EIS Fully Explained: What is the Enterprise Investment Scheme?

Your Comprehensive Guide to EIS

In 10 seconds: The Enterprise Investment Scheme – or “EIS” – is a government initiative designed to encourage private investors to take a risk and invest in early-stage UK businesses. Investors get generous breaks on income tax, capital gains tax, and inheritance tax if they invest in an EIS-qualified business, so this opens up a lot of opportunity for growing startups to raise extra funds.

The Enterprise Investment Scheme: Basic Background

If you’re a medium-sized startup planning to raise a funding round, you may have already come across the Enterprise Investment Scheme (EIS). This government initiative encourages private investors to invest in early-stage businesses with the promise of various tax relief benefits.

Because many angel investors will not take the risk of investing in an early-stage company without the “cushion” of the EIS, it’s certainly worth determining whether your company is eligible for it.

More recently, another initiative, the Seed Enterprise Investment Scheme (SEIS) has been launched, aimed at increasing investment in smaller, very early-stage companies. While the two schemes have many similarities, this article will focus specifically on EIS.

In this guide, we provide a comprehensive breakdown of EIS for business founders. You will find:

• An introduction to EIS: Advantages and rules for companies and investors
• EIS vs. SEIS: The differences explained
• The criteria for EIS compliance
• A breakdown of the Advance Assurance application process
• Advice on how to find EIS investors
• Information on our EIS-compliant SeedFAST Agreement
• A glossary of important EIS terminology

What is EIS? An Introduction

The UK government established the Enterprise Investment Scheme (EIS) in 1992, as an initiative aimed at encouraging private investors to support UK innovation and stimulate the growth of the economy. EIS provides tax relief for investors who invest in early-stage, “high-risk” companies.

The scheme has been hugely successful, with around £20 billion being raised since its inception. In June 2019, HMRC announced that during the 2017–18 tax year £1.929 billion had been raised for 3,920 companies. And this was expected to rise to £2 billion when further tax returns were received.

EIS for Companies: Advantages & Rules

EIS is a major driver of investment for medium-sized growing startups, as it provides an incentive for private investors and angel investors to take the risk of supporting their new company. In fact, around two-thirds of the UK’s angel investors will only invest in SEIS/EIS-eligible startups.

If your company qualifies (see “How to be/become EIS compliant”) you can raise up to £12 million in EIS funding – up to £5 million in any 12-month period. These figures include funds raised through not only EIS but also SEIS, venture capital trusts, social investment tax relief, and some kinds of state aid.

The money you raise with each new issue of EIS shares must:

• Be used to grow or develop your business
• Present a risk of loss of capital for the investor
• Not be used to buy all/part of another business
• Be spent within 2 years of the investment or the date you started trading (if later)

Although your company must have been trading for 7 years or less the first time you fundraise with EIS, as long as you raise some EIS funds during that period you can then carry on indefinitely until you hit the £12 million limit. In addition, if you’re over the time limit for EIS you can still “reset the clock” by introducing a new business activity that counts as a “startup” with HMRC’s guidelines. Then you can still fundraise through EIS.

Another advantage to note is that you can repay third-party loans using funds obtained via EIS, as long as the loan is not connected to the investor and you used the borrowed money “for the purposes of trade” (i.e. not for the founders’ annual skiing trip).

EIS for Investors: Advantages & Rules

To take advantage of EIS, an investor must be a UK taxpayer. An individual can invest up to £1 million per tax year under the scheme. At the time of investment, he or she must not be connected to the company as a director or by employment, although after the shares are issued, they could still become a director.

An EIS investor must not hold more than 30% of the company’s overall shares, and normally he or she would be disqualified from liquidation preference. However, as A Ordinary Shares provide a loophole here, the investor may ask you to issue these to give him or her priority.

EIS investors receive the following benefits as a result of participating in the scheme:

• A 30% income tax break against the amount invested
• No capital gains tax to be paid on any profit arising from the sale of the shares, as long as they are held for at least 3 years
• Payment of CGT can be deferred if the money gained is invested through EIS. The investment must be made 1 year before or 3 years after the gain occurred
• No inheritance tax is payable provided shares are held for at least 2 years
• If the shares are sold at a loss, the loss can be offset against any income tax in that year or the previous year

EIS vs. SEIS: A Comparison

So, what are the key differences between EIS and its sister scheme SEIS?

