How To Turn IDIOTS Into INVESTORS

JOHN BARNETT continues his practical guide to the enterprise investment scheme.

HIS IS THE second in a series of three articles looking the enterprise investment scheme from a practical point of view. The first article looked at why enterprise investment scheme applications can go wrong. This article will look at the practical steps which can be taken at the outset to try to ensure that they do not. Statutory references are to Taxes Act 1988, unless otherwise specified.

Getting it right

Getting an enterprise investment scheme application right is more than simply a matter of avoiding the pitfalls identified in the first article. In my experience, a successful application requires:

• proactive advice from the tax adviser at the outset;
• careful documentation of the investment process; and
• continuing vigilance for the following three years.

Advice at the outset

Managing client expectations

One of the crucial roles of the adviser at the outset of an enterprise investment scheme application is the management of client expectations. However, as clients and their expectations vary significantly, this is not always an easy task.

A surprisingly large number of clients have not heard of enterprise investment scheme reliefs at all. In this situation, expectation-management is fairly easy as the tax reliefs will only ever be a bonus.

Other clients will come fully aware of the benefits of enterprise investment scheme relief, and will need quite careful management. It is usually sensible to dampen their enthusiasm, particularly where the availability of such reliefs is one of the main motivating factors behind their decision to invest. References to dogs, tails and the wagging of one by the other should be made from the outset.

Advice to genuine 'business angels' and particularly to 'serial entrepreneurs' is perhaps the easiest, but individuals who are willing to invest in someone else's venture are few and far between. More common is the situation where a group of investors come together with a new project which they want to run between them. The earlier that advice can be given in this situation, the better because that advice will often re-shape the overall structure planned for the company.

In my experience it is by far the most common for the client to be an individual or group of individuals seeking to make an investment. It is much less common for a company looking for investors, to seek advice about how best to attract them.

The availability of enterprise investment scheme reliefs is a major incentive to investors. However, great care needs to be taken. Any promise of reliefs to investors need to be very carefully worded and hedged about with wide cautions and disclaimers. Furthermore, it is very important not to breach Financial Services Act rules concerning investment advertisements. See Box 1.

One of the main points where expectations will invariably need to be managed carefully is in terms of timing. Enterprise investment scheme applications can quite easily take three or more years before they are resolved. Clients need to be aware of this from the outset.

As always, a proper engagement letter is crucial.

Get the full facts

Having taken on a new enterprise investment scheme matter and managed the client's initial expectations, the next step is for the adviser to ensure that he is in full possession of all the facts. These should include:

• full details of the (proposed) company structure;
• proposed timing of investment;
• careful analysis of the relationship between investors and, in particular, whether any of them are associates of each other (e.g. business partners, relatives);
• full details of the exact trading which the company (plans to) undertake(s).

Informal clearance

It is invariably sensible to make an informal application for guidance from the Revenue at as early a stage as possible. Unfortunately, many clients see this as an extra expense, but they should be persuaded that it is ultimately likely to be more cost-effective getting such clearance at an early stage.

There are no formal procedures here, so a letter to the Small Companies Enterprise Centre (which is very helpful in this regard) possibly followed up by a telephone call or (in rarer situations) a meeting, is recommended. Informal clearance is vital if a brochure is being put together to attract potential investors.

The most common questions usually concern qualifying trades which are on the fringes of the definition in section 297. However, the Small Companies Enterprise Centre will often be prepared to give guidance on other matters as well, so advisers should not be reticent if problem areas are anticipated. Such guidance is invariably non-binding and will be hedged about with the usual caveats from the Revenue. Usually you will only get an answer if you specifically ask, so it is important to phrase the initial letter carefully.

Cashflow

Although often overlooked, cashflow issues can be crucial and it is vital to check that the investors will have all the funds in place at the right time. I have come across many situations where, come the day, one or more investors do not have cleared funds ready to invest.

Where this occurs, it is more than just a temporary annoyance. Sometimes the whole application can be jeopardised by the lack of proper funds:

• shares end up not properly issued or issued only partly paid;
• shares are issued on different days, potentially jeopardising earlier investors' 30 per cent limits;
• temporary loans are made from one investor to another (breaching section 299A);
• subscriptions are made on another's behalf (breaching section 291(1)(a));
• the company lends money back to an investor, resulting in a return of value.

Proper documentation

Having done the groundwork and given proper advice at the outset, everything else should slot into place with much greater ease. The next stage is to ensure that the investment process is properly documented. Three particular areas need to be watched.

Company documentation

It is vital to a successful enterprise investment scheme application to ensure that company documentation is properly prepared and completed:

• Where a new company is involved, attention should be given to this area from the acquisition of the company off the shelf. Simple mistakes at this stage, such as issuing shares other than subscriber shares or appointing the wrong first director, can be fatal. It may be worthwhile paying a little bit more for a tailored package rather than a basic off-the-shelf company.
• Board minutes must reflect accurately the way in which shares are subscribed for, allotted, and then issued. The sequence of events, and particularly the appointment of directors, needs to be watched carefully.
• Filings with Companies House, particularly form 88(2), must be properly completed, as the Revenue may well call for these in evidence.
• The company's books must be written up contemporaneously and share certificates should be issued as a matter of course.

Subscription agreement

Subscription for shares implies a formal and invariably written application for shares. At the very least, therefore, investors should complete a formal subscription letter, applying for shares and enclosing a cheque.

However, a well advised investor will almost certainly want to go further than this and ask for a proper subscription agreement. The investor, after all, may well have been enticed by the company with the prospect of enterprise investment scheme relief. In this situation, it is perhaps only fair for the company to give certain promises about matters which are within the company's control, such as:

• the proper completion of company secretarial procedures;
• the management of the application process and submission of form EIS1; and
• the conduct of the company's business during the next three years.

In appropriate cases, it may also be right for the company to give warranties and indemnities concerning these issues (see Box 2). Sadly these issues are dealt with far too infrequently.

Shareholders' agreements and/or articles of association

Many of the provisions in the enterprise investment scheme legislation refer to 'arrangements' being in place. Where such arrangements do exist, they can often lead to a denial of relief. While an arrangement for these purposes is defined as including 'any scheme, agreement or understanding, whether or not legally enforceable' (section 312(1)), the classic case of an arrangement will be provisions embodied in a shareholders' agreement or (less commonly) in the company's articles of association.

Insufficient thought is usually given to the terms of a shareholders' agreement. This is of particular concern given that the Revenue, as a standard question, will ask to see a copy of any such agreement.

There is no such thing as a typical shareholders' agreement, so it will always be necessary to analyse the exact terms of the document carefully from an enterprise investment scheme perspective. Points which may need to be checked include:

Preliminary steps:

Issue: 3838 / Categories: