A practical guide to EIS/SEIS Funds

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• What are SEIS/EIS funds.
• Explanation of the tax benefits.
• How to set a fund up.

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2. When should I consider subscribing to a fund?

EIS investments are only suitable to certain individuals, let's see who.

There are two rather basic requirements when an investor is considering an investment under EIS, which are:

• Sufficient tax capacity to benefit from the available tax reliefs;
•  Adequate knowledge and experience to understand the risk and reward of such investments.

Tax Capacity

Given the array of tax incentives available for a subscription in EIS qualifying shares, it really should go without saying that this type of investment is only appropriate for investors who are in a position to maximise the tax liability benefit of this type of investment. This is inherently linked to the second point,  the Investor has to have sufficient knowledge and understanding of this type of investment, as, if the Investor believes they are suitable for this type of investment without an adequate tax liability there is a high chance that this style of investment is not for them. The tax reliefs provided by EIS are all interconnected with the scheme, and some are reliant upon claiming previous reliefs. Once subscribed the Investor is eligible for upfront 30% income tax relief, subsequent reliefs such as CGT free growth are reliant upon claiming this income tax relief so the Investor must have a sufficient tax liability to offset.

Knowledge and Experience

Given the high-risk nature of the early-stage investment, regulatory bodies and managers alike wish to see a certain amount of industry knowledge or investing experience when deeming if an investor is suitable for subscription to an offering. This takes place in the form of a questionnaire which is within a fund's application form; this asks a range of questions trying to gauge information like the Investor's:

• Ability to bear losses;
• Current Financial situation;
• Investment experience;
• Professional experience; and
• Academic and professional qualifications.

These areas are very useful in determining if this kind of investment is right for the Investor. Although some clients receive advice by an FCA regulated Financial Adviser who carries out a suitability test on their client, additional responsibility has fallen on EIS managers (Such as Sapphire) as was highlighted in the Dear CEO publication to ensure that Financial Advisers are adequately assessing Investors. Some Investors may be classified within certain categories which require a less substantial assessment of their experience known as an Appropriateness Review; this is explored further in our further section on Eligible Clients.

3. Risks

All investments will carry a certain degree of risk, as EIS is investing in early-stage companies there are additional risks when compared to traditional investments.

Investment Risk

• Illiquidity risk

The illiquidity risk must be recognised and accepted by the Investor, as EIS investment is in early-stage unquoted companies there is a very restricted market for the sale of qualifying shares outside of typical exit strategies explored in section 13. Due to the illiquid nature of the investment, investors should only consider subscribing an amount which would not materially affect their quality life or which they would be required to liquidate in case of an emergency. Investors should keep monies in cash or readily realisable securities alongside their qualifying investment.

• Past performance risk

Past performance of investee companies is fairly limited compared to large established or quoted companies as they may not even have a trading history. As this can be the case when the Investment Adviser is considering a company for investment, the due diligence is rather subjective as each Fund has differing target criteria and their own idea of what makes a successful business.

The past performance of a fund which has made similar EIS investments should be considered when assessing if EIS investment is correct for you. In saying that, there should not be a reliance or an expectation for a fund to replicate their past performance. Past performance is not indicative of the future performance of the Fund many factors must be considered when assessing your suitability if you are in doubt of the relevance of EIS to your investment portfolio you should consult an Independent Financial Adviser ("IFA").

• Guarantee / Forward-looking statements risk

The financial promotions distributed for enticing investors must follow a very strict code of conduct, explicitly outlining the restriction on guarantees. No fund or IFA is in a position to guarantee any investor the safety or return of their capital and all investments carry a certain degree of risk. EIS investments being in early-stage companies means that many of these companies fail and investors must be acute to this likelihood.

All forward-looking statements within financial promotion will all be based upon an individual's opinions, and as such, there can be no guarantee or assurance that predictions of the Fund or its Adviser come to fruition.

Tax Risk 

The tax risk associated with investing in EIS is rather intricate for the average Investor, and it is suggested that anyone considering an EIS qualifying investment should consult a specialist tax advisor to assess the Investor's tax liability and suitability for an investment in such schemes.

• Early exits risk

There is an additional risk for ill-informed investors when considering selling their shares within the three-year qualifying period. The premature sale of the shares has consequences for the reliefs to the Investor; the upfront income tax relief is clawed back by HMRC alongside any capital gain which may have been deferred by the qualifying investment as well the liability for capital gain incurred through the sale of the shares. Given the knock-on consequences of selling the qualifying shares inside the three years, it would require specific advice on the sale of the shares by an adviser aware of the full repercussions.

• Business relief risk

Business Relief is assessed by HMRC after the Investor's death, so there is no guarantee that investments made through EIS Portfolio will qualify for 100% relief from Inheritance Tax. Any potential for an investment in a portfolio company to qualify for Business Relief ceases when that company is sold or listed on a stock exchange (although a company listed on the Alternative Investment Market may still qualify for Business Relief, subject to meeting several other criteria)

• No guarantee of retaining reliefs risk

As advance assurance is given on the condition of the qualifying company maintaining their qualifying status, there can be no guarantee that the company will remain compliant. The assurance is initially given on the company's conditions outline to HMRC in their application and is only given on the presumption that everything within the application is true and has not been structured to qualify for the scheme.

