Investing in businesses just starting out is always high risk, that’s why it’s important to understand the risk associated with investing in small private companies. When it comes to start-up and smaller companies, statistically speaking, they are significantly more likely to fail when compared to larger, more established firms. Below are some of the associated risks involved with investing in small companies and their associated EIS considerations.For context, the Risk to Capital condition requires EIS qualifying companies meet two criteria:
- Have the objective to grow and develop its trade in the long-term; and
- Be able to demonstrate significant risk of a loss of capital.
1. Investment Risk
Investment risk is the probability of losses occurring in relation to an investment.
EIS Effect: The EIS Risk to Capital condition means there must be substantial risk to the investor’s capital, consequently there can be no mechanism in place to protect investors. When investing in a single EIS qualifying company, the company will either prove successful where the investor receives a higher return upon exit or if the investment fails, the investor will walk away with loss relief and the initial income tax relief. Nevertheless, under EIS rules there can be no method by which the downside is protected and there is always the chance the company will be unsuccessful. Even with the generous EIS benefits, investors must always assess this risk when making an investment.
2. Liquidity Risk
Liquidity risk is associated with the ability of an investor to convert the investment into cash.
EIS Effect: With the Risk to Capital condition EIS qualifying companies must have the objective to grow over the long term. Some of the main benefits for investing in EIS qualifying companies is the Income Tax relief and tax-free growth, to qualify for these an investor must hold the shares for at least three years from the date of issue of the shares. Despite this, because the investee company is typically a small private company, investors should be aware that they will likely hold the shares for significantly longer periods of time. Therefore, investors must assess the length of time they are prepared to hold the investment (i.e. assess when they need the capital back) before making the decision to invest.
3. Exit Risks
Exit risk is related to the prospects of a lucrative investment exit.
EIS Effect: EIS qualifying company shareholders only receive ‘attributed gains’ which are only realised upon exit. And since a company cannot qualify under EIS if it is on a recognised stock exchange (except AIM), there are only three ways an exit can occur:
- IPO: If the company becomes listed on a recognised stock exchange the shares can be sold whenever the investor wishes (assuming there is liquidity in the market).
- Trade sale or management buyout: Shareholders sell their shares to other private investors, another company or the management team.
- Voluntary liquidation: Shareholders vote to wind up the company and distribute the proceeds to shareholders.
It is important for investors to be aware that none of the above may occur, there is the risk for the investment to continue indefinitely. All investments into private company shares carry significant exit risk as there is no guarantee that any of the three exits available will come into fruition. Similar to point 3 above, EIS investors must therefore assess this risk and their time scale for needing the capital invested back.
4. Tax Risks
Tax risk is the likelihood an investment will no longer qualify for the anticipated tax reliefs.
EIS Effect: There is a several conditions EIS qualifying shares must adhere too, some which apply at the point of subscription and others that apply throughout the minimum three-year holding period. If at any point during the three-year period the firm stopped meeting these qualifying conditions, the firm would lose their status as an EIS qualifying company. And therefore, investors would lose their tax reliefs and HMRC would clawback any relief already received. The likelihood of tax risk occurring is very much dependent on the management of the company. Of the risks previously mentioned tax risk is the least passive, this is because prior to investing investors should conduct research and due diligence on both the company and management. Careful investment selection by an investor will facilitate investors lessening the risk slightly.
All investments carry their own unique risk and should be evaluated on an individual basis to determine their own distinctive risks. Prior to investing into EIS qualifying companies, an investor should determine whether this kind of investment is suitable before they even take the investment reliefs available into consideration. Investors should ensure they have the capacity to handle the risks mention above prior to investing in an EIS qualifying company.