Clients could be losing out if their IFAs ignore the investment returns from the unquoted sector. The cost of due diligence is beyond the resources of most IFAs but they should not be put off exploring the unquoted sector jungle.
The Inland Revenue defines unquoted companies as those whose shares are either quoted on the AIM or the junior version known as Ofex. It also refers to the shares of companies which are either just starting life or are in the process of raising more capital to develop their businesses.
Once an investor has invested in these companies, it may prove difficult to exit until the company is sold or floats. In this jungle, there lurks some of the country's most entrepreneurial talent. Some of these small businesses will grow into the Vodafones of the next decade but others will crash and burn. Investing in these businesses needs to be left to specialists who can concentrate on careful research and stress testing while confirming the company's financial resilience and revenue growth potential.
Unlike the fund managers who specialise in selecting main market stocks, the venture capitalist needs to get his hands dirty. He needs to understand in detail what the business is, who the customers are, how the business is financed, what the competition is and what the customers and competitors think of it.
If a venture capitalist decides to invest, they often need to provide help and advice to the company as it grows. As a big investor in the business, the venture capitalist has a vested interest in trying to ensure the company succeeds and they get many times their investment when they are able to exit.
There are three viable paths open to IFAs. The first will appeal to those who like looking at individual businesses.
Many of the businesses which are seeking funds from venture capital investors also offer their shares to private investors. The wrapper, the enterprise investment scheme, or EIS for short, makes these shares attractive to investors.
To qualify for this tax-efficient status, the com-pany must have satisfied certain Revenue criteria.
If it does, it can offer its investors the following important tax incentives:
Investors can reclaim 20 per cent of the amount they invest up to a maximum investment limit of £150,000 a year and offset it against their income tax bill provided they hold the shares for three years.
Investors who have sold a business or second home and are looking at having to pay a big cap ital gains tax bill can defer all of it by investing the amount that they have realised in an EIS or number of EIS.
If the investor makes a profit on EIS shares, they may be sold completely free of capital gains tax after ownership of more than three years.
If the company fails, investors can offset some of their losses against either their income or CGT bills.
The second path is via venture capital investment trusts. These are normal investment trusts which invest predominantly in unquoted companies. The biggest of these, and indeed the biggest investment trust in the industry, is 3i. This trust gives clients access to a mix of big and small unquoted companies in both the UK and overseas.
As a direct investment, it does not offer any special tax advantages but, if it is included in an Isa, then both the dividends that it pays and the capital growth will be tax-free in the hands of the investor. In most cases, the dividends from venture capital trusts will be small but the growth prospects are substantial.
The third and newest route for private clients is a vehicle which is very similar to an investment trust but has some very attractive tax advantages attached to it. The VCT was first introduced in 1995 to encourage more private investors to put money into smaller entrepreneurial companies in the UK. In order to qualify as a suitable company for VCTs to invest in, it must have assets of less than £15m in size and be based in the UK.
There are four juicy tax incentives for investors:
Income tax relief
Clients who purchase newly issued shares in a VCT can reclaim 20 per cent of the amount they invest (up to £100,000 a year) and offset it against their income tax bills. They will need to hold these shares for a minimum of three years to keep this tax. This means up to £20,000 in the hands of the client.
Clients can defer the tax payable on capital gains of up to £100,000 a year by reinvesting in a VCT. If they invest £100,000 and they pay tax at 40 per cent, this will enable them to defer paying £40,000 of CGT to the Revenue.
Two sources of tax-free income
When the money is collected for a new VCT, it is normally initially invested in gilts and fixed interest. This is then drawn down by the fund manager as and when he invests in an unquoted company. Initially, investors will get a reasonable income which is tax-free in the hands of the investor. The second source of tax-free income is unique to VCTs. They are allowed to distribute the profits they generate from the sale of their holdings within the VCT as income which is tax-free in the hands of the investor.
No CGT on VCT shares when sold
This is the same tax advantage as is given to investment trusts when held in an Isa.
Since 1995, there have been about eight new VCTs launched each year. These have been steadily growing in popularity as they have proved the kind of returns they are able to deliver. Arguably, the most successful VCT so far is Foresight Technology managed by specialist managers VCF Partners.
Foresight Technology was launched in January 1998 at a share price of 100p. By December 1999, 3.9p per share had been paid as income dividends. However, several of the investments in the portfolio have seen good growth and in May 2000, having realised a substantial profit on one of its internet-related investments, it paid out of capital profit a further dividend payment of 100p per share.
Shareholders have received the whole of their original investment back as a tax-free income payout, ignoring the other significant initial tax benefits provided. In addition, they still hold their original shares which on July 24 had a share price of 195p. As the best tax advantages are only available on new VCTs, it is important to keep an eye on what is being launched and what is open to new investment.