Venture capital trusts: what are they and how do they work?

Venture Capital Trusts (VCTs) remain an appealing prospect to investors in the UK.

Introduced by the UK government in the mid-1990s, they encourage entrepreneurship by facilitating investment in local private businesses.

They also offer a myriad of benefits to investors, including generous tax reliefs.

But is investing in a VCT right for you? 

There’s no hiding from the enduring popularity of VCTs. In the 2021/22 tax year, they raised £1.13 billion.

And conceptually, there’s a lot to like; they encourage entrepreneurship, and there are opportunities for big returns. But investment in small companies is volatile, and therefore inherently risky.

So, before investing in a VCT, it’s important to be aware of how they operate and whether your investment profile fits the bill.  

What is a VCT?

The UK government created the VCT scheme in 1995 as a way of directing investment to local private businesses.

Recognising the risk involved compared with investing in larger, listed companies, like Shell or Barclays, the government introduced VCTs with the promise of large tax reliefs.

These remain in place today, with some VCTs offering up to 30 per cent upfront income tax relief, tax-free dividends and exemptions from capital gains tax on any shares that rise in value.  

There are different types of VCT, depending on their investment focus, but they all operate on the premise that they invest in small, entrepreneurial businesses.

This can range from tech start-ups to new clothing brands, and some real success stories have come out of VCT investment.

The likes of Gousto, Zoopla and Graze are all VCT-backed companies, but HMRC imposes strict criteria for a company to qualify for VCT funding.  

How do VCTs work? 

Since their inception, VCTs have raised more than £8.7 billion.

But how do they work?  

VCTs operate in a similar way to a standard investment trust. They are listed companies in their own right, and use money pooled together from investors to buy stakes in VCT-qualifying companies.

If you invest in a VCT, that is where your shares lie, rather than in the underlying companies that the VCT invests in.

So, if you invested in MMC Ventures, a VCT that backed Gousto, your shares would lie in MMC Ventures itself, rather than Gousto.  

Once you have invested in a VCT, you’ll receive a share certificate along with a tax certificate that allows you to claim the 30 per cent upfront income tax relief.

The VCT limit on investment is £200,000 per tax year. While you could theoretically invest more, anything over this sum would not qualify you for tax benefits.

A minimum investment, meanwhile, is generally around £5,000.  

Types of VCTs 

There are different types of VCTs, but they must all comply with a set of regulations to benefit from the government scheme.

A VCT must: 

• Be listed on a UK-recognised market, such as the London Stock Exchange 
• Publish its own annual report and accounts 

• Have an independent Board of Directors to look after the interests of shareholders 
• Hold general meetings for shareholders, including an AGM 
• Meet standard corporate governance policies 

The varying focuses of VCTs are the best way to differentiate them. They can be Generalist, AIM, or Specialist.  

Generalist VCTs are the most common, with around three quarters sitting in this category. They invest in companies spanning a range of sectors, and in doing so diminish risk through diversification.  

AIM VCTs exclusively invest in shares issued by AIM-quoted companies.

AIM — the Alternative Investment Market — are often small companies or start-ups that either can’t or do not wish to meet the demands and listing requirements of the main stock market.  

Specialist VCTs will tend to focus on just one sector, like tech or healthcare.  

Tax relief and VCTs 

One of the most appealing aspects of investing in a VCT is the various tax incentives that come attached.

This way, investment in smaller companies, which is inherently riskier, is balanced out by the attraction of tax breaks — which come in several forms: 

• Income Tax: As an investor, you’ll be awarded income tax relief of 30 per cent for up to £200,000 of your annual investment. It’s important to note that you must have held your VCT shares for at least five years to receive this benefit  
• Capital Gains Tax: You won’t need to pay any Capital Gains Tax on the sale of ordinary shares in VCTs, and this is applicable to both previously owned shares and any new shares you may purchase 
• Dividends: You will not need to pay any income tax on dividends from ordinary shares in VCTs

Investing in VCTs 

The appeal of VCTs does not end at tax relief, though. Yes, it’s an investment that comes with risk.

But with great risk comes great reward, and VCT investment can offer enormous growth potential.

Investing in smaller companies can be volatile, but they tend to grow much faster than larger, listed companies.

A VCTs investment offers an immediately diverse portfolio and a great gateway into a multitude of sectors.  

Buying and selling VCT shares 

Investing in VCTs can come in two forms: buying shares in new offers, or buying shares on the secondary market.

The former takes place when a VCT periodically looks to raise funds through subscription offers, something that closes once a fundraising target is met or a deadline is closed.

The latter sees investors looking to buy VCT shares without the benefit of tax relief. Although this is a notable drawback, shares on the secondary market are often offered at a discounted price, and retain the benefits of tax-free growth and tax-free dividends.  

But what about selling VCT shares?

Since they are less liquid than mainstream investments in larger companies, selling them on the open stock market will tend to return a lower share price.

VCT managers will occasionally offer a buy-back of shares, usually at around a five to ten per cent discount, but this is usually a better offer than selling shares on the open market.

You’ll also need to use a stockbroker or investment manager to sell your shares, so may incur additional transaction of processing charges.

Remember also, that you need to hold onto your VCT shares for at least five years to be eligible for the full tax relief — and if you sell up and then reinvest within six months, you may incur further restrictions.  

With so much volatility and propensity for losses, inexperienced investors should be wary of VCTs. There are certainly plenty of benefits, but equally, there are risks that could end up being detrimental to your investment portfolio.  

It’s always beneficial to get expert advice before making big financial decisions.

Investing in VCTs is an area that requires genuine expertise to navigate effectively — so let Unbiased match you with your perfect financial adviser today.