Building a financial safety net should be everyone’s first priority. The safety net is what ensures that you can recover if you are ever knocked down financially. It is hard and takes time.
If you completed all five steps, then congratulations. What you have achieved is truly amazing. You may still not be able to retire in Bali at 35 but you are a lot closer. Now is the time to grow your net worth by making riskier – yet well-reasoned – investments.
When making riskier investments, it is best to focus on the ones that offer tax-relief (if any) because the tax-relief will act as a cushion against future potential losses. Unfortunately, once you have maxed your pensions and ISA allowances, your tax-free options are severely limited from an Income Tax standpoint. Worst, your options mostly relate to venture capital schemes, which are incredibly risky. Besides buying a ticket for the lottery or some cryptocurrencies, funding a start-up with no revenue is as high risk as it gets.
A Brief Overview of Venture Capital Schemes
Venture capital schemes offer tax relief to individuals to incentivize them to invest in early-stage start-ups that are not listed on a recognized stock exchange. There are three schemes:
- Enterprise Investment Scheme (EIS): the start-up can raise up to £5 million each year, and a maximum of £12 million in its lifetime, including amounts received under other venture capital schemes. To qualify, the company at the time of the investment has (i) no more than £15 million in gross assets, (ii) less than 250 employees and (iii) been more than 7 years in existence since its first commercial sale.
- Seed Enterprise Investment Scheme (SEIS): the start-up can receive a maximum of £150,000 through SEIS investments on which investors can claim relief. This amount includes other de minimis state aid received in the 3 years up to and including the date of the financing round and will count towards any limits for later investments through other schemes such as EIS. To qualify, the company is less than 2 years old and at the time of the investment has (i) no more than £200,000 in gross assets, (ii) less than 25 employees and (iii) not previously carried out a different trade.
- Social Investment Tax Relief (SITR): the maximum investment that can be received through SITR is €344,827 (about £300,000) over 3 years.
You can either invest in a qualifying company using the venture capital scheme or invest in shares in a Venture Capital Trust (VCT). A VCT is simply an unlisted vehicle that invests in an unlisted company. Think of it as a fund that invests in start-ups, without the Silicon Valley VC label. Some people would qualify VCTs are a “fourth” venture capital scheme. Personally, I avoid VCT because the management fees they charge are simply ridiculous.
Can I claim Tax Reliefs?
Tax relief depends on the scheme. You may able to claim:
- Income Tax relief against your investment in qualifying companies, enterprises or VCTs
- Income Tax relief against a loan or “debt instrument” to a social enterprise
- Capital Gains Tax relief on any gains you make on your investment
- Capital Gains Tax relief when you invest a previous gain in a scheme
Income Tax relief
An investor will get relief by investing in newly issued shares or by loaning money to a social enterprise for SITR. You can invest in as many companies through the schemes as long as you within the limits for each scheme in that tax year.
For EIS, SEIS, and SITR, tax relief may be claimed:
- The tax year you make the investment
- The tax year before you make the investment – if you choose to treat some or all of the investment as being made in a previous year
Tax relief can only be claimed against the amount of Income Tax paid in the UK. For VCTs, you can only claim tax relief in the tax year you invest.
You cannot carry forward unused Income Tax relief to future tax years.
Capital Gains Tax relief
Capital Gains Tax relief may be obtained if you invest through a venture capital scheme.
Deferral relief (for reinvestments)
You will not have to pay Capital Gains Tax immediately if you use the gains from the sale of an asset to make any amount of investment in a company that qualifies for EIS. For SITR, this is limited to investments up to £1 million.
The investment must be made between one calendar year before and 3 calendar years after you sell the asset.
You need to pay tax when: (i) you dispose of the investment, (ii) the investment is canceled, redeemed or repaid, (iii) the company stops meeting the scheme conditions, (iv) you become a non-resident.
Capital Gains Tax exemption when you sell your investment
If you invest in shares in a company through either EIS, SEIS, and SITR, you will not have to pay any Capital Gains Tax when you sell your shares if both the following apply:
- You have received Income Tax relief on that investment which has not been reduced or withdrawn at a later date, AND
- You have held the shares for at least three years.
Loss relief
If you sell at a loss, you can choose to set the loss amount, less any Income Tax relief already given, against your income. You can do this for the tax year that you sold the shares or the tax year before.
These are the basics on EIS/SEIS/SITR venture capital schemes. If you require further information, check the guidance set out by HMRC on their website or contact your tax advisor.
How to make your first investments in the venture capital world
The first steps are exciting and daunting. On the one hand, it is a great feeling to think that you could be investing in the next Facebook or Twitter. On the other, you have no experience and most start-ups are complete failures within the first two years of launch.
Ideally, you will know people who are already working for Venture Capital firms or who are investors themselves. They should be your first source of information. They know the field, which means they have a significant information advantage on you.
Unless you live in Silicon Valley or you are a high-net-worth individual, your experience in the world of venture capital is likely to be limited. If this is your situation, I found it best to start small and follow a few simple rules. Those rules may not be the same ones for everyone. It is important that you develop your own based on the amount you have to invest and your risk profile.
- Read a book on Venture Capital: this should be your warm-up exercise. Reading a book will not make you an expert in venture capital investing. You should, however, familiarise yourself with the venture capital landscape, the main players and the terminology for two reasons. First, your self-confidence will grow a bit and you will feel less of a fraud attending investors’ events. Second, if you join a conversation with potential investors, you should be able to follow what is going on and respond to basic questions. If someone asks you if you prefer angel investing or series B rounds, then you should be able to respond. Remember that this will be the first time that people active in the venture capital space meet you. First impressions tend to last and negative first impressions can follow you for a long time. I recommend you read Venture Deals. It is easy to read and gives you a solid overview without dwelling on too much detail.
