Rewarding risk: how to protect investors against losing EIS relief
Ever since its launch in 1994, the Enterprise Investment Scheme (EIS) has played a key role in encouraging investment in smaller private companies. To date, over £18 billion of EIS investment has been made in 28,000 companies.
EIS investment is growing in popularity – more than £1.8 billion was invested under EIS in each of the 2016 and 2017 tax years. There are various reasons for this, including the attractive tax reliefs available to EIS investors, recent changes to pension regulations which have resulted in more high net worth individuals looking for alternative tax-efficient investment vehicles, and wider factors such as the continued growth of crowdfunding (much of which is in EIS-qualifying companies).
We are also seeing an increase in the number of higher-value EIS raises, with 43% of the amount raised being part of rounds of £2m or more, and more companies attracting multiple rounds of EIS investment.
The purpose of EIS relief is to encourage investment in early-stage and higher-risk companies which might struggle to attract traditional equity or debt finance. The fact that loss relief (against income tax) is built into the range of tax reliefs available under EIS recognises the inherent risk that many investee companies will fail. However, there is an important distinction to be made between the underlying risks associated with EIS investment and the quite separate risk that EIS relief itself will be lost.
Notwithstanding the inherent risks associated with EIS investment, we are seeing a growing trend of investors looking to protect themselves against the risk that EIS relief itself may be lost.
What are the inherent risks in EIS investments?
Whilst there are many risks associated with EIS investment, some are better known than others. As EIS investment grows in popularity and attracts a wider range of potential investors and investee companies there is greater scope for investors to be denied the very relief that attracted them in the first place.
To qualify for EIS investment, investee companies must be operating in higher-risk sectors, and the government has regularly taken steps to move lower-risk investments outside the parameters of EIS. For example, property investment is not a qualifying trade for the purposes of EIS, and renewable energy companies attracting government subsidies were excluded from EIS eligibility back in 2012-2013. Another risk factor for investors is that their shares cannot carry any preferential rights or other class protections that would serve to de-risk the investment.
There are also wider factors which contribute to the risks associated with EIS investment. Crowdfunding has widened the potential pool of EIS investors who may be less experienced than the average high net worth investor – and there is a perception that crowdfunding may involve lower levels of due diligence than traditional private equity investment.
One of the most fundamental principles of an EIS investment, however – and one that many investors are unaware of – is that the investee company must continue to qualify. In other words, it's not just at the point of investment that the company (and the investor) must satisfy the relevant EIS criteria; this is an ongoing obligation.
How can EIS relief be lost?
There are various circumstances in which EIS relief can be lost within a window of at least 3 years after the relevant investment is made, which currently include:
- annual (currently £5m) or lifetime (currently £12m) investment limits being exceeded
- the company being sold
- the company ceasing to be a qualifying company
- inappropriate use of funds raised under EIS, such as repaying loans to a director or acquiring another business.
In the event that a company ceases to qualify for EIS relief, this will effectively reverse all of the tax benefits received by the EIS investors. Whilst there are some circumstances in which loss of EIS relief might not adversely prejudice EIS shareholders – for example where an exit generates such a significant return on investment that this outweighs the disadvantages of losing EIS relief – a more likely outcome is that the loss of EIS relief is a disastrous outcome that investors will want to avoid at all costs.
In the subscription documentation we therefore look to provide various safeguards for investors against the possibility of the investee company deliberately or inadvertently ceasing to qualify for EIS relief. This also benefits both the company and the founders/directors because it provides certainty over who is responsible for maintaining the company's EIS status.
Practical steps: how to protect investors from losing EIS relief
Many companies will apply to HMRC for advance assurance prior to raising funds under EIS. Whilst this does not guarantee that EIS relief will be available at the point of investment (or indeed thereafter) advance assurance can give a measure of comfort to all parties that, on the basis of the information supplied to HMRC, the proposed investment is likely to qualify for EIS relief.
Recently we have started to see investors look for a greater level of assurance from one or more of the company's founders, management team and the company itself. One of the ways in which we have sought to do this is by including some of the following contractual protections in the investment agreement entered into between the shareholders and the company (sometimes also known as a "subscription agreement" or "subscription and shareholders' agreement"):
This involves the company/founders/management team giving undertakings to take various steps, including submitting an application for advance assurance (if not already received), sending all necessary paperwork to HMRC in a timely manner following the investment and ensuring that monies raised under an EIS round are applied to EIS-qualifying activities.
There can also be negative obligations on the company/founders/management team not to knowingly do anything that would compromise the eligibility of EIS investment.
These are effectively promises by the company/founders/management team that as at the date of the investment the company satisfies the various EIS criteria, and/or that nothing has been done which would prejudice the availability of EIS relief to the investors.
3. Restricted Acts
The investors may wish to insist that certain steps cannot be taken without the agreement of a certain percentage of the company's shareholders or an investor-appointed director. From the investors' perspective, this will help to ensure that EIS relief is not lost without their consent – which the investors may well be happy to give if there is a clear reason why an EIS-disqualifying act would benefit the shareholders (such as an attractive offer to purchase shares which have not yet been held for 3 years).
4. Board Responsibility for EIS Relief
The board may be required to take various steps relating to the continued availability of EIS relief to investors. This might involve the requirement to seek expert advice, perhaps prior to a proposed sale or restructuring which could jeopardise the availability of EIS relief, or to ensure that compliance with EIS legislation is an agenda item at board meetings.
It is worth underlining that these protections are limited in their scope – even if contractually they provide investors with robust protection. This is because in reality very few investors will want to bring a claim against a company that they have invested in, because any award they receive will directly reduce the value of their investment in the company. Similarly, suing the founders or management team will often be an unattractive option because they are the very people that the investors are relying upon to deliver a return on their investment.
What these protections can achieve, however, is ensuring that full disclosure is made to the investors of any possible issues relating to EIS compatibility so that the investors can make an informed decision about whether they wish to invest. They also encourage the company's founders and management team to remain focused on ensuring that the company continues to qualify for EIS relief.
Whilst experienced EIS investors appreciate the inherent risks associated with EIS investment, adopting some of these principles will help to ensure that if the investee company ceases to qualify for EIS relief, it is for a good commercial reason – and one that the EIS investors have consented to.
For more information on this topic, please contact Dan Partridge.