A guide to Venture Capital Trusts (VCTs)

Venture Capital Trusts (VCTs) are an established part of the UK investment landscape, giving private investors access to early-stage businesses and scale-ups alongside a range of tax benefits.

For financial advisers, they can provide an additional option for clients with established, diversified portfolios who are looking for other ways to invest tax-efficiently for the longer term.

This guide looks at what VCTs are, how they work, when they may be considered, the types of companies they invest in, and the key benefits and risks involved.

What is a Venture Capital Trust?

Venture Capital Trusts are companies listed on the London Stock Exchange (LSE) that raise and pool money from private investors to invest in early-stage businesses and scale-ups with strong growth potential.

VCTs were introduced by the UK Government in 1995 to encourage investment into entrepreneurial companies. They have since become an important source of funding for growing businesses across the UK, supporting job creation, innovation and productivity.

Over the three decades since the scheme was introduced, VCTs have become an established part of the UK venture capital market.

According to the Venture Capital Trust Association (VCTA), VCTs collectively represent more than £6.6bn in assets under management, with investment across more than 1,100 portfolio companies supporting over 100,000 jobs across the UK.

What are the benefits of investing in a VCT?

Investing directly in early-stage businesses and scale-ups can be difficult for private investors. Opportunities can be hard to access, while limited trading histories and available data can make individual companies difficult to assess.

VCTs provide access to a professionally managed, diversified portfolio of companies selected for their potential to scale. This can help overcome some of the barriers that would otherwise limit private investor access to this type of investment.

Tax benefits

The Government offers investors a range of tax reliefs to reflect the higher risks associated with investing in smaller companies.

These currently include:

• 20% income tax relief on new shares in the tax year of investment (forfeited if the shares are sold within five years).
• Tax-free dividends (although these are not guaranteed).
• No capital gains tax on the sale of VCT shares.

Tax benefits are subject to investors meeting certain conditions. Tax relief is only available to UK taxpayers, on amounts invested up to a maximum of £200,000 per person, per tax year, and is restricted to the amount which reduces the investor’s income tax liability to nil.

Investment benefits

Alongside the tax treatment, VCTs can offer:

• Access to growth companies that may be difficult for private investors to access directly.
• Diversification through exposure to a portfolio of businesses rather than a single company.
• Professional investment management, with experienced teams responsible for sourcing opportunities, carrying out due diligence and working with portfolio companies.

How do VCTs work?

A VCT manager raises funds from investors and invests the pooled capital into carefully selected qualifying companies, operating in a similar way to a standard investment trust.

Most VCTs are evergreen vehicles with no fixed end date, allowing them to raise and deploy capital over time.

Managers are selective about where they invest. Experienced investment teams review opportunities, carry out detailed due diligence and decide which businesses to add to the portfolio.

When an investor invests in a VCT, they hold shares in the VCT itself rather than in the underlying portfolio companies. This gives them exposure to the VCT's existing portfolio through a single investment.

Following an investment in qualifying new VCT shares, investors will also receive the documentation needed to claim any initial income tax relief.

When might a VCT be considered?

VCTs are higher-risk investments and will not be appropriate for every client. They would typically form part of a broader, diversified portfolio rather than replace more mainstream investments.

They may be particularly relevant for investors who:

• Have made use of their ISA and pension allowances, and are looking for additional tax-efficient investment options.
• Have a significant income tax liability, where the initial income tax relief available on qualifying new VCT shares may be relevant.
• Are planning for tax-efficient income, as VCT dividends are free from income tax, although payments are not guaranteed.
• Already have a well-diversified mainstream portfolio and want additional exposure to smaller growth companies.
• Are investing for the longer term, with no expectation of needing access to the capital in the short term.
• Can accept a higher level of risk, given the smaller and less established nature of the businesses VCTs invest in.

How could a VCT fit into a financial plan?

The scenario below is for illustrative purposes only and does not constitute investment, tax, financial or legal advice. It is not a forecast and does not represent the outcome of any particular VCT. The fees, charges and investment values used are hypothetical. Tax reliefs are not guaranteed, depend on individuals’ personal circumstances and may be subject to change. The value of VCT shares can fall as well as rise and James could get back less than he invested, or lose his entire investment.

Let’s look at James - he is 52, earns £180,000 a year, is an additional-rate taxpayer and has built an established, diversified investment portfolio.

He has used his annual ISA allowance and is already making significant pension contributions. He also has a substantial income tax liability and is looking for additional tax-efficient ways to invest for the longer term.

James speaks to his financial adviser about the options available to him. After considering James’s wider financial position, capacity for loss and willingness to accept a higher level of investment risk, his adviser recommends a VCT as part of his broader investment strategy.

Following the advice given by his financial adviser, James subscribes £20,000 for qualifying new VCT shares. For this illustration, an initial charge of 5%, comprising 3% initial commission and a 2% adviser fee (£1,000 in total), is deducted at subscription, leaving £19,000 invested.