The Seed Enterprise Investment Scheme (SEIS) was set up in 2012, aiming to encourage investment in extremely early-stage companies with a higher risk than the later stage startups supported by EIS. SEIS and EIS work in very similar ways, but the guidelines around SEIS are tailored to the needs of a smaller company. SEIS also takes into account the greater risk for investors with further tax relief benefits.

Here we list the key conditions for SEIS-eligible companies, with EIS figures in brackets:

• A company can raise up to £150,000 under SEIS (vs. £12 million EIS)
• They must have been trading for less than 2 years (vs. 7 years EIS)
• They must have fewer than 25 employees (vs. 250 EIS)
• They can have no more than £200,000 in gross assets (vs. £15 million EIS)

SEIS investors enjoy largely similar tax relief benefits to EIS investors, but the main differences are:

• Investors receive 50% income tax relief against the amount invested (30%)
• They can write off CGT up to 50% of the amount invested in the same tax year

Usually a company would fundraise under SEIS before moving on to EIS, but it is possible to fundraise under both schemes at the same time. It’s important to bear in mind that you must not issue EIS and SEIS shares on the same day.

How to Remain/Become EIS Compliant

In order for you to issue EIS shares, which allow your investors to claim EIS tax relief, you’ll need to make sure your company is compliant with HMRC’s EIS criteria.

As we touched on above, your company must have been trading for less than 7 years when you first apply for EIS funding. You must also have fewer than 250 employees.

Your intention must be to grow and develop as a company, so you must not be expecting to close after completing a project or series of projects. In addition, the company must not be a member of a partnership and must not be trading on a stock exchange at the time of the share issue.

Below, we look in detail at some other key criteria for EIS compliance.

Excluded Trades

To qualify for EIS, your company must not fall into the category of one of HMRC’s excluded trades. These include: banking, insurance, or money-lending; property development; dealing in land or commodities; legal or accountancy services; and generating or exporting electricity.

Check HMRC’s full list of excluded trades to make sure your company qualifies.

The good news is that you’re only disqualified from seeking EIS funding if a “substantial” proportion (+20%) of your trading activities fall into one of the excluded categories. Also, if your company provides support to one of the excluded trades (e.g. you’ve developed some software that will support online banking) without being directly engaged in it, then you could still be eligible for EIS.

Gross Assets Test

Your company will need to have less than £15 million in gross assets at the time of your funding round. So that’s the total value of the company’s assets just before the EIS shares are issued.

Your “assets” include:

• Fixed tangible assets (machinery, office equipment, etc.)
• Current assets (cash or another asset that can be converted into cash that same financial year)
• Intangible assets (intellectual property – but only when acquired by the company. So your own patents, for example, are not included.)

Crucially, the EIS funds themselves (if they’re paid just before the shares are issued) don’t count towards your current assets. But funds from a standard, non-EIS investor would count towards your £15 million limit. Therefore, standard investors should be asked to wait until the EIS shares are issued before sending in their money – otherwise you could find yourself in a tricky situation with HMRC.

Non-UK Companies

Another test that your company needs to pass to achieve EIS compliance is the UK Permanent Establishment Test. A non-UK-owned company can take part in EIS as long as it has a “permanent establishment” in the UK. This means that the company has either:

• A fixed place of business in the UK through which the company’s business is partly or wholly carried out, or
• A UK-based agent who acts on behalf of the company and habitually exercises the authority to enter into contracts on behalf of the company.

For EIS compliance to be upheld, this “permanent establishment” in the UK must be maintained for an entire 3-year period from the start of trading or from the date the EIS shares are issued.

Holding & Subsidiary Companies

As Anthony Rose outlined in his support article about EIS for holding and subsidiary companies, we believe a single company is generally better than multi-level company structures – especially for simplifying the process of investment for your investors. We advise you to keep things simple.

In the specific case of compliance for EIS, an investment must be in the TopCo (holding company), and cannot be for the ChildCo (subsidiary). Any investment in a subsidiary won’t qualify for EIS. If the company has a subsidiary, it must be 90% owned by the TopCo.

So, in a nutshell: if you’re running a multi-tier company, you must raise investment in the holding company for your investors to successfully access the Enterprise Investment Scheme.

Risk to Capital Condition

The Risk to Capital Condition is a test that HMRC only introduced in 2018. HMRC are intentionally vague about how to pass this test and each company will be judged on a case by case basis. However, you’ll need to provide evidence that:

• The company’s objective is to grow over the long term and this growth would be the result of the EIS investment, and…
• By investing in your company, investors will be putting their capital at “significant” risk.

