EIS/SEIS tips for investors
How do you protect your EIS or SEIS investment to avoid being taken for a ride? It is easy to get swept away by the generous tax reliefs and invest funds without protecting your investment. We act for investors and recommend safeguards.
It is a difficult balance between ensuring your investment:
- Grows in value, by allowing the company to nimbly manoeuvre;
- Is not foolishly, or worse, fraudulently frittered away.
Based on past experience, we have prepared a checklist of the more important protections for any investor and in particular EIS or SEIS investors. These protections should be reflected in the investment agreement, shareholders agreement or the company’s articles of association.
Checklist for investors
- Preventing squandering;
- Tag along and drag along rights;
- Veto rights;
- Confirmation of compliance with SEIS or EIS statements; and
- Identifying issues for non-executive directors
Preventing squandering the investment
Often the business’ founder(s) desire a “no-strings” investment. So there is a risk the founders might pay themselves an excessive salary, which ruins the business, or take their newly acquired knowledge and expertise and set up a rival company of which they own 100%. Hence SEIS and EIS investors should require:
- Veto rights on director salary increases and other types of expenditure;
- Leaver provisions that force the founder(s) to offer their shares to the remaining shareholders if they stop working for the company;
- Restrictive covenants that impose protective periods during which founder(s) cannot
- Poach staff,
- Approach customers,
- Set up in competition;
- Confirmation that the intellectual property has been adequately registered and protected;
- For businesses which intend to exploit and monetise intellectual property, that the business plan is secure; and
- Control to prevent the business failing to satisfy the qualifying trade requirement which is the same for SEIS and EIS.
Minority shareholders do have rights if the directors act in breach of their fiduciary duties. However, enforcing those rights will be much easier if the investment agreement contains the provisions they may need to rely upon if disputes arise.
Tag-along & drag-along rights
SEIS and EIS investors should ensure they won’t end up holding the company with a total stranger following a sale of the business. So investors should have:
- Tag-along rights: which give minority shareholders a right to piggy back (tag along) on any sale of shares to a third party.
- Drag-along rights: enables SEIS and EIS shareholder to require that any forced sale of their own shares, as part of a company sale, cannot happen unless the purchase price at least equals the original purchase price.
Anti-dilution is a tricky area. SEIS and EIS investors are usually involved at an early stage. Often additional investment rounds are needed to see the company really succeed. However, the new shares will “dilute” existing shareholding. Admittedly, the EIS investors will wind up with a smaller slice of a larger pie, which contains the same number of calories.
A good feature of the SEIS/EIS legislation is that subsequent fund raisings at higher values do not prejudice the SEIS/EIS status of existing investments. Investors generally assert one of the following two options, by holding:
- An absolute veto-right: over the issue of any new shares, which might kill the company;
- A pre-emption right: this is essentially a right of first refusal. For instance, an EIS investor holding 5% of the shares, who wants to maintain a 5% stake, gets first refusal to invest additional funds to maintain their 5% shareholding.
The directors usually determine the day-to-day management issues. However, SEIS and EIS investors may decide that certain matters require their approval. This “wish-list” requires consideration. A lengthy “wish-list” of matters requiring investor approval might hamstring the company. Nevertheless, such matters could include:
- Corporate structuring protections: e.g. no shares are subdivided or re-designated without investor approval;
- Loans or capital expenditure: greater than a threshold, say £5,000, which would be a fairly low level of micro-management.
Confirmation of compliance with EIS or SEIS statements
Investors often request a statement from the company that the company:
- Complies with EIS or SEIS requirements on the date of investing; and
- Intends to remain compliant through the process.
The company and investors should work together to ensure their SEIS or EIS investment does not fall outside the legislation. One common example:
- EIS or SEIS shares are issued before the investor has paid for them. However, to receive SEIS/EIS tax reliefs the shares must be fully paid. If the company has not yet opened a bank account, the investor cannot pay for the shares. The solution is to hold the funds in escrow accounts run by third parties e.g. solicitors. Gannons provide an escrow account service.
If you are a paid employee, you won’t get EIS relief. However, business angel investors are permitted to serve as unpaid directors. SEIS investors can be an executive director. However, it is unlikely the company can afford a high salary. Investor Relief is now a possibility for non-executives and angles which will provide them with the opportunity of Business Assets Disposal Relief (entrepreneurs’ relief) on the gain made on disposal. We weigh up the pros and cons of SEIS/EIS v Investor Relief.
The best way to protect your investment is probably to stay involved as a director and steer the company in the right direction. The voting of directors can be weighted, if necessary, to provide additional protection, but the weighting would need to be enshrined in the articles or shareholders agreement.