Whilst some investors typically select listed companies with an established share value, SME investment can be used to diversify, invest in a young business at a low share value, or even gain tax advantages through government-backed investment schemes.
Although there is higher risk in investing in a smaller company – the potential gains are high – which may suit investors with a higher risk appetite. The risk is offset by the agility and pace of growth available to a newer organisation which are substantially higher than that of a huge global entity that cannot adapt quickly to changing market environments.
So how exactly can you invest in SMEs in the UK and what are the benefits? In this article, we outline the typical routes for investing in SMEs and small businesses.
What Is a Small Business?
Firstly, how are small businesses defined? Although we might think it obvious, it is worthwhile clarifying the definitions that categorise an investment company as small. Most investment trusts assess businesses based on their market capitalisation, which indicates the total value of issued shares.
However, unlisted companies without a market cap cannot be quantified in the same way, so different investment trusts will use contrasting definitions based on balance sheet value, turnover, profitability or employee numbers.
Clarification is important because if you invest in a trust on the assumption that ‘small business’ means an early-stage start-up, this may not be the case.
The core difference between traditional and small business investments is that the latter provides returns through capital appreciation as shares become more valuable. Larger companies normally offer dividend income – so it is important to pinpoint your objectives before making any decisions.
Further considerations exist around your expectations in terms of returns, time horizons, risk, diversification, balancing other investments in your portfolio, and tax planning advantages available through the Enterprise Investment Scheme (EIS), Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trusts (VCTs).
Types of Small Business Investment
There are multiple possible routes to investing in UK small businesses, including:
- Crowdfunding
- Venture capital funds
- Investing in EIS or SEIS
- Angel investment
- Direct share purchases
- Exchange-traded funds (ETFs)
Below we’ll explain how some of the most popular small business investment options work.
Crowdfunding Small Business Investment
Crowdfunding has grown exponentially over recent years, where investors can contribute small capital values with low barriers to entry, pooling their investments together in return for an equity stake. According to the most recent stats by Beauhurst.com, the number of announced equity deals continues to increase:
Some well-known brands, including Revolut, Monzo and BrewDog, have used crowdfunding raises to expand.
Equity crowdfunding investments are the most common, where you pledge to invest a set value, and provided the business hits its crowdfunding targets, you receive a share certificate. An alternative is convertibles, which convert to shares at a discounted rate, normally during the next raise.
Venture Capital Funds
Private venture capital equity investment means you invest in early-stage businesses, or start-ups, with good potential but normally that aren’t yet profitable. The fund purchases stakes in the company and, in return, provides guidance and expertise to improve their chances of success.
Venture capital is common in the tech sector, with brands like Facebook, Moonpig and Google starting with venture capital backing. Bain.com shows that the tech companies consistently receive the majority of venture funding in recent years:
Investors can invest in venture capital funds as an alternative to direct investment, with minimum values normally starting at around £10,000, depending on the fund and the anticipated returns.
Investing in EIS or SEIS Funds
SEIS or UK EIS funds invest in small, unlisted, early-stage businesses which conform to the HMRC requirements around trading history, company asset values and workforce. Funds pool investment capital, but the investors hold shares in the company (or companies) rather than the fund.
The advantage over direct investment in an EIS or SEIS-qualifying company is that a fund with several assets can be diversified, reducing risk exposure.
Rates of return are projected at the outset, with an average of two to three times the invested capital over five to eight years – although the higher the potential return, the higher the risk.
EIS is considered a tax efficient investment as investors are eligible for tax relief. For example, na investor can claim income tax relief of up to 30% on an annual investment cap of £1 million. You can read more about EIS tax relief benefits here.
Small Business Investment Via Venture Capital Trusts
VCTs are a similar collective investment pool that differs from EIS and SEIS funds because the investor holds a share in the fund rather than the underlying businesses.
These funds are listed on the stock exchanges, so liquidity is higher – although it is not necessarily easy to sell a VCT asset depending on buyer demand.
Another contrast is that the returns are normally primarily made in the form of dividends rather than capital growth, although the risk of losses can be higher.
The Pros and Cons of Investing in Small Businesses
Start-ups and smaller businesses have the potential to deliver excellent returns. Although a younger company is more likely to fail than an established corporation – with around 50% of start-ups closing in their first three years – they also tend to grow at triple the rate of the rest of the economy when they succeed.
As a crude example, let’s say you invest £1000 into an SME that eventuall fails. You may have lost your capital but this can also work the other way. Say you invest £1,000 into a startup that becomes a success. Your investment could be worth millions or even billions of pounds.
The advantages depend somewhat on how you choose to invest. For example, SEIS, EIS and VCT investments may qualify for generous tax treatments, with up to 30% income tax relief, no capital gains on disposal, and tax-free dividend income.
Other benefits include:
- Choosing value-based investments, with a broad array of choices of sectors, operating spaces and business types.
- Potential to make higher-than-average returns with lower investment minimums and competitive management fees.
- Access to innovation, with new start-ups that solve problems, address needs, or have identified gaps in the market.
- Investing in companies that will have a significant socio-economic impact.
Risks of Small Business Investment
The biggest risk is that start-ups and smaller businesses without the asset base or backing of a larger firm are inevitably riskier. According to data from Fundsquire, around 60% of small businesses fail within the first three years (view source). However, remember that investing in a small business doesn’t necessarily mean a start-up with less than 3 years of trading.
Using a tax-efficient investment can offset the risk of loss, such as using an investment fund eligible for 30% income tax relief, where the potential losses have already been reduced by a third.
Another pitfall is that even successful start-ups are unlikely to provide an immediate return, and most investors need to commit to at least five years.
Should I invest in UK Small Businesses?
As we have indicated, the right options will depend on your expectations and objectives; some small business investments are easier to sell or offer periodic dividend payments, whereas others are illiquid and provide returns solely based on share value growth.
For further advice about creating a tailored investment strategy or selecting the optimal small business investments for your portfolio, please get in touch with EMV Capital at your convenience.