EIS: Raising money outside of the seven-year basic age condition
“How to raise money pursuant to EIS if your company has been trading for longer than seven years”
Generally, the position under the Enterprise Investment Scheme (“EIS”) is that a company cannot raise EIS qualifying investment monies once it has been trading for longer than seven years (this is termed by HMRC as the “basic age condition”) and this is confirmed in HMRC’s guidance manual VCM8151).
The rationale behind this is because the EIS regime was introduced so as to encourage investment in early stage / start-up companies, and HMRC’s position (as set out in VCM8153) is that older companies (i.e. companies that have been trading for longer than seven years) are expected to access funding from the market. This is because by this stage, it is presumed that such companies will have developed a sufficient track record on which a prospective investor can decide whether or not to invest in the company.
However, there are exceptions to the basic age condition, and this in-depth blog post sets out those exceptions. At the time of writing (April 2020), this blog post reflects HMRC’s most up-to-date guidance to the guidance manuals referenced, which were all updated by HMRC on 26 February 2020.
VCM8151 states that a company will meet the basic age condition if a relevant investment is made before the end of its initial investing period.
A “relevant investment” is defined under section 173A of the Income Tax Act 2007 (“ITA 2007”) as including an issue of shares in respect of which the company provides an SEIS1 / EIS1 compliance statement (which will be the case where you have investors that wish to benefit from SEIS / EIS tax reliefs).
The “initial investing period” is the period that ends seven years after the company’s first commercial sale. Note importantly that for knowledge-intensive companies, the initial investing period is the period that ends either:
- 10 years after the company’s first commercial sale; or
- the date on which the company’s annual turnover reaches £200,000.
The “first commercial sale” is defined by reference to the European Commission’s Guidelines on State aid to promote risk finance investments. Paragraph 52(xi) of the Guidelines defines a first commercial sale as “the first sale by an undertaking on a product or service market, excluding limited sales to test the market”.
VCM8151 goes on to say that “In most cases the date of the first commercial sale is likely to be at or around the time the company starts to trade but in some cases it may be later than the date the company starts to trade. A company may use the date of commencement of trade, or the date the business was started, rather than the date of the first commercial sale for the purposes of applying the maximum age rules if it wishes. The date of commencement of trade and the date the business was started will always be a date earlier than, or the same date as, the first commercial sale. It follows that using the date of the first commercial sale provides a more generous timescale for companies able to identify that date”.
VCM8151 then provides various examples to illustrate the concept of the first commercial sale for a start-up company where the company has no subsidiaries and has never traded through a business which it acquired from another person.
Example 16 in VCM8151 provides as follows:
- “Company A is incorporated on 1 January 2015 to carry out domestic roofing work. The company’s first supply to a customer is on 31 March 2015. The company builds up its expertise and reputation and in September 2020 it wants to expand into roofing historic buildings. It needs money to engage specialist staff and buy new tools and equipment. Its first commercial sale was on 31 March 2015, less than 7 years earlier. The company meets the age condition”.
Please consult VCM8151 which contains further examples illustrating the first commercial sale.
VCM8152 provides that there are special rules to determine the date of the first commercial sale of a company where:
- the investee company (i.e. the company raising the investment monies and making the advance assurance application or submitting the EIS 1 compliance statement) is, or has been, the holding company of a group; or
- the company or any subsidiary of the investee company has acquired an established business from another owner in the past, whether or not the business is still in the ownership of the company / group at the time the investment is made.
The rules look at all the businesses of every company that has ever been a member of the investee company’s group including businesses or parts of businesses acquired by any of the companies and take the earliest possible date of all those companies and businesses as the date of the first commercial sale. In determining a company’s first commercial sale, it does not matter that it or its subsidiaries may be, or may have been, carrying on different activities.
Example 20 contained within VCM8152 provides as follows:
“Company C was incorporated on 1 February 2016. It used private investments to acquire the issued share capital of company D on 1 March 2016.
Company D’s first commercial sale was made on 1 April 2005.
Company C’s first commercial sale was therefore on 1 April 2005 and it is not eligible to receive an investment under EIS / VCT”.
You must therefore consider carefully whether or not your company meets the basic age condition before making an application for EIS advance assurance or submitting an EIS1 compliance statement.
With that being said, there are two exceptions to the basic age condition meaning that a company which is older than seven years may still be eligible under the EIS regime. The two exceptions are:
- Condition A – follow-on funding (as explained in VCM8154); and
- Condition B – investment to enter new product market or geographic market (as explained in VCM8155).
The two exceptions are expanded upon in further detail below.
