Key areas of risk for advisors

There are certain areas to look out for which can indicate that an SEIS or EIS might require some careful planning work or additional advice.

(a) The business is raising a large amount under a dual SEIS and EIS round.

• A dual SEIS and EIS round can be achieved but they normally need to be separated into two distinct investment tranches with the shares issued in chronological order and on separate days (a quirk in the legislation that many advisors miss).
• For example, a business raising £350k will at the point of issuance of the SEIS shares have at least £200k in gross assets (usually cash) on its balance sheet.
• This would disqualify the company from the scheme. There is a gross asset threshold of £200k for SEIS (the SEIS funds themselves are excluded) so if a business is receiving a large amount of investment it must ensure that the SEIS shares are issued before the EIS funds are received.

(b) The directors are looking at investing under the scheme.

• The scheme is meant for external investors who act as “business angels” and act on an advisory basis but are not involved in running the business. Think Dragons’ Den.
• There is a provision in the legislation for the investor to become a director of the company, but this should be registered on Companies House after the shares are issued so that there was no connection at the time the investment was made.
• Care must be taken over remuneration paid to scheme investors by ensuring they are at market rate and not deemed to be a return of value or a type of benefit. 

(c) The funds raised are not going to be used for ordinary business activity.

• SEIS or EIS funds cannot be used to purchase a business or to repay loans (including director loans), they must be spent on the trading activity for which the investment is supporting.
• There are also restrictions on purchasing goodwill or other intangible assets.
• There is a difference between how SEIS and EIS funds can be used. Funds raised under EIS must only be used for ‘growth and development’ and not to fund existing working capital. There are no such restrictions under SEIS.

(d) Investors are being issued with B Shares whilst the founding members have A Shares. 

• Ideally, all shares in the company are of the same economic value. This means that all shares in issue are ordinary shares, with no other share classes that carry differing rights to dividends and capital.
• A qualifying company may have different share classes, but in order to qualify the investors must hold the lowest class of share. For example, if there are both ordinary shares and preference shares in issue, the investors cannot hold the preference shares.
• The rationale is that the investors are already receiving tax relief, so should not be given any further sweeteners such as preferential rights to dividends and capital.
• If the difference between the types of shares are due to voting rights then this is usually acceptable because the shares are on a par in terms of their economic value.

(e) The company has traded for more than two years but is looking to raise under SEIS. 

• SEIS only applies to companies that have traded for less than two years; however, the trading start date is normally assumed to be the date of the first sale by the business, and not when it began incurring costs. Care also needs to be taken when a trade is acquired by a new company.
• This definition of trading is different to the corporation tax return period for a company which usually begins prior to a company’s first commercial sale.
• EIS companies must have traded for fewer than seven years in order to qualify. However, if a company has already raised investment under the scheme this time limit does not apply.
• Companies that are deemed to be ‘knowledge intensive’ have additional time to qualify.

Advance Assurance

The best way to de-risk the entire process is to apply for the  ‘advance assurance’ clearance which gives companies an opportunity to present the information to HMRC in advance. If rejected companies are able to make amendments to the proposed transaction in order to meet the conditions. 

Whilst it is always recommended to obtain advance assurance for the scheme it may not always be possible to do so. For example, a business may need the money invested immediately and cannot wait for the six weeks lead time at HMRC to process the application. In these cases, it is important to ensure the client and investors are aware of the risks involved in not seeking a pre-clearance.

Example – a low risk case of SEIS

A company is looking for investment under the SEIS scheme. The company is owned by the two founding directors and its business is the development of a unique software application that is used in the constriction industry. The company was incorporated 18 months ago and began selling its product this year. The directors have found an investor who wishes to invest £100k in exchange for 25% of the ordinary shares of the business but the company has not yet applied for advance assurance. The money is required to hire two new developers to expand the product offering and enable the company to move into a new market.

This scenario is an example of a straight-forward SEIS application. Whilst the company has not obtained advance assurance it is highly likely the business will qualify for the scheme and therefore, depending on the company’s risk appetite and time constraints, prior approval may not be needed.

Example – a high risk case of EIS

A company is looking for investment under the EIS scheme. The company has two classes of shares (A and B) and ten shareholders on its register. The company is a long-standing family business, incorporated in 1991 with many of the shareholders related to each other. Its original trade was the rental of caravans but it is now moving to a new trade of designing motor vehicles. The father-in-law of one of the directors is looking to invest £100k in exchange for A shares, alongside an unrelated investor who is looking at investing £50k in exchange for B shares. The money will be used for marketing and to pay staff salaries.

Red flags and points to examine in this example

• The company’s articles and shareholder agreements need to be reviewed to understand the nature of the difference between the A and B shares.
• Whilst the father-in-law is not a connected party, there may be connections between the other shareholders that could lead to an investor holding more than 30% when combined with their associates.
• The previous trade was an excluded activity; there may be an element of this business activity still continuing in the new trade.
• The funds may be used to fund existing working capital in the form of payments to current staff members which is not allowable under EIS. 

Valuable tools

The EIS scheme and SEIS scheme are both valuable tools when advising clients on access to finance.  As with any scheme, the risks factors involved need to be assessed in partnership with the client to protect both the client and the Firm.

• Tasnim Mustafa is a Chartered Accountant and Director at Barnes & Scott Chartered Accountants, specialists in working with technology, digital and media start-ups.