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A start-up’s ability to secure investment is essential to its early-stage development. It is a daunting but oft-cited statistic that around 60% of UK businesses fail within their first three years. The most commonly cited reason for failure is running out of cash, and there is credible research to suggest that the inability to raise capital accounts for up to 38% of start-up failures.
A major difficulty for investors is that the high-growth potential of a start-up often comes with a high risk of underperformance or loss. It is with this in mind that the UK Government launched tax-relief schemes designed to mitigate these risks and incentivise investment. The schemes are the Enterprise Investment Scheme (EIS), introduced in 1994 and the Seed Enterprise Investment Scheme (SEIS), introduced in 2012.
This article will provide an in-depth guide to SEIS, and its potential advantages for very early-stage businesses. We’ll consider the benefits of SEIS for start-ups and investors, eligibility requirements, and how to avoid common pitfalls. (Note that we do not cover conditions for ‘knowledge-intensive’ companies).
Why should I care about SEIS?
- Thousands of businesses benefit from it every year:
Between the introduction of SEIS in 2012 and April of 2021, approximately £1.4 billion was raised by 31,965 companies. Between 2018 and 2019, 75% of the £163 million raised through SEIS went to companies using SEIS for the first time.
As these numbers attest, the scheme has been very popular with investors and investee companies.
- The scheme is soon to be extended:
The 2022 mini-budget announced changes to SEIS in plans that were unchanged in the Autumn statement. From April 2023, the existing investment limit per company will be raised from £150,000 to £250,000, and the annual investor limit will be doubled to £200,000. Certain qualification requirements will also be widened (see below).
The effect of these changes is to make fund-raising even more accessible to start-ups and early-stage companies. They increase the potential tax benefits for investors while reducing the investment risk by bringing more established companies into the scheme’s scope.
What are the benefits of SEIS for start-ups?
- Investor appeal
As described in the next section, SEIS increases investors’ returns by reducing their net funding commitment with tax breaks, and also lowers investment risk by offering loss relief. Consequently, qualifying for SEIS opens your business to a significantly wider pool of potential investors, many of whom may base their investment decisions on tax considerations.
- Overcoming barriers to debt financing
Early-stage companies tend to have limited options for raising finance. Bank loans may not be appropriate, either because the company has too few assets over which a bank could take a charge; or because its income is insufficient to meet repayment obligations. By contrast, SEIS provides a source of growth capital that is not dependent on collateral and has no repayment obligations.
- Independence and control
When approaching angel investors, founders can expect to give up a degree of control. Naturally, the investor will want to protect their interest, which often means sharing responsibility for executive decision-making. This can be uncomfortable for company founders anxious not to loosen their grip of the reins or compromise their original ideas.
SEIS acknowledges this by requiring that individual investors hold no more than 30% of the shares of the business. The scheme also requires that all shares sold to investors be generally non-preferential (broadly meaning that the SEIS investors are not treated preferentially to non-SEIS shareholders in terms of dividends or rights to capital upon a winding up).
- Commitment and expertise
SEIS investors are obliged to hold their shares for at least three years to retain the benefits of the scheme, and often hold them for much longer than this to maximise their return. This offers your company stability and assurance while you grow and develop your business.
It may be that you can secure funding from a specific SEIS fund (which invests in companies on behalf of individuals), or an experienced angel investor. During the period of investment, you may gain access to the expertise and network of the fund or the investor, which will be valuable to you for future financing, and could lead to other opportunities.
- Testing your business plan
A perhaps less obvious benefit of pursuing SEIS is that the thorough and detailed application process to HMRC (for advance assurance – see below) provides an opportunity to consider your growth strategy and fine-tune your investment pitch before meeting potential investors.
Why is SEIS attractive to investors?
As suggested above, the primary benefit of SEIS for investors is the range of tax reliefs it offers to minimise the investment risk of start-ups. Assuming investors hold onto their shares for three years, they can take advantage of the following benefits:
- Income tax – SEIS reduces income tax liability by 50% of the sums invested – effectively allowing investors to get back half of what they invest.
- Capital Gains Tax (CGT) – a blanket exemption applies to any gains made on the sale of shares in an SEIS company where income tax relief has been claimed.
- CGT Reinvestment Relief – this allows an individual who has disposed of an asset that would normally be liable to capital gains tax to treat up to £50,000 worth of gain as exempt from CGT provided they reinvest the proceeds giving rise to that gain into SEIS qualifying shares in the same tax year as the disposal.
- Inheritance Tax (IHT) – no inheritance tax is payable upon the transfer of shares on the death of an investor, provided that the shares have been held for at least two years.
- Loss relief – if an investor’s shares are sold at a loss, they can offset that loss against their capital gains or against their taxable income provided certain conditions are met.
