A Venture Capital Trust is a tax-efficient way of investing in small, new-starting businesses. Venture capital investments are as exciting as they are risky. This article will outline the different types of VCTs and how they work, alongside the advantages and disadvantages of investing in Venture Capital Trusts.
VCTs were introduced in 1995 and have grown in popularity since then for their tax relief benefits.
VCTs are a government-backed scheme in which investors can become a shareholder of the trust in order to support young businesses. These schemes offer support for small businesses with closed funds.
Many large, well-known companies started off as VCTs, expanding overtime through this scheme. Some examples of companies that started as VCT investments but are now household names are Zoopla and Graze.
Those who invest often gain generous tax reliefs and tax-free VCT dividends on any profit they make through VCT funds with these investments.
Here is a short video that explains how they work.
Most VCTs are Generalist. Generalist VCTs invest in companies in a variety of sectors, who are at various stages in the development of their business. These are mostly unquoted companies.
These VCTs use a variety of approaches. For example, some investing in start-ups with a lot of potential and others investing in more mature developed companies. They offer more regular returns at a lower risk than Specialist VCTs.
Unquoted companies are valued regularly, but not as often as AIM VCTs.
AIM VCTs focus on companies listed on the Alternative Investment Market – the junior London Stock Exchange – created to provide trading facilities specifically for the shares of these smaller companies. AIM companies are often more established and generally bigger than those invested in by Generalist VCTs.
AIM VCTs can be even riskier to invest in as they are valued more often than Generalist VCTs so will fluctuate more in value.
Despite this, they are more flexible as shares are more easily sold and bought from bigger companies – as opposed to the smaller Generalist VCTs.
Specialist VCTs are investments in companies from specific sectors. For example, from technology or healthcare. They usually offer higher returns but also higher risk (because they are more niche).
These could be either AIM or Generalist companies as well as specialist.
These VCTs are set to invest indefinitely.
A Limited Life VCT is designed to wind up after a set period of time, after the minimum five-year waiting period.
An investor can aim for a specific exit time, although this is not guaranteed, or shares can be divided to each shareholder after the company has wound up.
Companies listed on the London stock market invest in smaller, expanding companies. When you invest in a VCT, you become a stakeholder of the trust not of each individual company.
A VCT fund manager chooses a handful of (normally unquoted) companies in which to invest. The VCT manager will use their expert knowledge to help firms expand and excel whilst also bringing the firms’ investor(s) better returns.
VCT management sometimes places a member on the directing board of unquoted companies in which they invest, in order to monitor their investments. However, when investing in larger companies (such as AIM VCTs) it is less common to have a director on the board.
Investors can invest up to £200,000 cash in a VCT each tax year. Yet this is risky as small, private businesses can often fail a lot quicker than larger established companies. Also, in these early stages, these companies don’t bring in the most profit and are not always consistent in their income.
Often these kinds of investors are wealthier due to this risk factor and have more long-term prospects.
When claiming back VCT tax rebates, the investor’s 30% will be credited either in a lump sum by HM Revenue and Customs, or by a change in an investor’s tax code.
VCT investors will normally sell their shares after 3-7 years of investing in the same company. Often the VCT dividends they pull out of one company can be invested straight into another, and so on.
Despite being able to benefit from VCT tax relief, the maximum amount of tax rebate provided by HMRC is the amount of income tax you pay already.
Mr Brown invests £50,000 in a VCT this year. He earns £80,000 annually before tax, so will pay £19,469 in income tax per tax year.
The maximum tax relief Mr Brown can gain from his VCT investment is 30% of what he has invested, which in this case is £15,000, as 30% of £50,000 is £15,000. Because Mr Brown pays more income tax than the VCT dividend, then he is entitled to the full £15,000 in tax relief.
Miss Li invests £50,000 in a VCT this year. She earns £60,000 annually before tax, so will pay £11,496 in income tax per tax year.
Although 15% of £50,000 is £15,000, because Miss Li only pays £11,496 in income tax per tax year – which is less than £15,000 – so she is entitled only to the £11,496 that she has already paid.
VCTs create jobs and provide economic growth, and thus the government enthusiastically back these schemes.
VCTs allow for small businesses to grow and succeed in a way that they wouldn’t be able to without this funding.
Investing in a VCT can provide generous tax relief of up to 30% to those who invest. This is the government’s way of encouraging VCTs and so providing tax relief as a benefit by HMRC to investors.
Profits are paid to VCT investors as tax-free VCT dividends.
The value of the tax benefits does depend on individual circumstances of both the investor and the company.
In order to make it easier to sell VCTs back after the minimum five year tax period, VCT managers often periodically offer to buy the shares of the company back from the investor at a better price than it was sold to them (although this is not guaranteed).
VCTs are less risky than EIS investments as EISs are less liquid and less diversified as VCT investments (as EIS investments only offer access to 5-10 unquoted companies as opposed to VCTs access to 30-70 companies).
The biggest risk of investing in a VCT is that you could lose all the capital that you invest.
You must remain invested for at least five years in order to gain any tax benefits, thus VCTs are long term investments. This means that venture capital investment should not be an investor’s only financial prospect, as the VCT tax reliefs are not immediate and can be revoked at a later date.
This also means that only the wealthiest investors can take on VCT investments. Those who cannot afford to wait out five years until for VCT funds to be returned to them should not invest in VCTs.
VCTs are illiquid investments. The inability to predict their cash value results in it being hard for investors to sell their VCT shares.
The market value of VCTs may not reflect the value of the underlying investments. For example, because there is not much trading on the junior stock exchange, then VCTs are often traded at a discounted price to their net asset values.
Due to the companies being so young, the value of these schemes is likely to fluctuate, and so investors are less able to predict the exact profit or tax relief that they may gain from these investments.
There are certain VCT rules that investors and companies listed as VCTs have to adhere to.
HMRC’s criteria outlines that to qualify for funding as a VCT, a company must be small – grossing assets of no more than £15 million. Another restriction is that the company can only have 250 full time employees or less.
If HMRC does not consider your company to be in need of VCT funds, then it may not consider it as a ‘qualifying trade’. But most trades are eligible for the extra support that VCT schemes offer.
Rules on VCTs have gotten stricter in the last decade. For example, investing in bigger companies in order to buy out management is no longer permitted due to the above restrictions.
A VCT must invest at least 80% of its money into the qualifying company’s assets. The other 20% can be invested.
You must hold shares in a VCT for a minimum of five years in order to keep the tax rebate.
VCTs bought on the open market do not always offer the same tax rebate as buying new shares in a VCT would.
If your VCT investments make a loss, then you cannot get loss relief on your existing tax bill.
If these VCT rules are not adhered to, the investor could have any tax rebates taken off of them at a later date.