Condition A – follow-on funding
If a company has received its first relevant investment (i.e. investment monies received from UK resident, qualifying investors who are expecting to benefit from EIS tax reliefs) before the end of its initial investing period, it may be eligible to receive EIS investment as follow-on funding even after the end of the company’s initial investing period under the Condition A exception to the basic age condition if:
- the funding is used for the same (“relevant”) qualifying business activities as for the first relevant investment; and
- the need for the follow-on funding was foreseen in the company’s business plan at the time the initial investment was planned (VCM8160).
So, under this exception, the company must have received its first relevant investment within seven years of its first commercial sale (i.e. within its initial investing period). Then, provided that the company meets the two requirements above, the company will come within the Condition A exception to the basic age condition and will be able to raise EIS qualifying monies even once it has been trading for longer than seven years from the date of its first commercial sale.
VCM8160 confirms the point set out in VCM8154 that the need for the follow-on funding must have been foreseen in the company’s business plan at the time of the original risk finance investment. Note further that while the need for a business plan is not specified in the domestic legislation, it is an underlying requirement of the State aid rules.
Crucially, the company is not expected to anticipate in the business plan the exact amounts or dates it will need the follow-on funding.
For example, follow-on funding may be needed only once the company has reached a certain stage. The date of that next step may not be known at the time of the initial funding except that it is likely to occur in, for example, a particular year. Similarly, the exact cost may not be known although a broad outline of the activities to be funded would be.
However, where the stages, amounts and timings are significantly different from the original business plan the company should include an explanation of the discrepancies either in the business plan accompanying the application for follow-on funding or in a covering letter.
Where the initial investment was made before 18 November 2015 the company must demonstrate that it would have met either Condition A or Condition B if those rules had applied at the time of the initial investment. Companies that received their initial investment before 18 November 2015 and would not have met either Condition A or B will not be eligible to receive follow-on investments.
VCM8160 helpfully confirms that HMRC takes a pragmatic view where a company did not include the need for follow-on funding in its business plan before 18 November 2015. The company will need to show that the follow-on funding will support the same activities as those supported by the initial investment.
Example 38 contained within VCM8160 sets out a fictional scenario in which the company in question would qualify for follow-on funding under the Condition A exception to the basic age condition. This example provides as follows:
“Company D was set up in 2015 to develop new drugs to alleviate respiratory conditions. It receives its first relevant investment on 6 April 2016, when it issues £150,000 of shares to two SEIS investors to carry out a feasibility study. The company’s business plan specifies three further rounds of funding will be needed to develop a new drug if the feasibility study is successful.
The feasibility study is successful and the company goes on to raise the additional investments through a combination of EIS and VCT funding, broadly in line with the initial business plan expectations.
The company meets condition A for follow-on funding”.
In order to meet Condition A, each tranche of follow-on funding must meet the other conditions for eligible funding (for EIS qualifying investments, please consult VCM10100 and particularly the requirements set out in VCM12000 and VCM13000 for the main conditions that must be met), including the growth and development condition (as detailed within VCM8540). The money cannot be used for a new project or for the company’s other business activities.
There is no need for the initial relevant investment to have been made under the same scheme as the follow-on funding. For example, the initial relevant investment could be for £150,000 under the Seed Enterprise Investment Scheme (“SEIS”) and follow-on funding could be any combination of EIS and VCT investments.
Where a company has received an initial risk finance investment and part of its activities funded by the investment have subsequently failed, the company can still obtain follow-on funding under Condition A for the remaining activities.
However, follow-on funding may not be used for activities that differ from those for which the initial funding was used. If the company needed funding for a new activity it would need to meet the basic age condition or Condition B (explained below) in respect of those new activities.
For the EIS only, if a company (“Company 1”) that has received funding before the end of its initial investing period or under Condition A is later acquired by a new parent company (“Company 2”) under a share for share exchange within the terms of section 247 of the ITA 2007, Company 2 can raise funds under Condition A provided that:
- the need for follow-on funding was foreseen in the business plan for Company 2; and
- the money raised by Company 2 is used for Company 1, and for the same business activities as the earlier funding.
Condition B – investment to enter new product market or geographic market
As explained briefly above, generally, a company that has not received a risk finance investment before the end of its initial investing period is not expected to be subject to a market failure within the State aid guidelines as it should have developed a sufficient track record by that stage so as to access finance. It will have had many years to establish itself and have a track record to show to commercial investors who may be interested in investing in the company to support its ongoing growth and development.
However, in certain specific circumstances, some companies may decide to pursue significant new business activities that are so different from their existing business activities, and require disproportionately more investment compared with the company’s normal activities, that potential investors cannot rely upon the company’s existing track record to determine whether the investment is likely to be successful. Potential investors will have to carry out extra due diligence to reassure themselves of the viability of the investment.
