VCM8542 - Venture Capital Schemes: risk-to-capital condition: factors to be considered

Factors to be considered

When considering whether or not both parts of the risk-to-capital condition outlined above are met, the factors set out below may be taken into account. This list sets out indicators of potential capital preservation, but it is not exhaustive; all relevant factors will be taken into account.

This means that even if one or more of these indicators of potential capital preservation are present in a particular case, it will not necessarily fail the risk-to-capital condition; a judgement about whether capital preservation activity is taking place will depend on the overall context of the investment. Likewise, even if none of the indicators listed in the legislation is present, the risk-to-capital condition may not be met if the wider circumstances of a case suggest that capital preservation is intended. Ultimately, a judgement about whether the overall condition is met will depend on the level of risk posed to investors’ capital and whether the company has genuine intent to grow and develop in the long term.

The following gives a general overview of how each of the factors set out in legislation may be considered, but the approach taken will depend on the facts of each case.

Increasing number of employees or turnover

As explained above, to be eligible under one or more of the schemes a company must have objectives to grow and develop in the long term. Companies that are growing and developing are usually expecting to take on more employees. They will also expect to increase variously their production, customer numbers, markets and/or profits, though there may be other outcomes from a company’s growth and development, for example an increased commercial reputation and ‘brand’ creation.

The company will need to set out its growth and development objectives in its business plan. These should identify the relevant measurable growth metrics for the company, especially where these relate to additional factors and not the generic indicators specifically refrenced in the legislation.

The company must have objectives to grow well beyond any holding periods associated with the scheme under which the investment is made. The money raised is expected to fund increasing growth over a number of years. Though the company need not know exactly how much it will grow by, it must be clear that the company has genuine ambitions for growth. A company that uses the money to grow to a certain size by the end of a holding period, with little possibility of continuing to grow, will not meet the risk-to-capital condition.

When considering whether a company has objectives to grow and develop, both scale and proportionality must be taken into account. For example, depending on all the circumstances an increase from 10 employees to 15 employees might be a relatively strong indication of the intention to grow and develop whereas an increase in employees from one to two people might not in itself be indicative of growth and development, and would require the demonstration of growth in other factors of the company’s trade alongside it.

Sources of income

Companies being used to offer capital preservation investments often have in place assured income streams that make up a significant proportion of the company’s overall revenue.

Securing a future source of income, for example a contract to deliver products to a customer on a regular basis, does not necessarily mean that capital preservation is taking place. Whether the risk-to-capital condition is met will always depend on whether the facts of the case in question indicate that there is a significant risk that the investor will lose their capital, and that the company intends to grow and develop over the long term.

In some cases, a company may have secured an income stream before an investment is made. To meet the risk-to-capital condition, the investment must be genuinely at risk. Investments that are partly protected by small amounts of pre-agreed income or support may qualify for tax relief, provided that the investor’s capital is significantly at risk and other eligibility conditions are met.

Assets

Some capital preservation companies depend upon creating or purchasing an asset that is expected to be sold on, either at a profit or a small loss.

This factor does not prevent companies from using money raised to buy or create assets, so long as the intention is to make use of the asset in the company’s trade (for example, an item of plant or machinery). The asset should not be held mainly with a view to its disposal, or the disposal of a trade that depends upon the asset, or used to secure the investment or generate a low-risk income stream.

Similarly, where a company intends to raise money for the purchase of substantial amounts of stock, disproportionate to its spending on other operational activities, this may be an indicator of underlying risk mitigation strategy or a short term operational life of the company.

Subcontracting

Where an investee company subcontracts all or most of its activities to others, this may indicate capital preservation activity.

The use of subcontractors may not, by itself, point to capital preservation; a company may not have all the skills it requires in-house and it may therefore make commercial sense to subcontract certain activities to other businesses or individuals.

However, capital preservation may be taking place if the company holds assets but subcontracts all or most of its trading activity, and where decisions about the business are made largely by others, for example external industry specialists, fund managers or the ultimate customer. The existence of arrangements sub-contracting a company’s operational and management decision making would also indicate that the company is incapable of long term growth or development as a trading company.

Ownership or management structure

The expectation is that the company is managed by genuine entrepreneurs, with a long term view to its growth and development.

One of the indicators of capital preservation activity is where the investee company’s investor base consists largely of individuals who are using a tax-advantaged scheme alongside the promoter and their associates, with little or no entrepreneurial involvement.

Many capital preservation companies are set up and effectively controlled by the people who will, directly or indirectly, raise the funds from investors and ensure the company delivers the capital back to its investors after a period of three or so years. The capital preservation arrangement works because the promoter is able to control the company’s activities, including when it sells its assets or when it is wound up and the proceeds distributed to the investors.

VCTs are able to follow this model by investing alongside one another, with these investments often managed by the same fund manager.

That a majority of investors in a company are investing through a tax-advantaged scheme does not in itself indicate capital preservation. As long as the company’s founder or manager is wholly independent from the investors the investment would not be considered to involve capital preservation.

Examples of when the company would not be considered to be wholly independent from its investors include where the people running the company:

• have been appointed or otherwise secured their office by any relationship or affiliation with the investors or their representatives or nominees
• do not retain a significant share in the company or do not play a considerable role in management decisions, but instead operate the company in accordance with the instructions of the investors or their nominees

The presence of a fund manager or business angel on the board of a company does not mean that the investment in the company is a capital preservation investment. This is normal practice and often provides the founder or manager with invaluable support in managing and growing the company’s business.

Marketing of the investment opportunity

This factor considers what a potential investor (or their adviser) would expect in terms of the risk profile of the investment, based on how the investment opportunity is marketed.

Many capital preservation investment opportunities are marketed as short-term investments with low risk and good returns and, by itself, the content of such marketing material is likely to indicate that a capital preservation activity is intended. The absence of such material does not, however, mean that a company is not involved in capital preservation activities.

Fragmentation

Many capital preservation schemes depend on raising large amounts of money that are invested in a number of companies carrying out similar activities. The reason for this is that promoters have identified an activity that qualifies for tax relief under the schemes, but rather than creating a single company to carry this out they have fragmented the activity into a series of companies. Their clients then invest in each company the maximum amount allowable under the schemes, with the result that, collectively, they obtain more relief under the schemes than they would be able to if investing in just one company.

As a result, where a company is carrying out an activity that is closely aligned with that of another company, for example the same activity but in a different geographical area, this may indicate capital preservation. A company’s relationship to other companies will therefore be taken into account when its eligibility under the schemes is under consideration.

As explained above, investments in SPVs will not qualify for relief under the schemes, but investments in a company that sets up wholly-owned subsidiary SPVs as part of normal commercial practice may qualify, provided that all the eligibility requirements are met.