Venture capital trusts have only been in existence since 1995 and many people still don’t understand them. A VCT or venture capital trust is a closed-end collective investment scheme which was introduced by the UK government to encourage investments in new businesses. In return for backing small companies, investors get highly efficient VCT tax benefits.
Typically, venture capital trusts are publicly traded companies, listed on the London Stock Exchange, that invest in unlisted companies. There are three main types of VCTs:
- Generalists: Invest in unlisted small companies from a wide range of industries.
- AIM: Like a generalist, AIM (Alternative Investment Market) VCTs invest in a diverse array of companies but have a stronger preference for AIM-listed companies. The Alternative Investment Market is a sub-market of the London Stock Exchange.
- Specialists: Invest in unlisted small companies within a specific industry like healthcare or tech.
VCT investments can either be evergreen or limited-life. Evergreen VCTs are set up to invest indefinitely, while limited-life VCTs are normally wound up after the minimum five-year holding period so assets can be distributed to shareholders.
While the venture capital trust scheme was originally considered high-risk, it has proven to be far less risky than initially expected and has recently seen significant growth. Recent reports from the Wealth Club reveal VCT investment demands have reached a twelfth-year record with £728m being raised during the 2017/18 tax year. A 34% increase on the previous tax year.
How do venture capital trusts work?
Venture capital trusts are already established companies, listed on the London Stock Exchange, that collect money from investors to provide capital for VCT-qualifying companies. VCTs must comply with VCT rules established by HMRC:
- VCTs must publicly release their annual records and accounts
- An independent Board of Directors must be in place to protect shareholders
- Meetings must be held for shareholders such as an AGM (Annual General Meeting)
- Like any public company, VCTs must also comply with standard corporate governance standards.
How do businesses qualify for a VCT investment? HMRC VCT rules
HMRC has strict rules to screen potential companies for VCT investments. The government created these rules to ensure that a) venture capital trusts continue to meet the scheme’s initial objectives and b) funding is provided to companies that need it for growth.
To qualify for VCT investment, companies must be located in the UK and undertake “qualifying trades”. Only a few trades, like land development, finance, and farming, don’t qualify so this isn’t typically a problem for most businesses.
Businesses must have less than £15m in gross assets when they receive the investment or £16m shortly after. They must employ less than 250 full-time members of staff. In addition, companies need to be in the early stages of development.
Unless a business works within a knowledge-intensive sector, businesses that have been commercially viable for more than seven years don’t qualify for a VCT investment. In some cases, such as when an established company wants to move into a new market or create a new product, follow-on investments are permitted.
The rules for businesses employing highly skilled individuals or that meet specific innovative criteria are different. Knowledge-intensive companies are allowed to employ up to 500 full-time members of staff and have been operating for 12 (instead of seven) years. To fall into this category, businesses must spend at least 15% of its annual budget for the last three years on innovation and R&D.
Once a company qualifies, businesses are eligible for up to 15% of a VCT fund. Each business can accept up to £5m in VCT investments per annum or £12m in total VCT investments. Knowledge-intensive companies can accept a total of £20m.
What are the benefits of VCTs?
As Paul Latham, managing director of Octopus Investments, stated: “VCTs play an active role in supporting the next generation of UK businesses, as well as giving investors the opportunity to access some of the UK’s most exciting growth companies.”
For businesses, VCT investments can significantly accelerate a company’s growth. In fact, most companies that received a VCT investment experienced an average revenue increase of £12.7m, achieved an average turnover growth of 183%, and on average hired 51 new staff members.
Clearly, investing in VCTs is a fantastic way to support British small and medium-sized enterprises (SMEs).
Supporting unlisted SMEs has a number of benefits. For example, as VCT-qualifying SMEs aren’t listed on the London Stock Exchange, they have a greater potential for quicker growth than already established companies. However, this also means, on the other hand, VCT investments are also extremely risky.
To further encourage investors’ appetite, the UK government provides VCT investors with venture capital tax relief. Investments under £200,000 provide VCT tax benefits such as income tax relief, tax-free dividends and tax-free capital gains.
As long as you keep your VCT investments for five years, you can claim 30% upfront income tax relief although the amount detracted from your taxes can’t exceed the amount due. In addition, if you receive dividends from your VCT, you don’t need to pay taxes or claim them. Plus, when you’re ready to move on, any profit you make from selling your venture capital trust won’t be taxed.
What are the disadvantages of venture capital trusts?
While VCTs hold a number of benefits for unlisted SMEs and investors, there are also some disadvantages. Businesses must be prepared to lose some control over their company, as the investing VCT will want results.
To achieve these results, they will want some say over the direction of the company. To continue receiving VCT investments, businesses must also maintain their qualifying status which can prove challenging.
For investors, the biggest disadvantage of VCTs is the fact that they are inherently high risk. While you could financially benefit if the companies you’ve invested in thrive, the survival rate of new businesses is extremely low. If the company you’ve invested in doesn’t survive, there’s no guarantee you’ll get your money back.
VCTs are also a long-term investment as you can only benefit from Venture Capital Tax Relief if you maintain your investment for five years. If you exit the scheme before this period, you’ll need to repay HMRC any income tax relief previously claimed. It can also be extremely difficult to find a buyer and you may need to accept a lower price than the net asset value.
How to choose the right VCT investment
Both SME owners and potential investors should closely consider if a VCT is the right choice for them. The benefits and disadvantages will vary depending on your specific circumstances.