As simple as do re mi, EIS, VCT

Friday, 23rd March 2018 16:45 - by Tom Britton

When it comes to tax-efficient investing, there’s a lot of debate going on between the merits of VCTs (Venture Capital Trusts) and EIS (Enterprise Investment Scheme) funds. For those familiar with neither, I’ve put together a bit of a comparison below before going into the numbers. For those that know which offers what when, feel free to skip the first table.

The low down: VCTs and EIS funds both offer generous tax breaks for those that can afford to tie money up for a few years. While EIS reliefs are slightly more generous, and include downside protections, VCTs are listed vehicles and can be traded on the market.

VCT

Pros: Liquidity, liquidity, liquidity. In theory, VCTs are investing in high-growth companies that just happen to be listed on the stock exchange. Should things start to go wrong with the underlying investments, investors can always sell their shares – though they will not receive any of the tax breaks if the shares are sold within the five-year holding period.

Cons: In reality, VCTs don’t generally invest in the high-growth businesses that the term “Venture Capital Trust” might lead you to believe. They tend to invest in more established businesses, many of which are paying dividends. Given that dividends are paid out tax free, this con is less of a con than you’d think. Top VCTs return over 200% after five years, which is still a good (if not “home-run”) return for investors.

EIS

Pros: Potential for high returns. Given how risky early-stage investments are, the investment would not be worth taking unless there was a potential for high returns. According to NESTA, Business Angels – the term given to those that invest in and mentor early-stage companies – work to achieve an IRR of 22%. While that figure is impressive on it’s own, most Angels look for opportunities that could return 10x their initial investment. Since they know a few of their investments will ultimately be written off, they need one or two to hit that 10x mark to cover their losses and provide a solid return.

Cons: Illiquid, illiquid, illiquid. While the EIS tax-related holding period is three years, there is very little chance that an early-stage investment will end up exiting in less than 5 years; more likely the exit may come in around 10 years, if at all. As there are very few secondary markets for private shares, those who invest in early-stage companies should understand that they may be holding on to their shares for the long term. To read more about the risks involved, download this guide to early-stage investing.

Spreading the risk

Regardless of which route you choose to go down, you should always invest in a portfolio of opportunities. VCTs and EIS funds that don’t adequately spread the risk across a sufficiently diverse portfolio are less likely to achieve the desired returns, and are more susceptible to swings in a specific sector, or the market as a whole. This is particularly true for EIS funds that invest in few opportunities, e.g. between 6 and 10. While 10 may sound like a large enough group to give a good spread, the reality is that with early-stage investments, the target portfolio size should be 28 or more investments – that’s according to NESTA research too. That’s why SyndicateRoom developed Fund Twenty8, which you can read more about here.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.