Budget reaction, what is the effect on EIS and the VC market?

The headline is hugely positive for EIS as there will undoubtedly be more demand for EIS but a possible reduction in total funding in UK VC which may cause problems down the line...

How does OnePlanetCapital (an active EIS and SEIS investment manager) focusing on climate tech see the sector playing out.

1) VCT's will become less attractive investment vehicles. We do not know the result on demand but last time the income tax relief was cut from 40% to 30% inflows dropped ~60% year on year and took 16 years to recover to previous levels.

2) Some of these investors will look towards EIS as an alternative, not all, but some will. We will see an increase in demand and total market funding from EIS - partly due to VCT becoming less attractive but also more tax planning opportunities for EIS planning due to changes to the last few budgets and fiscal drag (see below)

3) There will likely be a reduction in total funding in the market & recalibration of valuations. 

We will likely see a drop in valuations from typical 'VCT funded businesses' as there will be less investment in this space and funding becomes more competitive. We think there will be a recalibration of valuations in the space as there will be more money supply in EIS funding and less in VCT. Whilst there is some crossover and the limits are the same for both vehicles, typically EIS supports lower value / earlier stage businesses and VCT slightly later stage due to their sizes.

4) We will see EIS company valuations rise in the next 2 / 3 years due to more demand and investment in the space which will in turn increase company valuations. 

5) Changes on investment limits. Whilst this is generally good news that these schemes can support larger and later stage businesses, as Reeves puts it 'supporting a scale up economy' I can't help but think this is a red herring. 

In a vacuum this means EIS and VCT have become 'less risky' by being able to invest in larger more mature companies, however typically EIS funds target an earlier stage market compared to VCT. It feels like most EIS providers this new change will not affect investment thesis as they tend to invest well below these limits anyway. Whilst VCT may benefit from this change there will be less funding in this space from 2026... which I feel may defeat the purpose of 'supporting a scale-up economy'

I can't help but think of the 'cobra effect' in action here, a parable of unintended government actions;

- The British government in colonial India was concerned about the large number of venomous cobras in Delhi.

- The solution: They offered a bounty, or a reward of money, for every dead cobra brought to them.

- The plan worked at first, with many dead cobras being turned in. However, some people began to breed cobras to sell for the bounty.

- The final result: When the government realized what was happening, they ended the program. The cobra breeders, no longer able to make money, released their cobras, leading to an even larger population of wild snakes than before.

Reeves wants to support a scale up economy but has pushed more funds into EIS and start-ups with these changes to VCT and less into typical scale ups. 

Why has Reeves done this?

Reason 1: Increased tax receipts? By reducing the attractiveness of VCTs the government can save on income tax relief. If we take last year's number of VCT funds raised, £873m and assuming a similar drop to last time the rate changed (60% reduction) is an income tax saving of £175m, which is a rounding error for a national budget. (This also assumes none of these funds flow into pensions or EIS which is unlikely) Also does not take into account the huge upside HMRC receives in the result of these funded businesses. Very short sighted.

Reason 2: To recalibrate the risk vs return profile of EIS and VCT. I think this is the core reason. VCT certainly are more stable, less likely to totally fail and generally fund later stage businesses than their EIS peers. I do think it fair that they have a different 'reward' profile.

What do we think should / will happen?

EIS and VCT, although they have similarities, behave and operate very differently for many reasons and provide vastly different investor outcomes. I think there should be a distinction in the investor limits for both vehicles with EIS supporting start ups and VCT supporting later stage scale ups. This provides a clear distinction in risk profile for clients and advisers and should come with a different reward and tax profile. 

Both of these spaces are important to a healthy economy and ultimately generate a positive net outcome for UK GDP and tax receipts. Instead of disincentivising VCT investment she should leave that at 30% income tax relief and instead increase EIS tax relief to 40% to better reflect the risk of start-up vs scale up investing.