Of course, this condition puts you in a bit of a Catch-22 situation: if you emphasise the potential for growth too much then HMRC might consider you too safe a bet for EIS investors and disqualify you from the scheme; if you emphasise the risk factor too much then investors will be wary of investing in you and you won’t get the funding you need. It’s a delicate balance!

Knowledge Intensive Companies (KICs)

If you can demonstrate that your company fulfils HMRC’s criteria for a Knowledge Intensive Company, then you will be eligible for extra benefits under EIS. It’s definitely worth checking, as we find a lot of companies don’t realise that their business activities count as “Knowledge Intensive”.

You will qualify as a KIC if:

• You’re creating or using IP to create products that you intend to become the company’s main business within the next 10 years, or…
• At least 20% of your full-time employees have a higher education qualification and their work for you is in the same academic field, and…
• A sufficient proportion of your operating costs include expenditure on research, development, or innovation, and this expenditure is within a certain time-frame in relation to the EIS investment.

Extra advantages for KICs under EIS include:

• You can raise up to £20 million in total and up to £10 million per year
• There is a 10-year fundraising window
• You can have up to 500 full-time employees
• Investors can claim tax relief on up to £2 million, as long as at least £1 million is invested in KICs

Once you’re confident that your company fulfils HMRC’s criteria for EIS compliance and you’ve checked whether you qualify for KIC status, you can move onto applying for Advance Assurance.

Advance Assurance for EIS

If you want to raise funds for your startup under EIS, the importance of Advance Assurance (AA) can’t be underestimated. AA is confirmation from HMRC that investment in your company should qualify for EIS tax relief – as long as nothing changes in the company and the information you showed HMRC is consistent with the information provided to investors.

It’s important to apply for AA at least 1–2 months before you start offering investment opportunities in your company, to give HMRC time to approve your application. Potential investors will almost certainly want to see proof of AA before they will seriously consider investing in you. However, there is a catch-22 because from October 2019, HMRC stipulates that potential investors should be listed on the cover letter, alongside potential intended funds, to prevent speculative applications.

At SeedLegals, we process more than 10% of AA applications in the UK, and companies that apply through us have a 98% success rate in achieving AA (compared to 62% on average). So if you want to apply through our platform, you’re in safe hands.

Here’s what you’ll need to do to complete your AA application:

• Check that you qualify for EIS (see previous section)
• Find your company’s UTR number
• Fill out the HMRC Advance Assurance Application Form – VCSAA v1.0
• Gather your supporting documents
• Submit the application to HMRC

Your Company’s UTR Number

When you registered with Companies House, you should have been automatically sent a 10 digit UTR number. You’ll need this to identify your company on the AA application form. If you haven’t received a UTR number, you’ll need to request one online. It usually takes about a week for HMRC to assign one.

Filling Out the AA Application Form

You can fill out the AA application form online via SeedLegals. It’s free to sign up and begin your application, and our team is on hand to guide you through the process.

Here’s what you’ll need to complete the form:

• A 3-year business plan and financial forecast: Essentially, this is a summary of your company’s business activities, financial information, and growth plan.
• The date your company started trading.
• The name and address of at least one investor, and the amount that investor intends to invest: These are recently added conditions from HMRC, designed to deter speculative applications, but the investor is not committed once you’ve submitted the form.
• A response to the Risk to Capital condition: This can be a brief SWOT analysis as part of your business plan.
• Details of any other venture capital schemes under which you’ve received investment in the past.

Writing a Cover Letter

Including a cover letter with your application is something we strongly recommend. It provides a quick, easily accessible overview of your company, and should include information about current and upcoming funding rounds, details about investors, and a summary of the company’s finances.

If you’re submitting your application through SeedLegals, we’ll use the information you’ve included in your application form to create a cover letter for you. So that’s one less thing to worry about!

Supporting Documents

Along with your cover letter, you’ll need to submit copies of other supporting documents. These will vary depending on your company and the proof required to demonstrate your compliance with the EIS guidelines. However, documents you will definitely need to include are:

• A 3-year business plan
• Pitch deck
• Financial forecast
• Details about previous investments or grants
• Latest bank statements or accounts
• An up-to-date copy of the memorandum and articles of association

When you apply through SeedLegals, our expert team will review all your supporting documents and check everything is in place before you submit the application.

