IN A WORLD in which economic growth has largely stalled, Governments are keen on anything which can encourage new companies to be set up.

For a variety of reasons, traditional Venture Capital (VC) companies have largely stopped funding start-up business and now concentrate on investing in later stage and larger businesses, leaving the task of supporting start-up companies to individual investors, usually called ‘business angels’.

The Government is currently undertaking a review of the tax incentives available to such individuals, the Enterprise Incentive Scheme (EIS), and want suggestions on ways in which it could be improved.

The EIS scheme allows individual investors significant tax breaks: 20% of the amount refunded from their income tax bill, and the deferral of an appropriate amount of Capital Gains Tax that is otherwise due.

However the really important tax breaks are that any dividends or capital gain made from their investment in the company are completely tax free. So if the investment turns out to be a success and the business is sold for significant money they will benefit without having to pay any tax on their gains.

The EIS scheme has been remarkably successful and has created a strong community of business angels in the UK, especially here in Scotland where Scottish Enterprise’s Co-Investment Scheme gives angel groups increased financial firepower. And unlike previous schemes there is no sign that the system is being abused.

In its consultation, the Treasury has suggested that a new type of ‘seed investor’ might be defined for really early stage companies, and that such investors might be granted a 30% relief of income tax instead of 20%. They want help in defining such seed investments, and also, slightly bizarrely, want help in defining what makes an ‘angel’.

But neither of these points are remotely important – what is important is the restriction in the type of share which qualifies for EIS relief. EIS investors are forced to buy only ‘ordinary’ shares which the Treasury likes because it puts the angel’s money genuinely ‘at risk’. But VCs never invest in ordinary shares and always insist on investing using ‘preference’ or ‘participating preference’ shares.

If an angel invests £100,000 in a company valued at £500,000, he gets a 20% share in the business. If however, the company is later sold disappointingly for £300,000, the entrepreneurs will still get a result and £240,000 of the proceeds, and the angel takes a bath and only gets £60,000.

This kind of result is not uncommon, and because of this VCs usually insist of a ‘preference’ over their stake, which would mean they would get their original £100,000 stake back and the entrepreneur gets £200,000. In fact VCs usually take ‘participating preference’ shares which allow them their stake plus participation in the proceeds - £160,000 in this example.

Unfortunately, because VCs always insist on such terms, EIS investors are very reluctant to seek VC investments for their promising companies and prefer instead to sell their company, often too cheap and too early, rather than suffer the dilution in returns that results when VCs exercise their ‘preference’. This means that we don’t get as many larger companies as we otherwise might.

So the real problem with EIS is this restriction to ordinary shares – if EIS investors were allowed to invest in ‘participating preference’ shares, then they would be much more willing to move their more successful companies on to Venture Capital, and we would get many more larger successful businesses.

Which, you have to assume, is what the Government actually wants.