to HMRC after the issue of shares when the company has been trading for a minimum of four months. Therefore, for early stage investing into companies that aren’t yet trading, investors should be aware that there could be a delay in them claiming the tax reliefs. Investment managers will be reliant on there being suitable deal flow available, and this is not necessarily guaranteed. We will discuss the issues surrounding deal flow later in this section. Of the open EIS offers that stipulate a target dealing frequency, 19 managers aim to have deployed all of the investor’s funds within a year. Five managers are targeting deployment within 18 months. A longer target deployment time should be a serious consideration for investors when selecting an EIS offer. EIS PORTFOLIO IN PRACTICE Investors in EIS portfolios should see a similar performance trajectory to typical VC funds. Especially now that EIS is purely focused on growth capital. SOURCE: FORESIGHT THE “J” CURVE PERFORMANCE Better performing companies revealed, exits occur Investments made: Impact of Fees and early losses TIME Generally find out about losers before winners Within 2 weeks 1 Within 1 month 2 Within 3 months 2 Within 4 months 1 Within 12 months 19 Within 18 months 5 TARGET DEALING FREQUENCY (NO. OF OPEN EIS OFFERS) Considerations for Investment / What are the Risks? Considerations for Investment / What are the Risks?