- Attend an investors’ event: the next step is to hear pitches from entrepreneurs and listen to the questions asked by attendees. The pool of talents on both sides of the room varies largely on the type of event and businesses. At first, don’t be too quick to judge and keep an open mind. It’s only when you are thinking of making an investment that you can cross-examine the founders and review financials. I would not recommend initiating conversations the first few times with other investors. However, feel free to speak to the founders pitching their companies. They are the ones asking for money and are therefore here to respond to questions (without judging too much). Investors’ events are regularly organized by crowdfunding platforms such as Seedrs and Crowdcube. Create a free profile and subscribe to the mailing lists. For people with more cash to spend, create a profile on the Angel Investment Network’s website.
- Make a small investment: once you have read on the company, now may be the time to make a small investment. Even if you think you found the next Google, start small and follow your investment rules.
What are those investment rules you keep mentioning?
Over time, I came up with a couple of rules for venture capital investing. Those rules are subject to change but I will let you know when I decide to update my playbook.
Rule #1: Spend money you can afford to lose
This is the golden rule for venture capital investing, especially when you rent your apartment (like me!) or you have more than two years left on your mortgage. You will sleep soundly and avoid undue stress. Due to the nature of venture capital investing, it may take years and several rounds of financing to recoup your original investment. Even then, there may not be an exit event available for you to dispose of your shares. Many investors, including employees holding troves of stock-options, are patiently waiting for an opportunity to sell shares (through an IPO for instance).
Venture capital investing, to some extent, is not that different from putting money in your YOLO account. It is incredibly risky (yes, the pay-out could be massive, emphasis on could) so make sure you are comfortable with the amounts at stake.
Rule #2: Invest only in companies where you can get tax-relief
At first, you will be inexperienced and will make mistakes. Worst, unlike the stock market, it may take years to realize that your investment is a mistake. If you claim back 30% of tax relief against Income Tax, then you can only be 70% wrong. Not a great percentage but still better than being completely wrong and lose everything. Rules on selling at a loss may also further mitigate the damage. Tax relief mitigates the potential loss and also boosts your net (i.e. untaxed) returns if successful.
I will acknowledge that this will mostly affect people with a significant Income Tax bill. If you are self-employed or can divert some expenses through the incorporation of a company, then it might not be as advantageous. For most people, who are taxed based on their salary via PAYE, the tax relief will be very valuable.
Rule #3: Invest small on crowdfunding platforms and invest big when you are an insider
The assumption here is that you are unlikely to have an information advantage on companies raising funds through crowdfunding platforms. On the other hand, if a friend of a friend is raising funds for his company, then you have access and you can get in at an earlier stage of the process.
Another common issue is valuation. I find most valuations on Crowdcube and Seedrs to be inflated. It is not necessarily the fault of the crowdfunding platforms although I find the issue prevalent with them. After all, there is an incentive for them to maximize valuations to show that the start-ups that they are promoting are successful. The low-interest environment and the limitless flow of free money seeking higher returns also exacerbate this phenomenon. On those platforms, I generally invest no more than £5,000.
The bigger tickets are around £25,000. There is a jump in the quality pool of investors. Valuations are still quite expensive across the board. I only invest that kind of money if I personally know the founder or I can have an impact on the running of the company. I try to avoid directorships due to compliance issues but I favor informal (unpaid) advisory positions.
Rule #4: Invest in a business you are proud of
I stole this rule from Chris Sacca who was interviewed by Tim Ferris a couple of years ago. You can find Tim’s podcasts here.
Invest in businesses you are proud to promote. I like to mention the investments I made because it is free publicity for those companies. If the company benefits, I benefit. This is a small world and you may meet someone who could help the start-up in a meaningful way. If things work out, that person will be your new friend and the founders will be grateful. It is a win-win.
It is harder to feel good when advertising payday lenders who lend money to less fortunate people at a usurious interest rate or subscriptions services who make it a Herculean task to cancel the subscription once you have signed up to their free trial. In addition, an investment loss is easier to accept when you think that it was all for a good cause.
My last investment (less than £5,000) was in Graphene Composites, a company that recently raised funds on Crowdcube. The company “combines graphene, aerogel and other advanced materials into strong, light and resilient composites for the armor, aerospace and renewable energy sectors.” They are producing the GC Shield, which protects against low energy gun and knife attacks. It fits in a school bag. They just secured their patent and they will be taking their first orders soon.
Rule #5: Have fun and make friends
Making money is the primary objective here. You may or may not succeed. All you can do is as much due diligence as possible and hope for a bit of luck.
What you should do however is make friends and build a network. A string of failing investments will be demoralizing and may even tarnish your track record for a while. But it should not be all for nothing. Build a network of entrepreneurs and investors, get invited to pitches and shake hands. The best career opportunities are made in person (and not on LinkedIn).
People often recall that Peter Thiel turned a $500,000 in Facebook into $1 billion. Fewer people know that Peter Thiel did not know Mark Zuckerberg and was not a Facebook insider. Reid Hoffman introduced Peter to Mark Zuckerberg. At the time, Reid Hoffman was working on LinkedIn and did not want to give the impression that he was backing a competitor. Peter Thiel, therefore, led the financing round. This is the reason why you want to cultivate your network and build a few meaningful relationships.
One last quick note
I mentioned earlier that I thought that valuations are inflated. I believe that they will come down in due time. I am building cash reserves that I can easily deploy when fundraising sources get drier and only the true venture capital firms and entrepreneurs are left in the game. The most profitable companies were launched within 2 to 3 years after the dot-com crash. If you are serious about venture capital investing, I suggest you do the same. It is fine to make a few investments here and there but ensure that you have enough also to play the long-term game.
Start slowly and start small. Build your confidence. Then, the sky is the limit.
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