By Matthew Cushen
Article originally published in The Great British Investment Yearbook
In 2012 the Government introduced the Seed Enterprise Investment Scheme (SEIS) to work alongside the Enterprise Investment Scheme (EIS). I’d already had around 8 successful years of investing and enjoying 30% income tax relief. So, I was dancing a jig at receiving 50% tax relief – and hugely reducing the risk of this earliest stage investing. Since then I’ve found it curious how many investors fall into a trap of automatically perceiving that EIS investing is lower risk than SEIS investing.
To start, it’s unhelpful that the tax wrappers have created two discrete classes of investment. In reality there is a spectrum of early stage investing, from just-formed businesses that are little more than an idea through to well established revenue & profit generating companies.
SEIS & EIS are categories that are based on arbitrary HMRC criteria – such as length of trading history and amount previously raised in investment. Although it is fair to generalise SEIS as being the earliest stage businesses, there is much overlap and two different businesses with similar financial performance and in the same market could fall into either scheme.
EIS covers a huge range of circumstances. There will be pre-revenue businesses that are raising their first investment – possibly even, say, a £250,000 investment where some investors are getting SEIS and other investors EIS reliefs. But another EIS business might be 7 years old and reaching maturity. Not so risky based on them having successfully made it that far, but still with significant market, executional or strategic risks.
Then these later stage businesses are unlikely to have the explosive growth and highest potential multiple of returns – particularly if they are already commanding a heady valuation. Too many investors focus on the attractive tax reliefs associated with SEIS/EIS investing and forget the fundamentals of investment. It is about returns. And returns are a factor of how much you pay going in and how much you get coming out.
We have stumbled into an era of frothy valuations. Crowdfunding has played a part here. For both entrepreneurs and investors, crowdfunding provides the most visible valuations. It also throws up two parties – the entrepreneurs and the crowdfunding platforms – that are incentivised to drive valuations up. But crowdfunding lacks professional investors providing seasoned objectivity and desire to temper valuations.
Even in the professional space we often see fund managers fishing in the same pool of deal flow, they end up fighting over the same deals and so inflating valuations. It is always useful to ask a fund manager how unique their deal flow is, how wide they cast their net and the advice, guidance and credibility they are offering entrepreneurs that lubricates the valuation discussion.
By looking at relative risk, ingoing valuation, exit returns and tax reliefs together it’s possible to be objective about the most suitable asset class. Consider the following two SEIS and EIS portfolios. Each have a dozen investments, and for simplicity just two different pre-money valuations and equity raise amounts.
Each portfolio has a number of successes, failures and the most frustrating of all – those that just bumble along. There are few studies into UK seed investment returns. The two most credible are ‘A Nation of Angels’ (published January 2015 by The Enterprise Research Centre (ERC), in conjunction with the UK Business Angels Association) and Siding with the Angels (published September 2009 by Nesta). The portfolios illustrated have 4 SEIS and 3 EIS failures from 12 businesses. From both market studies and our experience, this feels bearish. The SEIS portfolio predicts some higher multiples if the businesses are successful. Again, reasonably conservative.
Critically there is provision in this model for further dilution. Too many investors forget that either they need to have the cash to take up follow-on investment or their equity is going to be diluted by further funding. The dilutionary impact is likely to be higher for earlier stage, lower priced SEIS investments.
Before we even begin to consider the generous tax reliefs, we end up with a comparison of 44% SEIS returns vs. 23% for EIS.
Then there is the difference in returns when netting off tax reliefs. These tables only consider income tax reliefs, the picture gets a little complicated to illustrate when thinking about capital gains reinvestment relief (at 50%) for SEIS versus capital gains deferral relief (at 100%) for EIS. But when considering the 50% income tax relief for SEIS and 30% income tax relief for EIS, plus the impact of loss relief, the post-tax returns number are more pronounced at 203% for SEIS and 86% for EIS.
Clearly these are made up numbers to simplify the argument. We could have had the same structures, different numbers and a different conclusion. So please don’t take our word for it. We encourage you to try yourself and with your clients. These two tables are pre-populated at here. Just download the spreadsheet and you can play with all the numbers and see the impact calculate through. By the way, in the same location there is a simple one-page summary about SEIS & EIS reliefs and criteria as well as a link to an online tool we have built to allow you to calculate the detailed SEIS & EIS reliefs for a specific investment.
One watch-out, these tables conclude with a simple return multiple, they are not giving a time-based IRR. Generally (there we go again) SEIS investments will have a longer gestation period than EIS. And for some investors the lack of liquidity might be an overriding reason to favour EIS. If this is the case, then good to consider the breadth of maturity of EIS businesses as described above.
We know that there’s research and compliance effort when advising clients on either EIS or SEIS. And we are sympathetic that PI insurance is sometimes impacted by advising for this asset class. But they are remarkable schemes, generous to investors and structured to support UK innovation. They are an important part of wealth planning for any investor at the limits of their pension and ISA allowances. We hope that SEIS gets a fair hearing. The tax reliefs go a long way to mitigate the generally higher risk. But the true picture only emerges when thinking through the reliefs alongside potential valuations, potential returns and relative failure rates.