As such, if the qualifying company chooses to carry out any disqualifying actions, the Investor's tax liability will undoubtedly be affected and should be advised accordingly by an IFA.

4. Eligible Clients

Some Investors will be in a position to understand the risks and benefits of EIS more than others, see what category of Investor you or your clients will fall under.

Although there are restrictions around who financial promotions can be targeted at, there are certain categories of investors which the FCA deem appropriate for this kind of investment:

• Sophisticated Investor – A further sub-classification Sophisticated Investor is whether the Investor is self-certified or certified by an IFA. To qualify as a Sophisticated Investor, this requires the Investor to have been satisfying at least one of the following points:

1. Relevant professional experience (In the private equity sector) or in the provision of finance for small and medium enterprises within the last two years.
2. A member of a network or syndicate of business angels and have been so for at least the last six months prior.
3. The investor has made more than one investment in an unlisted company in the two years prior.
4. I am currently or have been in the two years prior been a director of a company with an annual turnover of at least £1 million.

See link to Sophisticated investor statement: https://www.handbook.fca.org.uk/handbook/COBS/4/12.html#DES586

• High Net Worth Individual - (A High Net Worth Individual for the purposes of the FSMA 2000.) - As an HNW they must satisfy one of the following criteria and must have signed the HNW statement:

1. I had, during the financial year immediately preceding the date below, an annual income to the value of £100,000 or more;
2. I held, during the financial year immediately preceding, net assets to the value of £250,000 or more. Net assets for these purposes do not include:

• the property which is my primary residence, or any loan secured on that residence.
• any rights of mine under a qualifying contract of insurance within the meaning of the FSMA 2000 (Regulated Activities) Order 2001;
  or
• any benefits (in the form of pensions or otherwise) which are payable on the termination of my service or my death or retirement and to which I am (or my dependants are), or maybe, entitled.

See link to High Net Worth Individual statement: https://www.handbook.fca.org.uk/handbook/COBS/4/12.html#DES582

• Restricted Investor - A restricted investor will qualify if the following condition are satisfied:

1. In the twelve months preceding, I have not invested more than 10% of my net assets in unlisted shares or unlisted debt securities, and
2. I undertake that in the twelve months following I will not invest more than 10% of my net assets in unlisted shares or unlisted debt securities. Net assets for these purposes do not include -

• the property which is my primary residence, or any loan secured on that residence.
• any rights of mine under a qualifying contract of insurance within the meaning of the FSMA 2000 (Regulated Activities) Order 2001;
  or
• any benefits (in the form of pensions or otherwise) which are payable on the termination of my service or my death or retirement and to which I am (or my dependants are), or maybe, entitled.

See link to Restricted Investor statement: https://www.handbook.fca.org.uk/handbook/COBS/4/7.html#DES620

Further to these classifications investors will fall into either of two categories, the investor will either be an advised client or an unadvised client, in addition to this either the investor, or their FCA authorised Financial Adviser will asses their situation and conclude where the investor will lie.

An investor which classifies themselves as one of these categories will no longer be able to submit a claim to the FSA or Financial Ombudsman.

5. Minimum subscription 

Minimum subscriptions to the fund are not explicitly outlined by the scheme, as the maximum subscriptions are.

The typical minimum subscription amounts to EIS funds range from £1,000 - £100,000, it must be stressed that EIS investment should only be considered by investors with a sufficient tax liability to benefit from the available reliefs.

6. Closing dates

EIS funds will either have several closing dates, the single closing date or run indefinitely.

• Evergreen Funds

Evergreen funds are funds which have no final close date rather a series of closing dates in tranches which will run indefinitely. The decision to finally stop accepting subscriptions to the Fund is left to the discretion of the Investment Manager. Another consideration when considering an evergreen fund is that when investing, there is no guarantee that the Investor has access to investee companies which have previously issued shares to the Fund.

• Tranches

Having several closing dates has similar risks for consideration as an Evergreen structure, the primary difference being that this type of Fund will have several closing dates before a final close where the Fund will no longer accept subscriptions.

• Single closing date

Some funds opt for a single closing date at which point the Fund will have raised its total subscription and can begin allocating their capital.

7. Typical entities within a fund

Within an EIS fund, there are usually the following entities involved with the fund:

• Investment Manager – This is an FCA authorised Manager responsible for ensuring compliance with FCA and the rules of EIS.
• Investment Adviser/mentor – Some funds look to take an active role in addition to the providing of finance to their investee companies. Investment Advisers will typically use their previous experience to help aid the development of these company; this may be in the form of consultancy or a board role.
• Legal Advice – As there is a multitude of legislation restricting financial promotion and investments, funds leverage the knowledge of specialist lawyers when those difficult to answer questions arise.
• Tax Advice – Given the inherent relation EIS has with Tax reliefs, tax advice must be available when it becomes necessary.

