Is VCT Investing Worth The Risk?

Takeaways

• Reduce your income tax through investment

• What are the (tax) benefits of VCT investing

• Why the risk may not be so great

What is VCT investing?

VCT investing or venture capital trust is a UK closed-end fund, which invests in high risk small start-ups. (In the US they are similar to business development companies).They were created to help smaller start-ups access capital which they would not always be able to. Small starts-ups are much more likely to go bankrupt, as a result it can harder for them to gain access to capital.

To encourage investors to get involved the UK government has provided certain tax advantages when you invest in VCTs. As a result, they are attractive for wealthy investors who are on the lookout for tax relief.

What kind of companies does VCT invest in?

Apart from being very small companies, sometimes with only a handful of staff, these are often companies which are unlisted. This makes them hard to access to the mainstream investor. VCTs solve this problem as they are listed on the London stock exchange whilst also holding a portfolio of such companies. As a result all your money is not in just one asset. Remember many small companies go bankrupt. 

The companies selected for inclusion in a VCT will depend on the specialisation of the fund. Large VCTs will often be invested in companies listed on the London's AIM market. Smaller VCTs will tend to focus on unlisted companies in areas where their staff have knowledge and experience. Technology-focused VCTs are an example of a sector which has become increasingly fashionable.

There are advantages and disadvantages with both. VCTs investing in quoted AIM companies will have a volatile share price. VCTs which invest in unquoted companies will be less volatile, but any 'performance' will happen periodically as these companies value is updated. Typically this can be only once or twice a year, when company results are published. In both cases patience is required.

What are the tax benefits?

There are benefits for the VCT funds as well as the investor who buy them. For VCT funds, they do not have to pay capital gains or any corporate taxes. This is attractive as it means your investment can grow faster due to fewer costs.

For individual investors, there are income and capital benefits. Depending on some circumstances, you may not be liable for any capital gains tax. Often the most attractive benefit is the income tax relief of 30% for annual investments up to £200,000. There are conditions though, for example: the investment has to be held for at least 5 years.

Why are VCTs popular?

Although VCT invest in companies which are starts-ups and are therefore increasingly likely of going bankrupt, some do grow. Indeed there are cases of investors investing in VCTs for the tax benefits, only for one of their investments to grow so much that it creates a newer tax liability! As these are smaller companies, and despite the risks, they have the ability to grow very quickly when successful.

As a result they are popular with the wealthy who are looking for guaranteed tax relief. Due to the increasing accessibility of information and curiosity with what the rich are doing, VCTs have been highlighted as another form of investment for DIY investors.

An important distinction is important at this point. VCTs are not ideal for those looking to grow their capital, but they are ideal for those who have capital and are therefore likely to be facing increased tax.

Is the increased risk a worry?

The 'gain' has been achieved from the off due to the tax relief on income (subject to meeting the requirements). This is why VCT investing is so appealing to wealthy people. For mere mortals with mortgages and credit cards it gets more complicated. They are not in a position to put capital at risk and do earn enough income to benefit from the tax relief. VCT investing is often therefore too risky for these latter types of investors.

In times of economic growth, start-ups can grow easily funded by cheap money. Yet when interest rates rise, this money dries up. A rise in interest rates can lead to a recession, with a sales dropping to a point where a company has to make cuts and even close. The inability for small companies to cope with negative events beyond their control is a huge risk and is highlighted by recent events at Klarna, Bolt and Fast.

Conclusion

VCT investing is at the specialist end of the investment universe. It is not one for novice investors contrary to what some commentators out there state. As they invest in small start-ups, which are classified as high risk, VCTs are not suitable for those with small amounts of capital.

Yet for those who have created some capital and are looking for a combination of tax relief and investment return, they could be attractive as a part of your stock portfolio. Give yourself a margin of safety though! You can achieve this by investing in a few of them and limit exposure to 10% of your portfolio.