This article addresses the subject of “Seed Enterprise Investment Schemes,” a variant of long-standing EIS structures. The SEIS vehicle was introduced by the UK government this year.

Editor’s note: The following article is by Mark Payton, managing director and co-founder of UK-based Mercia Fund Management, about “Seed Enterprise Investment Schemes,” a variant of long-standing EIS structures. The SEIS vehicle was introduced by the UK government this year and is an example of how governments are – or say they are – seeking to boost venture capital and finance for small and growing businesses. (To view more on wealth management and venture capital, click here.) Payton talks about the pros and possible cons of these structures. His views are his own and not necessarily endorsed by this publication.

In July 2012, the government confirmed the introduction of Seed EIS (SEIS) which will remain as a government-approved scheme for a further three years. The new scheme makes investing in early stage businesses highly attractive. Indeed, SEIS is an opportunity to evaluate start-up opportunities for investors who are new to this sector.

But promotion of SEIS by the government has been limited, indeed virtually non-existent. This seems wasteful, especially as in this tax year only (2012/2013), there are extra reliefs available: a high-rate income tax payer with a substantial capital gains tax liability investing in a SEIS and taking the loss reliefs available stands to recover most if not all of their original investment back in tax reliefs in the event that an investment fails.

The features of the SEIS scheme help to reduce the risk of investment. A SEIS is fixed to investment in businesses that have been actively trading for less than two years, have fewer than 25 employees and gross assets below £200,000 ($322,848). For investors, the additional risk of investing in young businesses is balanced by 50 per cent income tax relief, inheritance tax relief, loss relief, capital gains tax (CGT)-free returns. Private investors can invest in a range of start-up businesses with sums of as little as £10 while claiming up to 78 per cent tax relief.

This is hugely generous, but it is currently only for this year; in subsequent years the CGT liability loss will become a deferral – as is the case with EIS (Enterprise Investment Scheme).

A company can only take up to £150,000 of SEIS investment in total, but an investor can invest up to £100,000 per year across multiple companies as long as no more than £150,000 goes into one company.

Another feature of SEIS is that these shares won't have many preferential rights. This simplifies the investment and keeps the founders fully motivated.

The challenge

Although the tax breaks are highly attractive, the challenge for investors is to find investable businesses and ensure that due diligence and transaction costs are worthwhile for the tax reliefs. The detail of the actual SEIS investment can be complex. While an experienced fund manager will build a portfolio of SEIS compliant companies throughout the three-year minimum period, this can be time-consuming and there are traps for unwary groups of investors without an experienced manager.

Furthermore, with an investor only able to invest £100,000 per annum into SEIS, the opportunity for portfolio exposure can be markedly reduced, particularly as any one company can only receive a “maximum” of £150,000 of SEIS investment.

The danger of SEIS is that it could encourage some investors into the market who regard it solely as a tax break and are not prepared to engage with companies in the same way as venture capital funds do.  Through a VC fund, investors have the reassurance that the investee is gaining both capital and assistance via a hands-on approach which helps accelerate growth (and returns for investors).

When originally announced, SEIS opened up funding to "friends and family" of existing entrepreneurs, as wealth managers envisaged that it would not be cost-effective to conduct  research and due diligence for other investors, given the small sums involved.

However, for investors looking for professional help in choosing which start-ups to back, several fund managers offer portfolio services that include companies qualifying for SEIS.

Mercia Fund Management has launched the Mercia Growth Fund, which is a hybrid EIS and SEIS Fund. In the three weeks since its launch, more than 60 per cent of the SEIS portion of the fund has already been allocated to investors.

Fund managers work to identify companies that have the potential to deliver growth, fit the fund’s investment criteria, and fall inside the Seed EIS rules. Interestingly, there has been an increase in hybrid EIS/SEIS funds, especially where funders are able to source deal flow and de-risk a SEIS investment with follow-on investment opportunities. Investors in the SEIS portion of a hybrid fund often invest in the EIS portion which focuses on much later-stage investments, providing a balance both in tax reliefs and risk.

SEIS funding fills a clear gap in finance provision. It is an excellent opportunity for the government to re-direct investment and support to start up and early-stage funding while offering substantial downside protection in the form of tax reliefs to the investor. For investors considering SEIS significant tax breaks are attractive, but if investing through a fund, strong deal flow and a compelling and balanced portfolio can be a major factor in risk mitigation.

Start-up companies are almost always high-risk, so an investor should only part with money, if they are prepared to take that risk - but given these tax advantages, if investors and small businesses follow the rules, any losses will be minimised.