By Matthew Cushen
A profound shift has happened in our Western, developed, capitalist markets over the last few decades. In the 1970s there was a clear and accepted relationship between size/market share/market power/economies of scale and the ability of a company to enjoy outsized returns. But now business school boffins are showing an inverse relationship between market leadership and scale and the expectation of being the profit leader in a market.
We don’t need to see aggregated numbers to appreciate this. We have seen countless examples across multiple industries – Kodak, Nokia, Toys R’ Us, Thomas Cook, Woolworths, Carillion and many others – where incumbent market leaders have failed to adapt their businesses and have been destroyed. We are going to see many more. We currently have coronavirus top of mind and it is creating short term shocks. But more importantly it is accelerating other fundamental changes, the kind of changes where many established businesses have failed to adapt, and where smaller, nimble, innovative start-ups and scale ups are giving the incumbent corporates more than a bloody nose.
So, whilst the fundamentals, risks and volatility of around ‘mainstream’ investments get less attractive, what about the risks of investing at the other end of the spectrum – in start-ups?
Of course, this is inherently risky. Investing here often means unproven ideas, immature business models and businesses might even be pre-revenue. But these are reasons why they are relatively immune to the kind of economic shocks we are seeing currently. They have little revenue to lose. Cash flow is not driven by revenue, it’s driven by spend and these are the periods in which resources may actually be cheaper. Start-up businesses are well versed in the need and ways to be agile, nimble and able to flex their resourcing and operations.
Recessionary and other short-term shocks hit mature businesses (small, medium and large) harder and often the largest businesses, with complex supply chains and more revenue dependencies were hit the hardest.
So in times like these the relative risk between these two asset classes has narrowed. Therefore I would argue (with a vested interest by the way) that for some investors, it is well worth looking at early stage seed investing for a small portion of their portfolio. Then there are other reasons beyond relative risk.
1. The potential for outsized returns. With great risk can come great returns. The investor needs a broad portfolio, it might be that in a portfolio of 10 start-ups only 3 or 4 make it through a few years, and only 1 creates a significant return. Having a narrow portfolio is going to increase the chances of total failure and limit the chances of participating in the major pay-out. To get quality in their portfolio, the investor also needs to either have the time and expertise in picking their own investments or needs a fund manager that is experienced in this specialist area. The chances of the start-up creating value is then vastly improved when the founding team have access to expert help.
2. Remarkable tax breaks. 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 investors are having to reconsider their portfolios. ISAs are useful – no immediate tax breaks but at least tax-free gains. However, a £20k annual allowance may not ‘touch the sides’ for many moderately wealthy individuals.
Investors in start-ups can take advantage of the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS). These schemes go a long way to mitigate investment risk. When I started investing in 2004 there was only the EIS where 20% of invested cash could be reclaimed from your income tax bill. That was extended to 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 – including fully tax-free gains or loss relief if the investment fails.
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. This online calculator lets you play with the impact of income tax and capital gains tax reliefs.
3. It is investing made real. Has anyone ever sat their grandchild on their knee to talk about their pension, or entertained dinner party guests with tales about their ISA? But kids and dinner party guests love hearing stories about supporting real businesses to grow and nothing beats seeing a product you have helped to fund make it to the supermarket shelves. In our uncertain political and economic context, it is the innovation and energy of our start-up sector that will drive the success of UK Plc over the years to come.
Even with the reasons above, I doubt 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 it is a travesty if any investor with the means and the risk appetite does not consider investing under the SEIS or EIS schemes and miss 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.