This situation may also apply when a company that has previously received relevant investments for certain business activities decides to change direction for which follow-on funding is not available.
In these situations, an investment may be eligible for relief under the EIS where a company needs the money for the purpose of entering a new geographic market or a new product market.
This exception to the basic age condition does not apply to companies that are growing and developing by carrying out incremental changes, where each change can be funded through smaller amounts of investments and where investors can continue to rely upon the company’s track record to date when carrying out due diligence.
This condition does not allow companies older than seven years to access tax-advantaged funding for their existing activities, even if this would contribute to the growth and development of the company. All the money raised under this exception must be spent on the new activities, otherwise none of the investments will qualify for EIS relief.
The following conditions must be met if an investment in an old company (i.e. a company that has been trading for at least seven years since the date of its first commercial sale) to support a new and significant activity is to qualify under the EIS rules:
- the amount of the relevant investment, together with any other relevant investments made within a 30-day period, must be at least 50% of the company’s average annual turnover, averaged over the previous five years (“the 50% turnover test”); and
- the money must be used for entering a new product market or geographic market (or a new product market and a new geographic market).
Each new business activity must satisfy the 50% turnover test. A number of smaller unconnected initiatives cannot be combined in order to meet the 50% threshold.
All the money raised must be used for the new activity. If the new enterprise fails before the money is spent, the investment(s) will not be eligible for tax relief. The money cannot be recycled for use on other business activities. It follows that companies should be careful not to raise more money than they know they will spend on the new activity.
The 30-day period
HMRC’s rules consider the amount of relevant investments made in the company over a 30-day period, which provides some flexibility for a company that is assembling a pool of relevant investments from different investors where it may not be possible to process all of the investments on the same day.
VCM8156 confirms that for a specific relevant investment to be eligible for EIS, the relevant investment must be made within a 30-day period during which the total amount of all relevant investments made in the company is at least 50% of the company’s average annual turnover amount (explained in further detail below).
Note that it is up to the company and its prospective investors to agree the timing of investments.
VCM8156 contains useful examples to illustrate how the 30-day period works. Example 26 in VCM8156 states as follows:
“Company A made its first commercial sale in 2000 and has never received a relevant investment. It is seeking investments of £750,000 to finance entry to a new geographical market. Company A’s average annual turnover is £1 million. There are three potential investors, individuals B, C and D, all of whom wish to claim EIS income tax relief.
If individual B invests £150,000 on day 1, at least £350,000 must then be invested by individuals C and / or D by day 30 in order for the investment to qualify for EIS relief (£150,000 plus £350,000 will equal £500,000 which would match 50% of Company A’s average annual turnover). This will also mean that the investments made by C and / or D are also qualifying”.
Average annual turnover
There are special rules to calculate the average annual turnover of the company. The rules are designed to take the average of the turnovers of the company for the five-year period ending with the date of the company’s most recently filed (and audited, where appropriate) accounts.
Apportionments may be needed where accounting periods are less than a year, or the company is the parent of a group and the accounting periods of subsidiaries are not aligned or where the company or group has failed to file its accounts within the statutory time limits.
If the accounting date of a subsidiary or acquired business does not align with the parent company’s accounting date, the turnovers must be apportioned to align with the parent’s accounting dates.
If only part of a business is acquired the amount of turnover to be taken into account as a proportion of the whole business is determined on a just and reasonable basis, depending on the individual circumstances of the case.
If the relevant company has not filed its accounts by the statutory filing date the five-year period ends 12 months before the date of the investment. However, a company may elect to use the period ending 12 months before the date the investment is made, to apply to all investments made in the company before 6 April 2016, under new rules introduced by the Finance Act 2016.
The most recent accounting period is the accounting period with the statutory filing date that falls most recently before the date of the investment. The statutory filing date is the date by which the accounts must be filed with Companies House and falls nine months after the end of the company’s accounting period.
The period of five years is then determined by reference to the end of that accounting period.
VCM8157 sets out some examples relating to the average annual turnover. Example 28 in VCM8157 provides as follows:
“Company F made its first commercial sale in 2000 and has never received a relevant investment. It is seeking investments of £750,000 to finance entry to a new geographical market. Company F’s average annual turnover is £1 million and it has always made up its accounts to 31 December.
Individual G invests £750,000 in company F on 1 November 2016.
Company F’s most recent filing date before the date of the investment is 30 September 2016. The filing date relates to the accounts for the year ending on 31 December 2015.
The five-year period over which company F’s turnovers must be averaged is 1 January 2010 to 31 December 2015.
