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HMRC internal manual

Venture Capital Schemes Manual

Venture Capital Schemes: risk-to-capital condition: risk-to-capital examples

Example 1

A company is set up by postgraduate students to exploit their research, which they expect will eventually have wide commercial value. They have been using the university facilities but they now need their own laboratory. The directors prepare a business plan but, as their plans are high risk and long term and the company has no track record, the company is unable to attract investment from the market. The company secures initial investment under the EIS from members of an angel syndicate, and a fund manager acting as nominee for a number of individual investors. A schedule of follow-up funding is agreed for the next five years. The directors retain a majority interest in the company. The company uses the money to set up and equip a small laboratory on the university grounds, and employ a technician. It expects to expand the laboratory, and employ more technical and administrative staff, over the next five years.(Please note that expenditure funded by investment through a tax-advantaged venture capital scheme is not eligible for Research and Development tax relief.)

How the risk-to-capital condition might apply

Taking all the information above into account, the company can meet the risk-to-capital condition.

  • The directors of the company are entrepreneurs who have set up their own company to carry on their own business. The angel syndicate, fund managers and other promoters have not been involved in setting up the company; they have been approached by the entrepreneurs to consider investing as independent minority investors.
  • The company intends to increase its employee numbers and eventually launch a product on the market, which will be the company’s main trade. This suggests long-term plans to grow and develop its business.
  • There is significant risk for the EIS investors in the company as there is no certainty at the time of their investment that a commercial product can be developed or will be successful.
  • When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the relevant facts of the individual case will be taken into account.

Example 2

A company is set up to undertake a trade which relies on the use of property. It receives investment to construct this building. Once construction is complete, the company will engage subcontractors to carry out the trading activities for which the building will be used. As soon as the qualifying holding period ends, the company will sell on the building and trade to a previously identified buyer. The proceeds of this sale will not be used to help the company grow and develop, but will be distributed to the investors and promoters. The company is advertised as a low-risk investment opportunity. It is being advertised by a fund manager who is connected to the company.

How the risk-to-capital condition might apply

Taking all the information above into account, it is unlikely that the company can meet the risk-to-capital condition.

  • The construction and subsequent sale of an asset is the sole focus of the investment. The investors are not investing in a business idea or trade concept but providing funding for the creation of an asset that has intrinsic value. The asset is not intended to be used as a substantial part of the company’s continuing trade and was always intended for sale. If the company intended to carry out its trade from the building, and was not using it as an asset against which to secure investors’ incomes, it would be more likely to qualify.
  • The trade for which the asset is intended to be used is subcontracted. If the company intended to carry out the trade itself (and selling the asset was not part of this trade), it would be more likely to qualify.
  • The company is being marketed as a low-risk investment opportunity. The fund manager who is marketing it as such is also connected to the company. This is indicative of a capital preservation arrangement.
  • When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the facts of the individual case will be taken into account.

Example 3

A film production company is seeking investment for a new film it has developed. It sets up a wholly-owned subsidiary company, a special purpose vehicle (SPV) through which to produce the film, in line with usual industry practice. The company has agreed some pre-sales for the film and has also applied, or intends to apply for Film Tax Relief in respect of the planned investment. The pre-sales and tax relief provide security for a small proportion of the overall investment; the remainder of the investment is not secured. The film production company subcontracts elements of the film for which it does not have the expertise in-house, such as set design and visual effects, to different freelancers and companies. The production company however retains overall control of the project and of the decision-making in relation to production activities. The company intends to carry on developing content, such as screenplays, and making films in the future, and intends to reinvest most of the profits from making this film to help it grow and develop this activity, taking on more employees, and building its reputation within the wider industry and establishing a ‘brand’.

How the risk-to-capital condition might apply

Taking all the information above into account, an investment in the parent production company can meet the condition, although a direct investment in the SPV could not.

  • The SPV is a subsidiary of the film production company; investment is only permitted in companies that are not controlled by another company. If the SPV were set up as an independent company, outside a group structure headed by the film production company, investment in the SPV would not qualify for relief as the SPV will not grow and develop.
  • The film production company as the parent company of the SPV would be likely to qualify, as it has developed the project itself and intends to grow and develop as a company. It intends to retain the capital and reinvest the profits from making the film in future projects.
  • It is normal commercial practice in the film industry to secure pre-agreed income (for example pre-sales or eligibility for other support, such as Film Tax Relief). To meet the risk-to-capital condition, the investment must be genuinely at risk. If the investment sought covers pre-agreed income or support the company will be unlikely to qualify for tax relief, unless the amount of protected investment is insignificant and the overall risk of loss of capital remains significant.
  • Though the film production company contracts out many elements of the film production, this is standard industry practice and the company maintains control over end-to-end production of the film. As such, subcontracting in this situation does not necessarily indicate a capital preservation investment.
  • However if the company contracts out all or most of the activities it may not be eligible; the company must retain control and be active in the carrying out substantive and genuine film production activities. If the film production company acts mainly to deliver one or more projects developed by others, in other words acting as a shell, it will not be eligible for investment. The growth and development provided by such arrangements is of these sub-contracted companies, not the company raising the money.
  • When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the facts of the individual case will be taken into account.

Example 4

An investment manager sets up a number of companies. They all receive investment from individual investors through a fund that the investment manager runs, and are 100% owned by these investors. A director is appointed to each company, and each company will undertake a contract to install and operate infrastructure for a local authority, which the investment manager has negotiated. The amount of money invested in each company is close to the maximum permitted under the venture capital schemes, and is used to pay for the substantial costs of installing the infrastructure. Once this is completed, each company will receive a secure stream of income through long-term service contracts. The predicted income covers a considerable proportion of the investment amount. Each company has subcontracted the installation, operation and maintenance of the infrastructure to industry experts and has no intention to expand once the infrastructure is in place. Though the income each company receives may increase over time, for example due to inflation, the companies themselves will not actually grow, for example in terms of customer base, number of employees or industry reputation. The individual investors expect that the investment manager will aim to sell their shares to a strategic buyer as soon as the minimum holding period expires.

How the risk-to-capital condition might apply

Taking all the information above into account, it is unlikely that the investments will meet the condition.

  • That a company has a contract to supply something, and gets a reliable stream of income from this, is not in itself indicative of capital preservation. However, in this scenario there is little risk that the companies will not deliver the infrastructure asset or meet their contractual obligations so there is little chance that the income stream will fail. As a large part of the investment is therefore covered by a near-guaranteed, long-term income stream, this is likely to be a lower risk investment.
  • The company is marketed by the investment manager as one of many low-risk investment opportunities and the ownership structure is designed to enable an early exit for investors.
  • The investors have effectively invested in the underlying assets, there is no growth of the company’s trade.
  • The company’s trade is entirely subcontracted, and the company only holds the assets.
  • The company director has been appointed by the investment manager. The decisions about the company’s business activity are made by people connected with the fund making the investment, not by entrepreneurial company directors.
  • The company has no intention to reinvest its income for future operations to grow and develop in the long term.
  • When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the relevant facts of the individual case will be taken into account.