We Need to Talk about the Economy: Why It’s a Good Time to Invest in Startups.

Times of economic uncertainty can present challenges for investors, but also opportunities.

It’s a good time to look for investment opportunities that are as tax optimal as possible, particularly for higher-rate taxpayers. But which are the better tax-efficient investments to look at during an expected economic downturn, and why? Read on and we’ll look at some possible approaches.

Investing in startups?

In times of economic slowdown, the public markets can quickly become turbulent. For a number of reasons, which we’ll look at shortly, this means private investments like startups can be a comparatively stable place to put your money. Because they are not actively traded, they are in large part immune to the fluctuations of the stock market. That might seem counterintuitive given the high-risk nature of startup investing, but small businesses can often grow, if not flourish, during a recession in ways that larger companies can’t.

Good companies are built to solve problems

Many small businesses are built to address a problem. In many cases, these problems become more pronounced during periods of economic difficulty. Businesses go looking for tech to cut their overheads by, for example, connecting directly to suppliers and cutting out the middleman, optimising their energy efficiency, or looking for ways to address chronic health issues in their workforce. Individuals turn to the latest job seeking apps to find work, and look for ways to reduce their outgoings. Often, startups provide the solutions people are looking for, and an economic downturn just means more people need problems solving.

Startups can adapt more quickly to market conditions

The survival of small businesses often necessitates a flexible approach to market conditions, and thankfully their small size means they are often able to make changes in strategy quickly. The ability to pivot, refocus on new customer priorities, downsize teams or workspaces as necessary means that they’re well-placed to handle an economic downturn.

Immediate and significant tax benefits

Investments in small businesses are long term investments and by the time some of the startups in your portfolio achieve an exit, there’s a chance that any market downturn will have started to right itself again. However, you will still be able to reap some rewards – such as 30% income tax relief – as soon as you invest, depending on the product you’ve chosen (EIS, VCT etc), but mainly in the form of tax benefits, tax deferral options and in some cases, dividends.

Many startups are still in the product development phase and so aren’t as reliant on sales

While some startups do rely on sales revenue to keep the lights on, many secure investment on the basis of a product that is still in development and do not need to make sales to stay afloat. During a recession, these companies don’t need to worry about the impact of market conditions on demand and pricing, but can just get to work making their product and getting ready for launch when conditions are more favourable for sale.

Startups can actually capitalise on some aspects of recession, such as greater availability of quality talent

During a recession, as larger companies look to reduce costs by cutting staff, more high-quality talent becomes available for startups to draw on. Goods from vendors may be available at reduced prices as other businesses look to remain competitive. Finally, there’s a chance that established competitors close their doors, making way for the next generation as customers look for new providers.

What’s the best way to invest in startups?

In times of recession, the preferred approach should be indirect investment, where you invest through a professionally managed fund (instead of buying shares directly in individual startups). In the UK, this means investing into an EIS or SEIS fund, or a Venture Capital Trust (VCT). Keep in mind, all investments in startups are high risk.

EIS Funds

Annual investment limit: £1m (£2m if companies are Knowledge Intensive (KICs).

Tax benefits: 30% income tax relief, capital gains tax relief & deferral, inheritance tax relief, loss relief.

How does it work?

The Enterprise Investment Scheme (EIS) offers tax incentives for investing in startups. An EIS fund makes investments into companies that it chooses, building you a portfolio. Each company in your portfolio is considered a separate investment with its own EIS documentation that you can use to claim tax benefits when you file a tax return. Returns are generated for investors when companies are bought by larger businesses, known as an exit.

Why should I choose this?

Generous tax benefits, diversification across multiple companies.

SEIS Funds

Annual investment limit: £100,000

Tax benefits: 50% income tax relief , capital gains tax relief & deferral, inheritance tax relief, loss relief.

How does it work?

Similar to EIS, the Seed Enterprise Investment Scheme (SEIS) incentivises investments made even earlier in a company’s life cycle, so the risks are higher, but so are the potential returns.

Why should I choose this?

Excellent tax reliefs, albeit with even higher risk and a lower investment limit.

VCTs

Venture capital trusts are listed companies run by fund managers who are usually members of larger investment groups. These professionals spread the risk of investing in early-stage companies by investing in a portfolio on your behalf.

Annual investment limit: £200,000.

Tax benefits: 30% income tax relief, capital gains tax exemption on shares, any dividends are tax free.

How does it work?

Unlike EIS, you do not become a shareholder in the individual private companies when you invest with a VCT, rather, you become a shareholder in the VCT. You receive any returns the VCTs investments generated in the form of tax-free dividends.

Why should I choose this?

If the portfolio performs well, there is a chance of consistent, tax free dividends that can provide a source of regular income. Because the shares you own are in a listed company, they are easier to sell than shares in private companies.