Submitting the EIS Advance Assurance Application

In 2019, HMRC introduced a new AA Checklist that must be filled in and submitted with your application. This is designed to ensure you’ve included all the information they’re looking for and save time chasing up missing documents. However, when you apply via SeedLegals we’ll automatically fill out the checklist for you, based on the details you’ve provided.

Then all that’s left to do is to submit your application to HMRC. We’ve found that the quickest way to do this is via email, with all your supporting documents attached. Currently, HMRC takes 6–8 weeks on average to process applications, but with applications completed through SeedLegals we’re typically seeing a quicker time of 2–3 weeks.

Next Steps

Hopefully you shouldn’t have to wait too long to hear whether your application has been successful. However, if 7 or 8 weeks have gone by you can follow up with HMRC via email or by leaving a voicemail message. Email is generally the quickest route, and you should expect a reply within 2 weeks.

Once you’ve received your AA, you can approach EIS investors with confidence and aim for a successful funding round. Then, when you’ve completed your round and issued the EIS shares, you need to complete a compliance statement (EIS1) and send this to HMRC.

AA doesn’t have a particular expiry date; however, it will lapse if your company changes in such a way that you no longer meet the EIS eligibility criteria.

How to Find EIS Investors

With your AA confirmation in hand, you’re well prepared to begin offering EIS investment opportunities and meeting with potential investors.

To find likely investors, you can try approaching an EIS investment fund or by networking to meet individual angel investors. Alternatively, if you’re in a particularly niche sector where investors will need a bit of background knowledge to share your vision, you could try networking at trade fairs and conferences that are specific to your field.

SeedFAST: The EIS-compatible Alternative to a Convertible Note

In the build-up to a funding round, you may find that your company needs a small cash boost to tide it over. The good news is that there’s a way to do this and remain EIS compliant: our SeedFAST agreement.

The SeedFAST works in a similar way to a Convertible Note, where an investor agrees to loan funds now in the expectation of being repaid at an agreed milestone. However, as the Note is classed as debt it isn’t compliant with EIS, because the investor is guaranteed to get his or her money back and EIS requires the investment to be at risk.

In contrast, the SeedFAST doesn’t count as debt, as long as you convert the funds to equity within 6 months (reduced from 12 months on 31/12/2019) of receiving them. The investor can then claim his or her EIS tax relief in that same tax year.

Key Takeaways

The Enterprise Investment Scheme is a fantastic opportunity for startups to get the funding they need to grow. And qualifying for EIS doesn’t have to be lengthy or expensive. You just need to:

• Check you fulfil HMRC’s EIS eligibility criteria
• Apply for Advance Assurance in good time, before approaching investors
• Remember that it’s quick and cost-effective to apply for AA online with SeedLegals

If you have any further questions about EIS, please don’t hesitate to contact the SeedLegals team.

Glossary of Terms in this EIS Guide

A Ordinary Shares:

A type of Ordinary Share that has Liquidation Priority: when a company is liquidated or sold, the proceeds of the sale are split 99.9% to the AO shareholders and 0.01% to the Ordinary shareholders. Once the AO shareholders have all their money back, any remaining assets are divided up pro-rata between the other shareholders. Compatible with the EIS (must be worded very carefully in the Articles).

Advance Assurance:

Confirmation from HMRC that investment in your company is likely to qualify for EIS tax relief.

Convertible Note:

A method of raising funds between funding rounds, where an investor loans money to a startup under the agreement that it will translate into equity at an agreed milestone (upon valuation of the company during a future round, for example). It usually includes a clause to compensate for the risk, such as a discount on future shares.

Knowledge Intensive Company:

A company that is engaged in research, development, or innovation while it is issuing shares. It qualifies for extra advantages under the EIS.

Liquidation Preference:

A clause in an investment contract that gives certain investors priority, so they get their money back first when the company is sold or liquidated. Incompatible with the EIS (investors must be on equal footing).

Risk to Capital Condition:

A condition for obtaining Advance Assurance, introduced by HMRC in 2018. A qualifying company must be intending to grow over the long term, and there must be significant risk that an investor stands to lose more than they stand to gain. The condition is designed to deter tax planning.

Trading:

When applying for Advance Assurance from HMRC, it’s necessary to know the date your company started trading. HMRC uses the analogy of a shop: if you’ve turned the shop sign to “Open”, so it’s clear you’re looking for customers, that means you’ve started trading (“undertaking activities with a view to a profit”). Earliest date of trading will always be before or equal to the date you first received revenue.