VCM8560 - Venture Capital Schemes: risk-to-capital condition: examples of how the condition may apply

Example 1

A company is set up by postgraduate students to exploit their research, which they expect will eventually have wide commercial value. They have been using the university facilities but they now need their own laboratory. The directors prepare a business plan but, as their plans are high risk and long term and the company has no track record, the company is unable to attract investment from the market. The company secures initial investment under the EIS from members of an angel syndicate, and a fund manager acting as nominee for a number of individual investors. A schedule of follow-up funding is agreed for the next five years. The directors retain a majority interest in the company. The company uses the money to set up and equip a small laboratory on the university grounds, and employ a technician. It expects to expand the laboratory, and employ more technical and administrative staff, over the next five years.

How the risk-to-capital condition might apply

Taking all the information above into account, the company can meet the risk-to-capital condition.

• The directors of the company are entrepreneurs who have set up their own company to carry on their own business. The angel syndicate, fund managers and other promoters have not been involved in setting up the company; they have been approached by the entrepreneurs to consider investing as independent minority investors.
• The company intends to increase its employee numbers and eventually launch a product on the market, which will be the company’s main trade. This suggests long-term plans to grow and develop its business.
• There is significant risk for the EIS investors in the company as there is no certainty at the time of their investment that a commercial product can be developed or will be successful.
• When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the relevant facts of the individual case will be taken into account.

Example 2

A company is set up to undertake a trade which relies on the use of property. It receives investment to construct this building. Once construction is complete, the company will engage subcontractors to carry out the trading activities for which the building will be used. As soon as the qualifying holding period ends, the company will sell on the building and trade to a previously identified buyer. The proceeds of this sale will not be used to help the company grow and develop, but will be distributed to the investors and promoters. The company is advertised as a low-risk investment opportunity. It is being advertised by a fund manager who is connected to the company.

How the risk-to-capital condition might apply

Taking all the information above into account, it is unlikely that the company can meet the risk-to-capital condition.

• The construction and subsequent sale of an asset is the sole focus of the investment. The investors are not investing in a business idea or trade concept but providing funding for the creation of an asset that has intrinsic value. The asset is not intended to be used as a substantial part of the company’s continuing trade and was always intended for sale. If the company intended to carry out its trade from the building, and was not using it as an asset against which to secure investors’ incomes, it would be more likely to qualify.
• The trade for which the asset is intended to be used is subcontracted. If the company intended to carry out the trade itself (and selling the asset was not part of this trade), it would be more likely to qualify.
• The company is being marketed as a low-risk investment opportunity. The fund manager who is marketing it as such is also connected to the company. This is indicative of a capital preservation arrangement.
• When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the facts of the individual case will be taken into account.

Example 3

A film company, less than seven years old, is seeking investment to expand its business operations, grow its revenues, increase the number of markets within which it operates and its range of commercial partners and develop a brand and reputation. Its trade will involve the development, production and exploitation of films.

The company has begun with a core team of employees working from a small office space who have begun the development work on an initial slate of projects. The investment the company is seeking to raise will be marketed as a long-term investment in the company and the brand it is seeking to create, not in the film projects it is looking to develop and this is demonstrated in the business plan it has prepared. The company expects to make a profit on the services it offers and the films it makes and it meets the financial health requirement.

The company intends to use the investment to further develop its slate of films which are at various stages of development, for production costs on its first film and the remainder of the investment will be used on expanding the company. Whilst the company will recruit some staff on short term contracts to oversee aspects such as the casting and marketing of certain projects, the company will build on its core team of employees by taking on a head of production and a creative director in the second year of its activity when it will move to a new and larger office.

The company will set up a wholly-owned subsidiary company, a special purpose vehicle (SPV) through which it will produce the first new film, in line with usual industry practice.

The company has agreed some pre-sales for the first film in its slate and the subsidiary will apply for Film Tax Relief in respect of the planned film. The pre-sales and tax relief provide security for a small proportion of the overall investment in the parent company; the remainder of the investment is not secured.

The SPV subsidiary, supported by the resources of the parent company and the new staff, manages the overall production but also subcontracts some elements of the film for which the group does not have the expertise in-house, such as set construction and visual effects to third party freelancers and companies. The subsidiary and the group continue to be actively engaged in the decision-making in relation to the production activities and therefore retain overall control of the project. The parent company also continues its other development activities and will be responsible for the future exploitation of this film.

The parent company’s objective is to carry on developing content, such as screenplays, and making films in the future. As set out in its business plan, it will reinvest the profits from this film to continue to improve its operational capacity, build its reputation within the wider industry and increase the range of commercial partners and markets of operation and in doing so establish a ‘brand’. Once the company has established its brand, and a sustainable business, it will be able to continue to grow by accessing funding from the market instead of using the EIS.

