Venture Capital Schemes: risk-to-capital condition: introduction to the risk-to-capital condition
The tax-advantaged venture capital schemes
The tax-advantaged venture capital schemes, including the EIS, SEIS and VCTs, are intended to encourage individuals to invest in certain small, higher risk, early-stage trading companies that would otherwise struggle to access the funding needed to enable them to grow and develop, as they have little or no track record.
Tax relief is offered as an incentive to invest directly in these companies, or indirectly through a VCT, because of the higher risk such investments pose to the investors’ capital. The tax-advantaged venture capital schemes are therefore aimed at investors who are prepared to lose some or all of their capital in making a higher risk investment.
Companies the schemes are intended to support
The schemes are intended to support early-stage, higher risk, entrepreneurial companies that have the potential to grow in the long term. Typically, such companies will be set up by one or more entrepreneurs who, as directors, have the intention of expanding it over the longer term but need financial support from a third party to realise this ambition. The company will be set up to carry out a trade on an ongoing basis, not to carry out a single project, or projects developed by other people, before being wound up.
The directors develop a business plan setting out their intentions for the company’s growth, but struggle to access funding because the company has little or no track record. They present their business plan as part of a ‘pitch’ to one or more investors or an investment house.
Once they obtain the funding, the directors work to grow the company over the longer term. The money raised is reinvested to support the company’s growth and development, often helping it to attract future rounds of funding, ultimately from the market.
The investors are broadly independent third parties who are interested in supporting the company and participating in its success. They know their capital is at genuine risk of substantial loss and is not secured. They are minority investors and have no intention of running the company; though they may support the company’s directors to run the company, they are not able to determine the company’s future direction by themselves. They do not expect their capital to be repaid shortly after the end of any scheme holding period; they expect the company to retain the capital and reinvest any profits, to support the company’s growth and so increase the value of their investment.
Activity that the schemes are not intended to support
The generosity of the tax reliefs available through the venture capital schemes has resulted in the creation of tax-motivated, low-risk investment opportunities, where the tax relief provides a considerable proportion of the gain. Such arrangements are often referred to as ‘capital preservation’.
Capital preservation arrangements enable investors to take advantage of the tax reliefs the schemes offer, at minimal risk to their capital. These arrangements may, depending on the facts, comply with the letter of the current law but are contrary to the policy intention of the schemes.
Certain activities are already excluded from the schemes (see VCM3000+) and the risk-to-capital condition does not affect those exclusions. The risk-to-capital condition does not exclude any other industry sectors from the scheme.