Introduction – EIS Risk to capital condition – Example & HMRC
The Risk to Capital Condition was introduced in March 2018. As well as being a new concept to the Seed EIS /EIS checklist, it is a somewhat subjective condition.
Any new application after March 2018 will have to pass this condition. So, it must be properly addressed in potential raise. It is clear that HMRC will return an application to sender where it is not clear how this condition is satisfied. So be warned.
What is the EIS Risk to Capital Condition?
The condition imposes a two limbed test:
- The Company must have the growth and development of the business over the long term as an objective;
- The investor must be at a significant risk that they stand to lose more than they stand to gain as a return – after tax relief!
Condition 1 – Growth and development objective
Under the first limb of the test, it is is essential that the Company is able to demonstrate two things:
- That there is an objective for growth and development; and
- That the growth and development is as a result of the capital raised
There is a statutory list of the factors that HMRC will take in to account when determining whether this condition is satisfied. Those factors include:
- Is there projected increasing turnover?
- Is there projected increasing Customer Base?
- Is there projected increasing Employees?
- Is the investment being applied towards company infrastructure?
- Is the investment being applied towards subcontractors or specific projects?
Condition 2 – Significant risk to capital
Limb two is concerned with how secure both the company’s finances are and investor’s investment in the business.
HMRC will look at the following:
- What is the return on investment set out in the business plan?
- Is there genuine commercial risk in the proposition?
- After factoring in dividends, interest, fees etc, what is the net return to investors?
- Does the company have significant capital assets on their balance sheet?
- Does the company have a secure income stream? For example, does it have a single major sales channel or partnership already in place?
- Is the business model one that is tried and tested business, or is there a genuinely new venture?
- Is there an element of genuine entrepreneurship and commerciality in the business when one looks at the shareholders? Or is the company largely owned by the SEIS / EIS investors?
- How have any of the risks in the business opportunity been marketed to potential investors? Is the opportunity marketed as a guaranteed win?
Significant Risk to Capital – a high-wire act???
As one will have gathered, this second limb of the test provides those attempting to raise capital with a bit of a conundrum.
When it comes to their potential investors, they will want to promote as strong a picture as possible. Clearly, dwelling on the risk and uncertainty does not a great prospectus make!
However, if one presents the opportunity as a ‘sure fire thing’ then HMRC might ask questions.
As such, it is a balancing act.
As we have said in some of our other articles on Seed EIS and EIS, this relief is designed to encourage investment in start up and growth companies.
As such, a useful question to ask oneself is whether, absent the relief, the investment would still be rather attractive to investors. If the answer is yes, then it may well be that one has problems with this second limb of the Risk to Capital Condition.
If you have any queries about the EIS Risk to capital condition or EIS generally, whether as a potential investee company or investor, then please do get in touch.
Albeit, we can’t give you investment advice as we are not regulated by the Financial Conduct Authority – so please get that type of advice from someone who is!