Tax benefits on investing in startups

Although startups are known for their potential for rapid growth, just like any other traditional firm, they need initial finance to get off the ground. Accounting for startups isn’t always as easy as taking on an existing enterprise with many setups and structural aspects to consider. However, financial incentives are available in the UK to support the expansion of these new businesses.

The risk involved with startup investments is higher than other asset classes, despite the potential for returns being significant. However, in the UK, part of this risk can be reduced by the government’s provision of tax reliefs and incentives. In this article, we shall see the tax benefits of investing in startups.

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What is a startup, and who invests in UK startups?

Startups refer to concepts in the early stages of development or ones that have only recently been created. They are appropriate for the market but still undergoing marketing and product research. These businesses may be generating revenue and have a designed business plan but might not be profitable yet.

Private investors frequently finance startups and early-stage companies. They are commonly known as angel investors.

Why does the UK government provide tax relief to startups?

The government recognises the long-term benefits that successful startups have for the economy. But funding startups are notoriously risky. Since so many startups fail in their first year, investors have little confidence that their money is secure.

As a result, the government is ready to provide incentives in the form of tax relief to make it easier for investors and entrepreneurs to launch successful startups.

Which tax benefits are offered to investors in UK startups?

Tax relief schemes for startups include:

1.  Enterprise Management Incentives (EMIs)

Startups with limited resources can use EMIs to recruit the talent they require. A qualifying company (with assets under £30 million) may provide fixed-price share options to retain workers. If the staff purchase the shares, they won’t be subject to Income Tax or National Insurance.

EMIs don’t apply to certain industries, including property development and banking, but the tech-heavy startup and catering sectors are covered.

2.   Enterprise Investment Scheme (EIS)

The scheme provides investors several perks and incentives for investing in small, high-risk businesses.

For instance, investors who buy shares through the scheme are eligible for income tax reduction up to 30% of the cost of the investment. They can apply for loss relief if they lose money selling their EIS shares, which will lower their tax liability.

An investment made through EIS is intended for businesses at the early stages of development, with reasonably low levels of assets and staff. This indicates that the scheme is crucial to assisting British startups.

The scheme regulations state that the investors can claim and keep EIS tax reliefs relating to their shares. The government can withhold or withdraw tax relief from your investors if you break the guidelines for at least three years after investing.

What amount of finance can EIS raise?

According to the scheme’s rules, you can only raise a maximum of £12 million from individual investors throughout your company. This involves any amount received from other venture capital schemes.

It’s significant to note that the amount contributed through EIS varies greatly by industry.

What kind of companies qualify for the EIS?

EIS-qualifying businesses differ significantly across a broad range of industries and sectors.

The regulations are relatively specific, but essentially to qualify, a business requires to carry on a trade to create a profit. Some companies and sectors are excluded, for instance, those that deal in commodities, land or shares. Firms with substantial asset backing or contractual revenue streams are recently excluded.

Additionally, there are limitations on the size and age of a firm (knowledge-intensive companies enjoy preferential treatment). Although there is a lengthy list of exclusions, investors still have many options.

What returns could EIS investments offer?

Any returns from EIS, in contrast to VCTs, will mostly come from capital growth instead of dividends.

Each offer will typically imply a target return, which is only a target and not guaranteed. These differ from around 1.3x to over 10x capital invested. Higher target returns frequently indicate more significant risks.

Seed Enterprise Investment Scheme (SEIS)

Similar to the EIS, the SEIS is intended for younger firms. Like EIS, the SEIS helps raise funding for startups by providing tax benefits to investors who purchase shares during the initial stages of trading, up to a maximum value of £150,000. This amount counts towards the £12 million total permitted under EIS.

Startups must be under two years old, with assets under £200,000, and have less than 25 FTE employees eligible for SEIS. A startup cannot issue shares under SEIS if it obtains EIS funding.

Investors in SEIS are eligible for up to a 50% income tax relief on their initial investment, capital gains tax reductions on share sales profits, and even loss relief if the business fails. As with EIS, some businesses and sectors are excluded, including those dealing in commodities, land, or shares.