Where a number of investments are being made over a period of up to 30 days the filing date will be the most recent filing date in relation to the investment that clears the 50% hurdle”.
New product market or new geographic market
As detailed above, the money raised under the 50% test must be used for entering a new product market or new geographic market. VCM8158 provides additional detail as to what is meant by a new product market and new geographic market.
A product market means all those products and / or services which are regarded as interchangeable or substitutable by the customer, by reason of the products’ characteristics, their prices and their intended use. It is not the same as a new product, and relates more to the customer base.
A geographic market means the area in which the company is involved in the supply and demand of products or services, in which the conditions of competition are sufficiently similar and which can be distinguished from neighbouring areas because the conditions of competition are appreciably different in those areas. Entering a new geographic area is not on its own the same as entering a new geographic market.
Whether a company is entering a new product market or geographic market will depend on the precise circumstances of the company – namely, what it has done in the past and what it is intending to do in the future. The company will need to explain in detail as part of its application what it has been doing (and where), what it will be doing (and where) and why the new activity means it is entering a new product market or geographic market.
The venture capital schemes are intended to address the market failure caused by the difficulties that smaller, unproven companies face in trying to access finance, particularly the lack of financial and performance information available to potential investors. The schemes target the market failure where investors are unwilling to invest owing to the relatively high cost of due diligence.
The key issue for the Condition B exception is when a company is entering a new growth phase, and whether its previous track record can be used to assess the potential of its new activity for investment purposes. Condition B is for use in situations where a company is entering a new product market or a new geographic market, which is analogous to the setting up of a completely new business, with no relevant track record that can be used by investors. It is not intended for instances where the company is growing incrementally.
The scale at which the new market is defined will also vary depending on the specific circumstances of the company. For example, a Manchester-based business which only sells products to passing trade will not meet the ‘new geographic market’ test just by setting up a second branch in Leeds unless it can be demonstrated that the conditions of competition for its products differ between the two cities. Similarly, a company which currently serves a UK market which is seeking to expand into both Germany and France may be considered to be expanding into one new European market or two new separate markets or none, depending on the conditions of competition that relate to its particular activities.
Factors that HMRC will take into consideration include the nature of the competition within the new geographical area(s) compared with the competition within the company’s existing geographical areas.
The investment must be made before the company embarks on the new business activities. The test is the extent to which the company has already started activities for the purposes of entering a new product market or geographic market or not. This is different from the approach taken to determine a company’s initial investing period which relies on the date a company has made its first commercial sale. A first commercial sale may take place after a test sale.
For example, test sales may be for proof of concept only or for seeking feedback rather than generating revenue. They may be at prices that are at or lower than cost, or in very specific areas in order to test the response from a particular type of customer. An equivalent for an app might be a private beta test.
By contrast, if a company has already taken definite steps to enter a new product market or geographical market, for example by setting up processes and delivery chains to allow it to deliver products at scale, the company will have taken sufficient steps for commercial lenders to evaluate whether the activity would be viable, bearing in mind the company’s previous business track record.
Ultimately it will be a matter of fact as to whether a company’s previous activities in a new market are materially significant. Factors to consider include, but are not limited to:
- the amount of activity already carried out by the company in the new market: the more activity carried out, the less likely the company is to be preparing to enter a new market;
- the length of time those activities have been carried out for: the longer the company has been investigating the market, the less likely the market is to be new to the company; and
- the amount of money already expended in the new market as a proportion of the amount of the investment sought: the more money and resource expended before the relevant investment is received, compared with the amount of the proposed investment the less likely the market is to be new.
The factors above are for illustrative purposes only. Other factors may also come into play depending on the exact circumstances of the company, its history and its past and future activities.
Example 33 in VCM8158 provides as follows:
“A company making bespoke shoes for its customers in the UK, selling for more than £5,000 a pair, wants to expand its activities and enter the US market by offering a range of ready-made shoes. The shoes would still be high quality but would retail for less than £500 a pair and, unlike the existing bespoke products which are sold direct to the end user, would be sold wholesale. The company wants to test the appetite of US retailers and commissions another company in Europe with the appropriate machinery to produce a limited run of 500 pairs of a single style of shoes.
The company visits a number of high end shoe retailers in the US with the product. The retailers take the shoes on a sale or return basis and report their findings to the company. On the basis of the sales achieved the company decides to enter the US market. It buys new equipment and takes on staff to make the shoes itself, and advertises its new product line to stockists in the US.
The sales of the 500 pairs of shoes were test sales designed to understand if there would be a viable market for the shoes. The company is entering both a new product market and a new geographic market at the point when it decides to manufacture the shoes and advertises its product”.