Where seed investing fits in a portfolio

Investor blog by Matthew Cushen: where seed investments fit into your portfolio - shoes

Where seed investing fits in a portfolio

In his Autumn budget last year, Philip Hammond announced the results of the Government’s ‘Patient Capital Review‘. It slightly broadened the conditions for individuals and companies benefiting from real – high growth – Enterprise Investment Scheme (EIS) investing. And apart from some admin changes left the Seed Enterprise Investment Scheme (SEIS) the same. The big impact was to remove the possibility for ‘asset backed’ investments to benefit from EIS. Quite rightly as these were products engineered to deliver tax reliefs but against the spirit of why the EIS/SEIS reliefs are so generous – to mitigate some of the risks of investing in high growth businesses. So it was good news for investors and entrepreneurs.

However, unfortunately, both schemes are still woefully under-utilised in most investors’ portfolios.  In 2016/17, HMRCs figures show less than 30,000 investors benefited from the EIS tax reliefs (on investment of £1,797 million). And only 2,260 investors in SEIS qualifying investments (through £175 million of investment).

Why are these numbers so small when the tax reliefs are so generous and potential returns so attractive? We think the answer is straightforward – a lack of understanding and an inertia within financial services that benefits the most ‘traditional’ products.

Having a well-diversified portfolio has typically included the likes of bonds, equity, property, pension funds and some cash. The equity portion has usually been stocks in established mature businesses – either held directly or through funds. Of course, a mature business is considered lower risk than a start-up. However, that risk profile is changing rapidly. In the last 12 months we have seen multiple companies fail – from multi-billion turnover Carillion and House of Fraser through to Conviviality and Henri Lloyd. Businesses that fail to innovate quickly don’t now just wither slowly on the vine, they face an accelerated demise. Their place taken by nimble young companies with their ear to the ground for what customers really want.

Pensions have been the most tax-efficient way to reduce tax liabilities. But with a £40k cap on annual contributions and the lifetime allowance just over £1 million many people (that would not consider themselves ‘rich’) are having to reconsider their portfolios. ISAs are useful – no immediate tax breaks but at least tax-free gains. However, a £20k annual allowances may not ‘touch the sides’ for many moderately wealthy individuals.

So, against this context, seed investing through EIS & SEIS should be popular. I have been investing in start-ups for around 12 years – because:

  1. the generous EIS & SEIS tax reliefs go a long way to mitigate investment risk. When I started there was only the EIS where 20% of invested cash could be reclaimed from your income tax bill. Now EIS investments are 30% and SEIS was introduced in 2012 with 50% of the investment being able to be reclaimed from your income tax paid. Then there are multiple other tax reliefs. A higher rate tax payer can find that 78% of their investment risk is covered by tax reliefs. So only 1 in 4 investments has to pay back at par to make a positive return.
  2. the returns can be significant. Investing at the early stage of a business is the only way to make a multiple return on investment. My first start-up investment delivered an 8x return in 4 years. However, 4 years was quick, I wouldn’t expect returns before 5 or 6 years from most seed investments. And, of course, many start-ups fail. It is essential to build a diverse portfolio. Diverse in sectors, stage of business growth and risk profile. Some investors may wish to do this themselves, and can do now courtesy of crowdfunding platforms. But many investors will prefer professional investors to pick the best opportunities, negotiate fair valuations and provide oversight and help to the growing businesses – all of which reduce risk and increase returns. In these cases an EIS/SEIS fund are helpful.
  3. investing in start-up, high growth businesses is both fun and important for the strength of our economy. Have you ever seen someone sit their grandchild on their knee and talk about their pension? Or chat about their ISA at a dinner party? But seeing a product you back come to market is exciting and story-worthy. And in our uncertain political and economic context, only one thing is guaranteed, the innovation and energy of our start-up sector will drive the success of UK Plc over the years to come.

Even with the reasons above, I don’t believe that seed investing should make up more than 10% of any investor’s portfolio. There are risks and very limited liquidity, with returns unlikely for 5 years or more. But I do believe it is a travesty that too many investors – despite the means and the risk appetite – are missing out on the tax reliefs, potential returns and opportunity to support and enjoy supporting new innovative, high-growth business that will be the lifeblood of our economy.

 

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