A Venture Capital Firm is a private fund that invests in early-stage and emerging startups that have the potential for high growth. The investors in such a fund are large multinational companies or High Net Worth Individuals (HNIs).
Venture Capital operates on a high-risk high-return model. If a startup fails, the entire investment made by the venture capital is written off. Hence, these types of investments are done by people who have ample surplus funds.
What is a Venture Capital Trust?
In the United Kingdom, there is a structure of ‘Venture Capital Trust’ (VCT), a closed-ended investment company listed on the London Stock Exchange introduced in 1995, that provides small retail investors access to the opportunity of investing in small companies and earn above-average returns, and support the growth of small businesses in the country.
Some of the big names in VCT include Octopus investments who manage over 1 billion pounds across its different products, Foresight which manages 155 million pounds of assets, and Downing which has over 1.4 billion pounds of funds under its management.
What do VCTs invest in?
VCTs do not invest in one-man-band startups but small established and often profitable companies in a wide variety of sectors including engineering, wine retailing, cake making, care homes, and brewing. These are the companies that have the potential to generate high returns. A VCT must invest a minimum of 80% of the amount it raises in the companies that satisfy the given criteria.
Since 1995, more than 8.4 billion has been invested in VCTs.
Her Majesty’s Revenue and Customs (HMRC) provides strict criteria for a company to be eligible for VCT investment. Businesses like land dealing, financial activities, farming, operating hotels, forestry, and energy generation are excluded from ‘qualified trade’.
Such companies must be less than 7 years old having fewer than 250 employees and assets less than 15 million pounds.
The shares of the VCT are structured to offer tax incentives such as relieving the tax or lowering tax implications on dividends and capital gain as provided by HMRC.
For example, there is a 30% tax relief on investment in VCTs. i.e. when you invest 10,000 pounds, you get a tax savings of 3,000 pounds. However, there is a cap on the amount of investment a person can make in VCTs (i.e. 200,000 pounds) thereby restricting the income tax benefit to 60,000 pounds.
Typically, any gains from VCTs are distributed to the shareholders as a tax-free dividend. Additionally, the capital gains arising out of such VCTs are also exempt.
Risks of VCTs
Investing in VCTs comes with a risk factor and is not for everyone. Small and unquoted companies are statistically more likely to fail and hence are riskier than buying shares of blue-chip companies having decades of operational history.
To get the upfront tax relief, an investor must hold VCTs for at least 5 years and although VCT shares are listed on the stock market, they are not particularly liquid. Therefore, if an investor wants to sell the VCT shares quickly, they may not be able to do so unless they sell it at a discount to the Net Asset Value (NAV) of the VCTs.
Types of VCTs:
Generalist VCTs: These VCTs usually invest in a wide variety of sectors ranging from retail to healthcare and technology to diversify their portfolio risk. It is the most common form of VCT.
AIM VCTs: These VCTs invest in companies whose shares are quoted on Alternate Index Market (AIM) on London Stock Exchange. These are the companies that cannot or do not wish to comply with the extensive listing requirement of the quoted shares.
Specialist VCTs: These VCTs focus on one specific sector and are riskier as there’s little to no diversification of sectors.
VCT & EIS:
Enterprise Investment Scheme (EIS), launched in 1994, provides investors with tax benefits for investment in small companies. On the face of it, VCTs and EIS may look similar but there are some significant differences between the two.
VCTs, unlike EIS, do not provide relief to the investors in the form of a ‘carry back’ facility restricting them to offset tax relief only in the year of purchase of shares of VCTs. They also lack the inherent tax advantage and facility to offset the loss against any other capital gain.
In EIS, the investor acquires shares in the underlying company while in the case of VCTs, the investor acquires shares of the trust which then invests the money raised in different companies.
EIS are not listed on the stock exchange and hence are not freely tradeable. The only way to sell the shares of EIS is when the company is sold or listed on the market.
VCTs pay a dividend as the main source of tax-free return to the investors. In contrast, investors have to wait till the shares are sold to make any returns on their investment.
Structuring a deal might take months for VCTs to invest in an eligible company as a result of harder due diligence than ordinary quoted shares. Hence, more management is required to source, structure, and maintain the investments.
As a result, there are charges involved in investing in VCTs. The annual management fee is around 2% and initial charges can be as high as 5%. In addition, there can also be additional director fees, performance fees, custodian fees, and other costs as mentioned in the information document of the VCT.
Valuation of VCT:
The value of a VCT is usually measured by its Net Asset Value (NAV) which is the aggregate value of all investments made by the VCT. In most cases, the shares are not listed on a stock exchange and the value is determined by the management based on various valuation principles as set by them. Such a valuation exercise is typically conducted twice a year.
The performance measurement is based on NAV and the total dividend paid over the period by the VCT. These measurements are provided in VCTs annual and interim reports.