EIS/SEIS - is there any protection against loss

It is easy to be attracted by generous tax reliefs and invest funds without fully considering the risks. As explained below, there are some protections available to investors, but these are relatively limited.

It is a difficult balance between ensuring your investment:

• Grows in value as the company grows; and
• Is not misused or, worse, fraudulently dissipated.

Based on our experience, we have outlined some of the common concerns investors should consider. Protections should be reflected in the investment agreement, shareholders’ agreement or the company’s articles of association.

Legal safeguards for EIS/SEIS investors

Often, the founder(s) will want as few restrictions as possible on how they run the business. This creates a risk that founders might pay themselves an excessive salary, make inappropriate expenditure decisions or leave the business to establish a competing venture. SEIS and EIS investors should therefore consider requiring:

• Veto rights over director salary increases and other significant types of expenditure;
• Leaver provisions that require founder(s) to offer their shares to the remaining shareholders if they cease working for the company;
• Restrictive covenants that impose appropriate restrictions during which founder(s) cannot poach staff, approach customers or set up in competition;
• Confirmation that intellectual property has been adequately registered and protected;
• The opportunity to review and monitor the business plan; and
• Appropriate protections to help ensure the business continues to satisfy the qualifying trade requirements for SEIS/EIS.

Is there a minimum investment requirement for EIS and SEIS?

There is no minimum subscription level required for an investment to qualify for SEIS or EIS relief.

What rights should minority shareholders look for with EIS or SEIS?

Minority shareholders have legal rights where directors act in breach of their duties. However, enforcing those rights will generally be easier if the investment agreement contains appropriate protections and mechanisms to rely on if disputes arise. Things to consider include:

• Tag-along & drag-along rights - SEIS and EIS investors should consider how they will be protected if the business is sold. Tag-along rights give minority shareholders the opportunity to participate in a sale by a majority shareholder on the same or equivalent terms. Drag-along rights can enable shareholders to require other shareholders to participate in a sale, subject to the terms agreed between the shareholders.
• Prospect of future dilution  - SEIS and EIS investors are not automatically protected from dilution. Investors should therefore carry out appropriate due diligence and consider whether contractual protections, such as pre-emption or anti-dilution provisions, are appropriate.
• A pre-emption right - this is essentially a right to subscribe for new shares before they are offered to other investors, subject to the agreed terms. For instance, an EIS investor holding 5% of the shares who wants to maintain a 5% stake may have the opportunity to invest additional funds to maintain their percentage shareholding.

What veto rights do EIS/SEIS investors need?

The directors usually determine the day-to-day management of the company. However, SEIS and EIS investors may decide that certain matters require their approval. This reserved matters list requires careful consideration. A lengthy list of matters requiring investor approval might unnecessarily restrict the company’s ability to operate and make commercial decisions. Nevertheless, such matters could include:

• Corporate structuring protections:  e.g. no shares are subdivided, consolidated or re-designated without investor approval;
• Loans or capital expenditure: expenditure above an agreed threshold, such as £5,000, depending on the size and nature of the business; and
• Information rights: investors may require rights to receive financial, management and other relevant information about the business.

Warranty as to satisfaction of EIS/SEIS conditions

Investors can request a warranty that the conditions for EIS/SEIS are satisfied at the time of investment. However, events occurring after the investment can cause the investment to cease to qualify for EIS/SEIS relief. A company may therefore be unwilling to provide a broad warranty covering its future compliance with the relevant requirements. Investors should undertake appropriate due diligence and consider what contractual protections are available.