In return for the Approved fund investing at least 90% of its money in at least four EIS qualifying companies within 12 months of the fund being closed, HMRC will allow EIS income tax relief to be claimed at the point of investment in the fund.
The Unapproved fund is more flexible. It can invest when it likes and in as many or as few investments as it likes, but EIS relief is only available on a deal-by-deal basis from the date individual investments are made.
Finally, there is the EIS portfolio service which is specific to one investor and has some greater flexibilities such as the right to withdraw from the service at any time.
HMRC publishes guidance notes on EIS and EIS funds, which are available from its website (www.hmrc.gov.uk/eis).
Pros and cons of EIS funds and VCTs
One positive feature of EIS funds is that the proceeds of investment sales or dividends from them are returned to investors, less fees due, more or less as soon as they are received by the fund. The fund manager can only invest an investor’s money once and must launch a new fund each time a fund is fully invested.
The constant need to raise new EIS funds as old ones are fully invested is one of the reasons many fund managers prefer the VCT. The VCT is by contrast an evergreen vehicle (unless shareholders insist it is liquidated) and so capital availability and fees continue indefinitely – which is music to a fund manager’s ears.
There are also drawbacks to the typical EIS fund or portfolio:
15% or more of an investor’s money does not receive EIS reliefs. This is because 5% goes to pay the costs of launch (including IFA commissions) and around 10% may be held back for fund management fees. Ironically, the VCT is less cost-efficient as an investment vehicle due to the expense of its stock market listing and compliance but, as all costs are borne by the VCT itself, the investor receives tax reliefs on their gross investment.
Prospectus EIS deals
Prospectus EIS deals are investment opportunities which are promoted to the general public using formal prospectuses. The fact that prospectuses are available to the public means they are subject to strict legal rules but that does not mean they are safe investments.
The issuer, or promoter, of any prospectus has a legal duty of utmost good faith so as to not mislead potential investors and he must disclose all material facts about the company’s business. But that is completely different to the promoter believing the company will succeed. In the unquoted market, promoters often do deals simply because they think the public will buy them. Many promoters are fee driven and have little interest in the company succeeding once they have pocketed their fees and moved on to the next deal.
The prospectus route can also be a very expensive way of raising capital and I have seen total costs as high as 30% of investors’ money. Entrepreneurs will accept such high costs as high share valuations can more than offset them. For example, if an entrepreneur is prepared to raise money at, say, £5 per share but a promoter says he can raise it at £10 with costs of £3 giving the company £7 per share net, then the entrepreneur gains. It is the investor who suffers. So investors need to be vigilant.
None of this is to say there are not excellent prospectus offers and Case Study 3 describes one of these.
Loans to companies
Finally, there are ways of lending to small companies and receiving an attractive headline rate of interest whilst making a secured and credit risk assessed loan. That idea may appeal as part of the diversification of your portfolio.
I am aware of two organisations that organise lending by individuals to companies using online techniques:
1 Funding Circle (www.fundingcircle.com) offers lenders a portfolio of small stakes in several credit agency risk-assessed loans.
2 Thincats.com takes a different approach and instead uses experienced sponsors (for example ex-bank managers) who directly assess a loan application, which might be for as much as £1m over five years.
With both these organisations, once a potential lender has decided they like a particular opportunity they can bid an amount and an interest rate to join the syndicate. Those lenders offering the best interest rates are selected to make up the lending syndicate and get the interest rate they have asked for.
In both cases the deal completion, including legal documents and security, are arranged for the lender. Because the costs and profit margin of a bank are missing, both borrower and lender benefit. At least that is the theory.
I do need to end on a cautionary note. The headline interest rates quoted by websites such as these are very misleading. They take no account of costs or bad debts. Proper allowance for these may easily halve the headline rate and then the returns do not look at all attractive. Coupled to this is the lack of certainty of the timing of repayment, which may make bank savings accounts seem a better bet.
Case studies
1. Cautionary tales
I can’t resist offering a warning about how people can ignore the simple principles discussed in this chapter.
Two unrelated software entrepreneurs I know made a great deal of money from their specialty. They each then invested in other things besides the industry they know because the investments seemed easy to understand. One lost a lot of money on Spanish property when the market crashed. The other invested in Indonesian rubber trees that are thousands of miles and many time zone hours away, and in a wildly different culture, and had huge problems as a result.
Learning point
Investing outside your area of expertise is risky. Success in a particular venture does not guarantee future success in a different venture.
2. An example of an angel portfolio
I have summarised below the portfolio that one of our clients at Endeavour Ventures has assembled by investing through us over five years. It illustrates some of the points I have made in this chapter. It is not his complete portfolio but only those made through us. He has other angel investments that I am aware of and has also diversified risk by investing in funds.
Portfolio
The client has looked at 18 investment opportunities shown to him by us.
All were early stage companies which were not yet profitable.
He has invested £750,000 in 11 investments and turned down seven.
He has typically invested £30,000 to £50,000 initially.
He has followed on with more money in later financing rounds in six companies.
Four of the seven rejections were retail or property, neither of which sectors he likes.
The