At the current 20% rate, and assuming he has sufficient income tax liability, he could potentially claim £4,000 in income tax relief for the tax year of investment. To retain that income tax relief, he would need to hold the shares for five years.

For illustrative purposes, assuming the initial net asset value (NAV) attributable to James’s shares is £19,000, annual dividends equivalent to 5% of NAV per share would initially amount to £950 for his holding. If the NAV per share remained unchanged over the five-year period, James could receive £4,750 in tax-free dividends. This assumes sufficient investment growth to offset the dividends paid and any ongoing costs. Dividends are not guaranteed and depend on the VCT’s performance.

After five years, James would therefore have received £8,750 through potential income tax relief and illustrative tax-free dividends, while continuing to hold VCT shares with an assumed NAV of £19,000. If the NAV per share had fallen, the value of his holding would be lower and he could lose some or all of his original investment.

If James subsequently chose to sell his shares after holding them for five years, any capital gain would be exempt from capital gains tax. VCT shares can be difficult to sell and usually trade at a discount to NAV. Assuming a sale at a 5% discount to the assumed NAV of £19,000, he would receive £18,050 before any additional adviser charges. Although many VCTs operate share buyback programmes, these are not guaranteed, and a sale may take time or realise less than expected.

What types of companies do VCTs invest in?

VCTs use the money they raise from private investors to back smaller, ambitious companies with the potential to grow.

These businesses may be developing new products, services or technologies and can operate across a broad range of sectors.

To qualify for VCT investment, companies must meet criteria set by the UK Government. These include:

• They must be relatively small - typically with gross assets of no more than £30m and with fewer than 250 employees at the time of investment.
• They must be relatively young - usually less than seven years old.
• Their shares must not be quoted on a recognised stock exchange (such as the main market of the LSE), although companies listed on the Alternative Investment Market (AIM) may qualify. They must also be independent and not controlled by another company.

These rules are designed to ensure VCT capital is directed towards smaller, growing businesses.

Different VCTs then take different approaches to building their portfolios.

• Generalist VCTs - they invest across companies in a range of sectors rather than focusing on one particular area.
• AIM VCTs - they invest primarily in companies whose shares are quoted on the Alternative Investment Market (AIM), the LSE's market for smaller growth companies.
• Specialist VCTs - they focus their investments on a particular sector or area of the market.

How does investing in a VCT work?

Investors can apply for qualifying new VCT shares during an open offer for subscription through a financial adviser, an execution-only broker or directly to the VCT.

The process broadly involves six stages:

1. Review the offer - review the prospectus and Key Information Document (KID) for the relevant VCT offer, information on fees, dividend policy and risk factors. This guide is not a substitute for those documents
2. Apply for shares - submit an application and fund the investment.
3. Shares are allotted - the investor becomes a shareholder in the VCT and gains exposure to its portfolio. The date the shares are allotted, not the application date, determines the tax year in which relief may be claimed.
4. Claim tax relief - a tax certificate is issued and can be used to claim any qualifying initial income tax relief.
5. Hold the investment - new VCT shares must generally be held for at least five years to retain the initial income tax relief.
6. Dividends and eventual sale - VCTs may pay tax-free dividends, although these are not guaranteed. Shares can later be sold on the secondary market or through a VCT's share buyback programme, where available.

Existing VCT shares can also be purchased on the secondary market. However, these shares do not qualify for the initial 20% income tax relief available on qualifying new VCT shares. In practice, the secondary market for VCT shares is relatively illiquid, so many VCTs operate a buyback policy, purchasing shares at a discount to the latest published net asset value. Buybacks are not guaranteed.

What are the risks of investing in VCTs?

As with all investments, there are risks to consider. Advisers and their clients should review the relevant VCT's prospectus and KID before investing.

The key risks include:

• Capital at risk, investors may lose part or all of their investment.
• VCT tax reliefs are subject to change, possibly retrospectively. Income tax relief is only available to UK taxpayers, on amounts invested up to a maximum of £200,000 per person, per tax year, and is restricted to the amount which reduces the investor’s income tax liability to nil.
• VCTs should be considered as a long-term investment. If investors sell their investment within 5 years, they will have to repay the initial income tax relief.
• VCTs invest in smaller companies which may fall or rise in value much more sharply than shares in larger, more established companies. They may also be harder to sell.

Important Notice

For professional advisers only.

This article is for information purposes only and does not constitute investment, tax, financial or legal advice. It does not constitute an offer to buy or sell an investment or solicit any such invitation.

The information is believed to be accurate at the date of publication, but no representation or warranty, stated or implied, is made or given by any person as to its accuracy or completeness and no responsibility or liability is accepted for any such information or opinion. Tax treatment depends on individual circumstances, and tax rules may change.

Issued by Beringea LLP of Charter House, 55 Drury Lane, London, England WC2B 5SQ. Registered in England and Wales under number OC342919. Authorised and regulated by the Financial Conduct Authority under number 496358.