The crucial role of tax incentives in startup investment

EIS startup investment
iStock/RichVintage
Mark Brownridge
Director General
Enterprise Investment Scheme Association
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Getting funding for a new business can be tough. Rejection rates for startups seeking loans exceed 50%, which translates into more than 100,000 businesses a year being turned down for about £4bn of financing according to the British Business Bank.

The reasons for the high numbers of failed applications include that traditional lenders do not always have the resources to assess a new business’ longer-term potential or viability. Startups are also rarely in a financially strong or stable enough position to be able to make regular loan repayments. In these circumstances, perhaps understandably, many lenders simply consider them too risky or unsuitable a proposition.

But debt funding is not the only option available to startups. It is not even the most suitable one. There is also raising finance through issuing equity, which in many cases may be more appropriate for startups and newer businesses, as the British Business Bank notes in its report:

“Equity investors are typically more active than lenders in the day-to-day operations of the business and are prepared to take on higher levels of risk. Increasing equity flows therefore can play a useful role in improving smaller businesses’ ability to scale-up.”

The role of government-based tax incentives

This is certainly true of the investors who back startups and small companies through the equity-based Enterprise Investment Scheme (EIS) and its startup-focused younger sibling, the Seed Enterprise Investment Scheme (SEIS). EIS and SEIS are defined by the government, which established and administers the schemes, as “tax-based Venture Capital Schemes designed to help smaller higher-risk trading companies raise finance”.

And they do a great job. Since EIS was launched in 1993-94, over 26,000 companies have received investment through the scheme and over £15.9bn of funds have been raised. Since SEIS was launched in 2012-13, some 6,515 companies have received investment and £608m has been raised.

Eligible businesses can receive up to £5m a year in EIS funding (or a lifetime total of £150,000 for SEIS) from external private investors, who benefit from a range of tax incentives, including 30% income tax relief (up to 50% for SEIS), which help to offset the risk of investing in startups and smaller businesses.

Debt funding is not the only option available to startups. It is not even the most suitable one.

And often, it is more than just money that EIS and SEIS investee companies receive. A common – and very valuable – benefit comes from the involvement of investors in a business, who can provide guidance and direct, hands-on help to the companies in which they invest. Individual investors, business angels and professional EIS and SEIS investment managers will frequently draw on their own experience, expertise and networks of contacts to assist in growing a business in which they have invested. Many investee companies say this support can be as important in helping them to grow as the funding itself.

Given these benefits, it is no surprise that the amounts raised through EIS and SEIS have been steadily rising year-on-year, along with a broadly rising trend in the number of individual companies receiving funding.

Why has EIS fundraising begun to fall?

Until last year, that is. The most recent figures from HMRC, for the 2015-16 tax year, showed a drop in total EIS fundraising amount and a drop in the number of companies receiving funding.

The declines are not enormous in the context of the overall numbers; around £1.6bn raised through EIS in 2015-16, instead of £1.8bn the previous year (a record high) and a net drop of 45 companies raising money overall - though 3,285 businesses still received EIS investment. But within this latter figure, there was a slightly more worrying fall in the number of companies seeking EIS investment for the first time, from 1,710 in 204-15 to 1,500 in 2015-16.

These may just be blips in an otherwise upward trajectory for EIS and SEIS fundraising – and changes to EIS and SEIS rules introduced over the past few years go at least some way to accounting for the reductions.

Yet, any drop in the numbers should not go unremarked or unconsidered. We should try to look at why it might have happened and see if there’s anything that be done to prevent it becoming a downward trend. This is something we particularly want to avoid as it becomes ever clearer that Brexit is going to have negative economic consequences, at least in the short-to-medium-term.

A healthy and growing startup and scale-up sector is therefore going to be extremely important to our future economic performance – in real terms, giving people jobs and generating taxes to support government spending on vital services such as health and education.

Access to finance is an important element of the startup and small business eco-system and my organisation, the EIS Association (EISA), would like to see the government make changes to EIS and SEIS rules that would mean more small companies are eligible for funding under the schemes.

We also believe that more companies would make use of the schemes if they knew more about them. To this end we have produced a quick-and-easy-to-read guide, Grow your business with the Enterprise Investment Scheme, designed to provide a simple overview of how EIS and SEIS work, their benefits and information about how to get funding.

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