How the risk-to-capital condition might apply

Taking all the information above into account, an investment in the parent production company can meet the condition, although a direct investment in the SPV subsidiary could not.

• The money being invested in the parent company is intended to support the growth of the company’s infrastructure (the means and capacity to conduct its trade) as well as the project activity.
• The SPV is a subsidiary of the film company; investment is only permitted in companies that are not controlled by another company. If the SPV were set up as an independent company, outside a group structure headed by the film company, investment in the SPV would not qualify for relief as the SPV will not grow and develop.
• The film company, as the parent company of the SPV, would be likely to qualify for EIS investment: it is building a reputation, it has developed the latest film project itself using its own employees, and its objective is to carry on growing and developing as a company. It will retain the capital and reinvest the profits from making the planned films.
• It is normal commercial practice in the film industry to secure pre-agreed income (for example pre-sales or eligibility for other support, such as Film Tax Relief). To meet the risk-to-capital condition, the investment must be genuinely at risk. If the investment sought covers pre-agreed income or support the company will be unlikely to qualify for tax relief, unless the amount of protected investment is insignificant and the overall risk of loss of capital remains significant.
• Though the subsidiary contracts out some elements of the film production, this is standard industry practice and the company manages and directs these aspects, its employees are actively engaged and maintain control over end-to-end production of the film. As such, subcontracting in this situation does not necessarily indicate a capital preservation investment.
• However, if the subsidiary contracts out overall control of the activities to third parties, the investment in the parent is unlikely to be eligible; the group must retain control of decision making and be actively engaged in carrying out substantive and genuine film production activities. If the parent company acts mainly to deliver one or more projects developed by others, in other words the company is effectively a vehicle to fund projects developed, and in reality delivered, by other film producers whose own trades and reputations benefit instead, it will not be eligible for investment; in that case the money would be used to finance each film and not support the growth and development of the parent company.
• Similarly, were the company in this early stage of its development to distribute profits or otherwise repay capital to its investors after completion of a film that would indicate that the funding was raised for project finance, particularly where a further round of tax-advantaged funding is then required in order to make the company’s next film. Activities involving financing are excluded from the venture capital schemes.
• The company’s objective is to grow and develop so that it is capable of operating wholly within the market and not reliant on tax-advantaged funding. If, once it passes the seven year age limit, it were to wind up and the activities pass to a new company, the new company would not be eligible for EIS investments as the original business would be more than seven years old. The EIS cannot be used to fund a limitless succession of films, as financing is not permitted, and neither can the EIS be used to support a trading company that is otherwise unable to make a profit.

When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the facts of the individual case will be taken into account.

Example 4

An investment manager sets up a number of companies. They all receive investment from individual investors through a fund that the investment manager runs, and are 100% owned by these investors. A director is appointed to each company, and each company will undertake a contract to install and operate infrastructure for a local authority, which the investment manager has negotiated. The amount of money invested in each company is close to the maximum permitted under the venture capital schemes, and is used to pay for the substantial costs of installing the infrastructure. Once this is completed, each company will receive a secure stream of income through long-term service contracts. The predicted income covers a considerable proportion of the investment amount. Each company has subcontracted the installation, operation and maintenance of the infrastructure to industry experts and has no intention to expand once the infrastructure is in place. Though the income each company receives may increase over time, for example due to inflation, the companies themselves will not actually grow, for example in terms of customer base, number of employees or industry reputation. The individual investors expect that the investment manager will aim to sell their shares to a strategic buyer as soon as the minimum holding period expires.

How the risk-to-capital condition might apply

Taking all the information above into account, it is unlikely that the investments will meet the condition.

• That a company has a contract to supply something, and gets a reliable stream of income from this, is not in itself indicative of capital preservation. However, in this scenario there is little risk that the companies will not deliver the infrastructure asset or meet their contractual obligations so there is little chance that the income stream will fail. As a large part of the investment is therefore covered by a near-guaranteed, long-term income stream, this is likely to be a lower risk investment.
• The company is marketed by the investment manager as one of many low-risk investment opportunities and the ownership structure is designed to enable an early exit for investors.
• The investors have effectively invested in the underlying assets, there is no growth of the company’s trade.
• The company’s trade is entirely subcontracted, and the company only holds the assets.
• The company director has been appointed by the investment manager. The decisions about the company’s business activity are made by people connected with the fund making the investment, not by entrepreneurial company directors.
• The company has no intention to reinvest its income for future operations to grow and develop in the long term.
• When making a decision on whether the investment meets the risk-to-capital condition, other relevant factors will be considered along with those above, and all the relevant facts of the individual case will be taken into account.