How SEIS works in practice
To put this in context, we’ll consider the SEIS prospects of Company X.
The following three scenarios assume that Company X successfully raises funds through SEIS. The SEIS investor buys £10,000 of new ordinary shares in Company X and sells them after three years.
- Over three years, the company’s value increases by 100%
The investor makes £10,000 profit from the sale, pays nothing in capital gains tax, and receives a £5,000 reduction to their income tax bill; making an overall tax-free return of £15,000.
- The value of the company doesn’t change
The investor makes no profit from the sale but gains a £5,000 reduction in their income tax bill.
- The company goes into liquidation and the shares hold no value
The investor’s prima facie capital loss of £10,000 is reduced by the amount of income tax claimed, being half the initial investment which in this case is £5,000. The remaining capital loss of £5,000 loss can be set against other capital gains. Alternatively, the investor can elect to treat the original £10,000 loss as deductible against taxable income of that tax year or the previous tax year, resulting in a small rebate of income tax.
What are the qualifying criteria for SEIS?
Basic Conditions
The basic conditions a company must meet to qualify for SEIS are as follows:
- The company must have a permanent establishment in the UK for corporation tax purposes.
- It must not operate in an excluded trade:
- Most trades are ‘qualifying trades’ but there are specific exceptions in various sectors.
- A company may operate in an excluded trade only if it comprises no more than 20% of the activities of the company.
- The company must not be a listed company at the time of the share issue, and have no arrangements to become a listed company or a subsidiary of one at the time of the share issue.
- The company cannot control another company unless that company is a qualifying subsidiary (within the legislation), and
- must not have been controlled by another company since the date of incorporation (and must not be so controlled for three years after the share issue).
SEIS-specific criteria
These criteria focus on the size and stage of the business:
- The company must not have previously received investment through EIS or a venture capital trust
- Generally, it must have been trading for less than two years (or three years from April 2023)
- The company, and all of its subsidiaries, must:
- not have gross assets over £200,000 (rising to £350,000 from April 2023)
- not be a member of a partnership
- have fewer than 25 full-time employees (on a group-wide basis if applicable) in total when the shares are issued
Advance Assurance
It is possible and often commercially necessary to apply for Advance Assurance (AA) before attempting to participate in the scheme.
Broadly, AA is a statement from HMRC to confirm that your business is likely to be eligible for SEIS, provided its circumstances do not substantially change. It is optional but highly prudent to secure AA before issuing shares that are intended to qualify under the scheme.
Obtaining AA confirms that HMRC consider the company’s business plan solid, which provides comfort to start-ups and potential investors alike, but this requires a meticulous and comprehensive application.
Key considerations start-up applicants should be aware of
Though SEIS provides considerable advantages to qualifying businesses, there are potential pitfalls to be wary of.
The risks
- Advance Assurance
Getting this step right is essential – HMRC will not respond to an incomplete or ‘unconsidered’ application, and negative responses cannot be appealed.
- Issuing shares
It is crucial that full cash payment is received before shares are issued, and that no preferential rights are attached to those shares which would offend the relevant legislation, or the beneficial tax treatment for owners of the shares will not be available. Careful consideration needs to be given to the rights attaching to shares which are not SEIS shares.
- Independence
That investors can hold no more than 30% of the ordinary shares of the company is part of a broader requirement that the issuing company not be under anyone else’s control. Accordingly, directors must ensure that an investor’s shares do not allow them to take decisions unilaterally or appoint a majority of board directors. This requires judicious and ongoing corporate governance.
- Spending the money
The money raised from the investment must be spent within three years of the share issue, and must be spent in accordance with SEIS rules to avoid disqualifying events which could result in the withdrawal or reduction of relief.
- Timing
SEIS is only available within the first two years of your business’ trade (although this will rise to three years from April 2023, so it is important to prepare for the application process as early as possible.
How we can help with the SEIS application process
Bearing in mind the value of SEIS participation to prospective investors and the complexity of the rules applicable to companies and investors both, it is vital to prepare for the application process as early as possible and to take professional advice.
The government’s application page does not explain the steps applicant companies must take in great detail. However, Michelmores’ corporate and tax specialists are well-equipped to guide you through the process:
- evaluating your business against the qualification criteria;
- assisting you with the AA application and with ongoing SEIS compliance and documentation (HMRC has very recently updated the format and method of application);
- facilitating and advising on the investment and the issuing of the SEIS shares, and
- using the invested capital to grow and develop your business.
If you’d like to discuss how your business can benefit from SEIS, Michelmores has a wealth of experience in venture capital schemes, and all aspects of corporate advice. Please do get in touch with Anthony Reeves for general SEIS enquiries, by email.
Michelmores run a programme dedicated to giving extra support to innovative and scalable businesses. Find out more here.
This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.
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