How To Become A Business Angel. Richard Hargreaves

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      There are two main types of funds available to individuals, namely VCTs and EIS funds.

      What they have in common is that participants invest in a blind pool managed by professional fund managers and receive significant tax benefits. Both funds are the result of successive governments’ encouragement of entrepreneurial activity via tax advantages.

      The diversification of risk that funds offer, coupled with the inevitably high fees charged by managers and promoters, does mean you cannot expect the level of return that angel investment can deliver.

      In practice, and it is very sad to say this, many of these funds are thinly disguised tax shelter schemes. These are designed to give investors an investment return through the use of tax reliefs in the safest way that can be squeezed through the legislation – in other words the economy sees little or no benefit. That to me is an abuse – albeit legal – of the tax system and hard to defend morally. It illustrates, though, how much smarter the tax shelter industry is than the public servants who design these schemes.

      A minority of these funds – and it is a minority – do back real growth businesses in the full spirit of the legislation.

      The key differences between funds and angel investing are that the investor has no say in which companies will be in the portfolio nor how they are helped post-investment. The investor in the fund has to trust the fund manager to do what they have said they will.

      Let’s look in more detail at VCTs and EIS funds, taking them in turn.

      Venture Capital Trusts (VCTs)

      A VCT is a company whose shares are listed on the London Stock Exchange which must invest in qualifying companies – broadly smaller UK businesses carrying out a permitted trade. The investor subscribes for shares and receives income tax relief on his investment. All dividends and capital gains on the shares are tax free if certain rules are obeyed.

      The VCT has become a central part of the tax shelter industry and very large sums of money have been raised. The most successful fundraising year was the tax year 2005-06, when £779m was raised and, more recently, £330m was raised in 2011-12.

      However, following the close of the 2010-11 season, one IFA was quoted as believing that only around 30% of new VCT money goes into investment in small unquoted companies: “Much of the rest is going into other investments which, while allowable under VCT rules, are not so much in the spirit of what VCTs were originally intended for,” he said. One example he cited was the pre-sale financing of annual season tickets for premier league football clubs. “So, while the headline VCT sales figures may appear to be very good news for small British companies, the overall reality is likely to be somewhat different,” he commented.

      If you want to learn more about the rules VCTs operate under, a good starting point is the HMRC guidance notes available from its website (www.hmrc.gov.uk/guidance/vct.htm).

      Enterprise Investment Scheme (EIS) funds

      Unlike the VCT, the EIS fund is not really a fund at all in the sense of being a discrete investment vehicle. Instead, it is a series of parallel investment mandates controlled by a fund manager – but this technicality is not important to the investor. Like VCTs these funds are generally marketed to the general public.

      Despite having a flexible and attractive set of tax benefits, EIS funds have historically raised much less money than VCTs. However, over the past few years there has been increasing government commitment to EIS – reflected in improved tax benefits – and government disenchantment with VCTs – reflected in reduced tax benefits.

      Taken together with the increased highest rate of income tax and sharp reductions of the amounts that can now be invested in SIPPs, the EIS has become more and more appealing. As a result EIS funds are now the tax advantaged vehicle of choice.

      The amount raised by EIS funds overtook that raised by VCTs in the tax year 2007-8. The tax changes made by the coalition government since it came to power can only reinforce the trend.

      Approved and Unapproved funds

      There are two types of EIS fund, the Approved and Unapproved. These formal HMRC terms are ill-chosen as they imply the Approved fund is lower risk. It does offer certainty of getting EIS reliefs, which some might see as a benefit. However, from an investment standpoint, the Unapproved fund is lower risk because it does not have artificial time pressures forced upon it by the rules.

      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.

        An EIS fund is very poor at investing further in a particular venture – especially if it is an Approved Fund – so it needs to favour investments that will not need more money. If the fund manager has a series of EIS funds he can invest further in earlier deals but there are grave conflicts of interest. These may result from the temptation to support a weaker investment in an older fund which he might not support as a new investment or from an inability to make an independent decision on the investment price for the newer fund. In the professional venture capital world a fund manager would be barred from follow-on investments from a new fund for just that reason.

      Prospectus EIS deals

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