How taking a punt on start-ups could cut £300,000 from your tax bill

Investing can be hugely rewarding, and not just financially. Backing young start-ups, watching them grow and deliver stellar returns can be an exciting journey for both a business and its shareholders.

You may miss out on this experience if you are only invested in big blue-chip companies that are already well-established. And, while these companies typically make for the most reliable investments, you might miss out on the scale for growth that start-ups can offer.

The enterprise investment scheme (EIS) is a Government-backed venture capital scheme, which offers a way for you to incorporate younger businesses into your portfolio, and the very generous tax reliefs that come with it alone are enough to consider them seriously.

While these should not normally take up a significant portion of your investments, they are a very popular way to diversify – investors poured a record £2.3bn in EIS in the 2021-22 tax year alone.

However, compared with more traditional investments, this is not a very transparent industry, and investing in start-ups involves a lot of risk. You are more likely to lose money in this area compared with investing in big, well-known businesses.

Here, Telegraph Money sets out what you need to know before going ahead with a riskier investment.  

What is the enterprise investment scheme?

The EIS is a Government initiative that encourages savers to invest in young British start-ups. They are usually smaller, higher-risk companies – past success stories include Bloom & Wild, the flower delivery service, and Gousto, the meal subscription box.

The scheme does not work like open-ended funds you might buy through your regular investment broker. Jason Hollands, of the broker Bestinvest, said: “EIS “funds” are not actually “funds” in the true sense – you are effectively giving a manager the discretion to allocate into a number of companies raising capital under EIS, and the returns will ultimately depend on the specific deals you end up participating in and the exit values achieved on these.”

This means that a new investor in an EIS “fund” is unlikely to invest in the same companies as an old one, unless the scheme has announced a fundraise specifically for those shares.

What tax relief can I get?

The tax reliefs alone are enough to attract investors into EIS. You can get 30pc income tax relief on the amount invested upfront, applicable to a maximum of £1m each tax year – so you can potentially cut up to £300,000 off your tax bill.

You also get 100pc capital gains tax relief if your shares grow in value, as well as up to 45pc loss relief if a company fails. In order to qualify for loss relief, the value of the investment when it is sold must have fallen below its effective cost – this is the amount invested minus whatever was claimed in income tax relief.

If you hold the investment for at least two years, they will also come free of inheritance tax.

All these reliefs together mean that your money is well protected against losses. For example, if your initial investment is worth £10,000, its effective cost is £7,000 after income tax relief. In the worst case scenario where the investment falls to zero, you could get loss relief at 45pc and record an effective loss of -39pc, according to calculations from Wealth Club, a broker. 

Alex Davies, of the broker, added: “Investing in start-ups also gives you diversification. The types of companies you can invest in will be very different from those in the bulk of your portfolio.

“It can also be a lot of fun seeing your chosen start ups potentially growing from an acorn to an oak.”

Beware significant risk

Companies in the EIS are typically high risk, and should only make up a small part of your portfolio.

This is not a very transparent industry – it is hard to compare different schemes’ returns, for example. Performance is measured by investors’ subscriptions in a single tax year – this is because, unlike typical funds, there is no net asset value or share price that can be tracked.

Instead we can only compare the best realised returns, which measure the cash returned to an investor after the scheme “exits” (sells) a holding, and unrealised returns, which is the value of the existing portfolio based on the latest valuation of its underlying portfolio.

MMC Ventures has one of the best track records, as well as Fuel Ventures and Parkwalk. The latter is a scheme that focuses on businesses that spin out of universities. 

There are other ways to invest in start-ups, such as venture capital trusts (VCT). These are easier to keep track of as they are listed investment trusts, with a share price that you can follow. 

Mr Hollands added: “A common misconception is that EIS investing has an edge over VCT investment because you only need to hold the investment for three years to keep the 30pc income tax relief, rather than five with a VCT. 

“While that is technically correct, in practice these are unquoted companies. The timing of an exit isn’t in the investor’s hands, and will come down to when the business is acquired or – in rare circumstances – it might be listed on Aim. These are highly illiquid investments and you may be in them for several years. EIS companies don’t pay dividends, and tax-free dividends are the main source of return from VCTs.”