8. Knowledge Intensive HMRC Approved Funds

With recent amendment to HMRC approved EIS funds, lets explore the changes to this category of fund and see what now constitutes as qualifying.

As of 5th April 2020, HMRC has replaced approved funds with knowledge-intensive approved funds ("KIAF"). HMRC approved funds are only approved concerning their tax reliefs and are in no way a guarantee or indicative of the performance of the Fund. The conditions a KIAF must meet are as follows:

• The Fund must invest 90% of the Investor's subscription within two years of the close date of the Fund; and
• The Fund must invest 80% of the Investor's subscription into qualifying knowledge-intensive investee companies.

A reason investors may prefer to invest in a KIAF allows them to submit a single EIS 5 form with their tax return as opposed to the individual EIS 3 forms which would be issued on each investment into the investee companies. Another reason is the Investor can claim their upfront income tax relief as of the closing date of the Fund.

9. Financial Services Compensation Scheme

The Financial Services Compensation Scheme ("FSCS") allows investors to claim compensation.

EIS funds are classified as Alternative Investment Funds (AIFs) and as such are not eligible to claim under the FSCS. Investors would be eligible for a claim in the event of default by the custodian with a maximum claim being £85,000.

10. Typical fund documents

There are a number of standard documents to be produced by a fund. Sapphire works side by side with our clients to review and produce these documents.

• Key Information Document

EIS funds as venture capital investments are classified as Packaged Retail and Insurance Based Investment Products (PRIIPs) and as such, are required to produce a Key Information Document (KID). A KID document is a 3-page summary document which outlines the Fund, contact information for the relevant parties, a summary of the Fund's investment strategy, a comparison of how the Fund will perform over a range of scenarios listing possible returns of investment, a list of fees (This will be explored in the following section on fees) incurred by the Investor, to name a few. The purpose for these documents is to present investors with a standardised format which will allow them to compare with similar offerings in a concise form.

• Information Memorandum

This document is critical to get right as they are the best and usually the first opportunity for the Fund to communicate to the Investor if this is right for them. Funds (using the term collectively meaning EIS funds and managed portfolios) issue an Information memorandum to their prospective invests to help communicate their expertise, investment strategy and previous experience (if they have any). These outline how the Fund will operate and the responsible parties involved as discussed in the section: Typical Parties

They typically explain the Funds due diligence and selection process explaining how and why they pick the type of qualifying companies that they do.

• Application Form

Application forms are when the suitability and appropriateness reviews are conducted. These forms require the Investor to provide copies of their IDs and Anti-Money Laundering documents for the Investment Manager to conduct the relevant checks as per Anti-Money Laundering February 2020 Directive. Investors may have limited exposure to the application form dependant on the use of a Financial Adviser, however, either the Adviser signs a declaration saying they are satisfied with their clients understanding and experience making this a suitable investment; or the Investor answers a series of questions asking them to outline their professional, academic and financial investment experience. Taking into account their current and future financial situation the Investor must inform the Investment Manager if they would require the investment sum within the short term, as with the nature of Non Readily-Realisable Securities ("NRRS") their illiquid nature means even if the Investor wanted to realise value from them, there might not necessarily be a buyer available.

11. Typical Exit Strategies 

There are three typical ways in which an investor can realise their EIS investment.

IPO

Initial Public Offering ("IPO") would be quite a rare exit for an EIS qualifying company; however, that is not to say that there haven't been. Zoopla recently became the first company which raised under EIS to reach a valuation of £1 billion. An IPO is when the investee company lists on a registered stock exchange such as the London Stock Exchange.

Trade sale/management buy-out

This exit method is the most typical exit method for EIS investment. It would typically require a more established company within a similar market performing acquisition of the qualifying company, allowing the investors to sell their share at a profit to the already established company. Another similar potential exit method would be a management buy-out which would see the senior management within the business buying the investors out of their shares in the business.

Voluntary winding up

This would see the company wind up through the choice of the shareholders to liquidate the assets of the company. This would typically be seen as the company failing, however, this may still provide the Investor with attractive returns even though the company has been wound up. After the assets of the business have been sold, the proceeds are distributed across the companies’ outstanding liabilities and shareholders.

12. Types of fees

Below is a brief summary of typical fees that could be incurred by the investor when subscribing to a fund. These will be concisely broken down with the KID and information memorandum

There is a range of fees which are typically incurred in the management and administration of an EIS fund they are as follows:

• Initial Fee
• Annual Management Charge (AMC)
• Custodian Fees
• Administration Fee
• Exit Fee
• Performance Fee

Disclaimer

Please note that this is only a condensed summary of the FCA, legal and taxation legislation and should not be construed as constituting advice which a potential investor should obtain from his or her own investment or taxation adviser. The value of any tax reliefs will depend on the individual circumstances of investors. 

Sapphire Capital Partners LLP does not give FCA, legal or tax advice and recommends that you consult a tax adviser if you are in any doubt about any of the technical aspects of the SEIS and/or EIS fund legislation.