Although the list of exclusions is rather long, it does leave you massive scope for investment. Over recent years, music, app development, and film production businesses have been popular investment sectors.

Like EIS, any SEIS returns will mostly come from capital growth rather than dividends, and projected returns range widely from about 1.3x to over 10x the amount of money invested.

What are the charges of  SEIS?

SEIS fees differ widely, and it is essential to study each document section thoroughly. Individual SEIS businesses may not impose any explicit charge.

However, expenses for running the business, such as administrative and other fees, may be deducted.

Managed SEIS investment portfolios typically charge an initial fee of 5–6% and a 2% yearly fee. There will usually be a performance charge as well.

What are the main differences between EIS, SEIS, and VCTs?

Despite investing in broadly similar types of businesses, these investments differ significantly.

Firstly, there are differences in the types of tax relief available, the amount you can invest, and the minimum holding time.

In contrast to EIS and SEIS, VCTs do not provide a carryback option; the tax relief can only be offset against the income of the same year in which you receive shares allotment. Also, there is no inheritance tax benefit with VCTs; you cannot offset losses against capital gains made anywhere else.

Secondly, you receive shares in the trust rather than the underlying firms when you invest in a VCT. Therefore, although there might be restrictions, theoretically, you could sell your shares at any time and profit from your investment.

Instead, you purchase shares in the underlying companies when investing in an EIS or SEIS fund. You cannot often sell your shares on the stock market because those are not typically listed. Only when there is an exit, such as when the business is sold, listed on a stock exchange, or refinanced, can you profit from your investment.

Thirdly, a large portion of any return to investors from VCTs—unlike EIS investments—comes from tax-free dividends.

SEIS prioritises younger and smaller businesses in comparison to EIS. To account for the increased risks, SEIS tax reliefs are greater.

Social Investment Tax Relief (SITR)

The UK government will let investors offset the risk if your startup is a charity or “community interest company” by providing up to a 30% tax refund on shares purchases or new debt investment loans under SITR.

The company must not be a profit-making enterprise, have assets under £15 million, and employ fewer than 250 FTEs to be eligible. The maximum amount you may fund through SITR is £1.5 million.

Why is investing in UK startups profitable?

Angel investors typically have experience in business or are themselves, entrepreneurs. They put their own money into companies in exchange for small ownership, typically between 10% and 20%, and frequently concentrate on the mentoring and assistance of the company.

These investors adopt a hands-on strategy, spending a lot of time with the entrepreneur and assisting in the development and expansion of the company. It is critical to have a strong working relationship because the angel and the entrepreneur will often collaborate closely for at least five years.

Although an investor may not be entirely focused on their financial objectives due to the educational and supportive aspects of startup investment, the return target can be high but involves higher risk.

Although some believe there are differences between the two based on the investor’s relationship with the startup, these investments are also sometimes referred to as “seed investments.”. They suggest that an angel investor take on a more central role as a mentor in startup investing, drawing on their expertise to assist entrepreneurs.

Seed investors, on the other hand, are more likely to concentrate entirely on helping the entrepreneur, perhaps as a friend or family member. However, people frequently use the two names interchangeably.

Final thoughts

The UK now has a fantastic selection of tax breaks and incentives accessible to startup investors. Startup investments, which are among the most generous of any investment asset class, undoubtedly have a higher risk profile than other assets. Still, tax reliefs are offered to help individuals to invest in startups.

And given the wide range of startups available for investment and how easy it is to invest in such startups today, it is possible to build out your portfolio with excellent diversity while taking advantage of several tax breaks and benefits.

Experlu Editorial Team
The editorial team at Experlu is comprised of seasoned financial professionals dedicated to providing high-quality content on accounting and finance. With a wealth of experience and diverse expertise, the team produces insightful articles that have established the Experlu blog as the UK's leading financial and accounting resource. The team includes accountants, auditors, and business advisors who stay updated with the latest industry developments. Their commitment to excellence ensures that Experlu remains a trusted source of information, helping readers stay informed about audit, business, finance, and tax matters.