What is the risk to capital condition for SEIS or EIS application?
Companies incorporated in the UK are generally familiar with the application for SEIS / EIS.
Many small companies have used the schemes to attract top investors.
The main difference between the two schemes are their target market. SEIS is great for start-ups and smaller companies whereas EIS can be effectively used for larger and more mature companies.
The general process if you are making an application would be,
1. Getting an advance assurance: This is an application to ensure that when you do apply there is reasonable certainty of the outcome. Needless to say, if the advance assurance application you put in come back negative, reassess your position
AND / OR depending on whether you go for an advance assurance
2. You put in an application. You can also directly go for an actual application under the scheme. This is called a compliance statement. So this can be your first step instead of having an advance assurance done.
The good news is that both of these can be completed online via the gov.uk links.
How you would demonstrate that you meet the risk to capital condition if you are already operating and have 1-2 years worth of actual operating results.
Now the “Risk to Capital condition” was introduced in 2018 and all companies applying for either of EIS or SEIS should explain how they meet this condition when they make the application.
HMRC’s rationale is explained via their policy paper published in Nov 2017, as follows,
The measure introduces a new condition to the EIS, SEIS and VCT rules to exclude tax-motivated investments, where the tax relief provides most of the return for an investor with limited risk to the original investment (that is, preserving an investor’s capital). The condition depends on taking a ‘reasonable’ view as to whether an investment has been structured to provide a low risk return for investors.
These schemes have been abused for the tax breaks and having this test questions the main reason for the investment - that it’s just not for the sake of a tax break.
This is usually prepared in a word document and converted to a PDF document before upload. You explain your thoughts as to how your company meets the requirements and attached as part of your submission.
What to include?
There are 2 main conditions you need to address when preparing this document,
1. Does the company have objectives or the intention to grow and develop over the long term?
2. Is there “significant risk” that the investor will lose the money they invest under the scheme - this includes any returns they would gain under the tax relief allowed?
The tricky part is that the answer to both questions should be “aye”. They are sort of self conflicting in a way but it’s a fair question to ask. In a true entrepreneurial venture, as the company grows, there are also risks associated with that growth.
Let’s focus on question 1 - Does the company have objectives or the intention to grow and develop over the long term?
This is perhaps the easier of the two questions. Answer it truthfully.
1. Start with your financial assessment, have yous sales grown? Do you expect the growth to continue into the future
2. How about the key metrics applicable to your industry type? Such as number of customers, average sale value or the number of employees
3. How would having the investment help your company? Would it be used to develop new products or purchase new equipment.
4. Include a graph of growth to make the statement more factual.
Keep the write-up simple and easy to understand. There is no right or wrong length. A recent statement we helped a client prepare ran to approximately 200 words for this section.
Question 2. Significant risk to investors capital
This is more tricky than showing you have intentions to grow. Entrepreneurs are usually tuned to put their best foot forward in all circumstances, so we would have to think long and hard about what would constitute an actual risk for the company.
The first question I would ask here is, “Why do I actually need the money?” The answer to this question might give you an indication.
I need the money to develop a new product, why? Because the new product might give a market edge that a competitor is lacking. What if that product you are developing fails to deliver? Then there is a risk that the money we put into it is also lost. See what I mean….
It’s slightly negative but it’s important. At the least the entrepreneur asking for the money should realize and acknowledge that where money is concerned, risk is a natural.
Here are some examples of what could constitute significant risk
~ Key / Major client dependency - there are start-ups in certain sectors that have only a handful of clients, there is nothing wrong with this. But if one of them decide to stop services / go out of business themselves, it could present a genuine risk to the company applying for SEIS.
~ Industry specific risks - there is hardly any industry left in the world where you do not compete against a new entrant / larger businesses pivoting into newer areas. This is something you can talk about without essentially shooting yourself in the foot.
Something like - “While we enjoy sufficient market certainty, the threat of new entrants / low cost global competition is very real. Research shows there are XXX% new entrants into this area. This can have an impact on the long term health of the business if risk mitigation procedures are not adopted. *
Remember - speak facts, you are not here to present doom and gloom, rather a realistic view of what may be potential threats to your business model.
~ Key product / tool dependency - if your revenue model is centered on a specific product; that particular product going out of favour / newer and more slick replacing it would mean that your business growth would slow down.
You could say, there are potential risks that the tools we use to drive our sales, such as Salesforce, become a less popular choice with customers. If so, that would mean we would then have to change our business model market realities. While this sort of pivot can be achieved, it would slow down the current growth trajectory and could cause risk to money invested.*
~ Summarise your position - Make sure you summarise the statement. There is no one right answer here as you can very well imagine. The risks differ per company across industries. And example to summarise would be,
As demonstrated, we are a growing company with definite pipeline. But we are also conscious of areas where our business model would need a pivot. So we genuinely feel there is significant risk involved with the amount of investment we have made.*
Be confident in what you present
In general, a two-pager alongside your Business plan (which is one of the documents you submit) should be sufficient to address this issue. A word-count of between 500-525 should convey the matters nicely.
HMRC may ask you more questions relating to the risk to capital condition you have presented. View this as a positive, it enables you to explain matters clearly. This is one area which does not cause an automatic rejection of your SEIS most of the times. There is a right to appeal should the company be rejected on this basis as well.
We also recommend this highly valuable article written by Seedlegals as essential reading.
If you are looking at SEIS/EIS and confused with the risk to capital condition, we would be happy to vet your statement. Feel free to reach us via our Contact Us page.
* the examples provided are meant as guidance only. Feel free to use the wordings if it applies to your specific scenario, but remember that one size doesn’t fit all. You need to write about your business in realistic terms. We are happy to review your risk statements, please feel free to contact us via - Contact us.