Deconstructing Britain’s Helping Hand for Entrepreneurs

With no money left in government coffers, the “only strategy” for growth is to get behind Britain’s entrepreneurs, U.K. Prime Minister David Cameron told his party’s spring conference earlier this year.

Declaring war on the “enemies of enterprise” and pledging his allegiance to “go-getters,” he vowed that the 2011 Budget, passed on March 23, would be the “most pro-growth this country has seen for a generation.”

“The spark of initiative. The courage to make your dream happen. The hard work to see it through. There’s only one strategy for growth we can have now and that is rolling up our sleeves and doing everything possible to make it easier for businesses to grow, to invest, to take people on,” he said.

He didn’t disappoint. Simon Clark, a partner at Fidelity Growth and chairman of the venture committee of the British Venture Capital Association, says: “An entrepreneur in the U.K. now pays lower tax than an entrepreneur in California on the first $20 million they make. Tax breaks for angel investors are probably now the best in the world: these are important.”

He adds: “But the biggest thing is the overall tone from the chancellor and prime minister saying ‘startups matter, we’re focused on this and we’re going to stay focused on this.’ It’s very encouraging.”

Among the key measures of Britain’s Budget include a doubling of entrepreneurs’ relief to £10 million ($16.3 million), despite it having already been increased from £2 million ($3.3 million) to £5 million ($8.2 million) in the Emergency Budget in June 2010 (just after the Conservative-Liberal Democrat coalition came to power).

Another component of the Budget is a reduction in corporation tax, taking it from 28% to 23% by April 2014.

And there was a significant boost to the Enterprise Investment Scheme (EIS). Tax relief was increased from 20% to 30% on April 6, bringing the EIS into line with Venture Capital Trusts (VCTs). Further changes—to investment limits and the allowable size of investee companies—will come into force next year.

Generous Hand to Companies

Sweeping changes to the EIS saw George Osborne, Chancellor of the Exchequer of the United Kingdom (who is responsible for all economic matters), deal a “very generous hand to British companies involved in creating wealth through innovation,” according to Julian Hickman, a partner at London-based Longbow Capital, a health care investor.

While raising the rate of income tax relief on subscriptions made it into the chancellor’s Budget speech, changes that also impact VCTs were buried in supporting documentation.

Both the EIS and VCTs will see an increase in their universe of potential investee companies to those with up to 250 employees, up from 50 full-time employees, and gross assets of £15 million ($24.5 million), up from £7 million ($11.4 million), beginning on April 6, 2012. In addition, next year, companies can take up to £10 million of financing in a year, a sharp increase from the £2 million allowed under present rules.

“The number of businesses that will be able to benefit from [changes to the] EIS and VCTs will increase dramatically,” Hickman says. “The Budget has put VCTs and EIS back where they belong: enabling private investors to get behind British innovation and allowing more companies, not just startups, to benefit from tax-efficient investment.”

Alex Macpherson, head of early stage investments at Octopus Investments, says the current limits mean companies often delay or miss expansion opportunities.

“We want to see the U.K. produce really big businesses and provide the finance to enable this to happen,” Macpherson says. “All too frequently our successful ground-breaking businesses are sold early in their life when they could have developed to be £1 billion businesses.”

The rule changes should also revitalize the AIM marketplace, which has been “devoid of new cash,” Macpherson says. “Enabling businesses to come to market and raise new funds provides a further step on the growth path. For the right businesses, this is a very attractive source of funding.”

However, with many of the measures not coming into force until next year, Barry Murphy, a tax partner at PricewaterhouseCoopers, says that the “impact is less immediate than desired.”

“The delay is perhaps inevitable, but businesses hungry for investment will be counting down the days,” he says.

Rewarding Private Investors

Charles McIntyre

, a partner at IBIS Capital, a London-based media investor, says that the measures will help to address the shortage of capital for smaller companies, at the same time that it shows that the government “understands that private investors need to be encouraged and rewarded if they are to take on higher investment risks and supply capital to smaller companies.”

A growing number of investors are flocking to venture schemes, particularly in light of the introduction of a new top rate of income tax in Britain in April 2010.

With the highest rate of income tax now 50%, interest in schemes which attract income tax relief has grown and there are a number of VCTs currently raising money, says Jason Hollands, head of corporate affairs at F&C Investments.

“The changes will enable VCT managers to do more substantial deals on bigger businesses than available at the moment, widening the universe of potential investments,” Hollands says. “This is welcome news for investors.”

Investors will not only benefit from 30% tax relief on EIS and VCTs, but the amount that can attract upfront tax relief and be sheltered in an EIS will double to £1 million after April 6, 2012, giving a maximum income tax saving of £300,000 ($489,822). The Treasury estimates this will cost £450 million ($734.7 million) in lost tax revenue. The most that can be invested into VCTs will remain at £200,000 ($326,524) a year.

“Increasing tax relief has slashed the effective cost of investing in EIS growth businesses,” says David Mott, investment director at Oxford Capital Partners. “The opportunity to invest in a well-diversified portfolio of EIS businesses has never been more attractive.”

Boost for Entrepreneurs

Some gains from business disposals are liable to capital gains tax (CGT) at just 10%, compared with 18% for basic-rate taxpayers and 28% for everyone else, thanks to entrepreneurs’ relief, introduced in 2008.

Relief will now be available on gains of £10 million, equating to a reduced CGT liability of £1.8 million ($2.9 million) per entrepreneur, says Greg Limb, a partner at accounting firm KMPG. “This is over 20 times higher the value of this relief [on April 5, 2010], fantastic news for those who qualify.”

Macpherson at Octopus hails the move “significant,” given that entrepreneurs who earn liquidity from exits tend to re-invest gains into new business initiatives.

“Entrepreneurs recycle their gains by either developing new businesses themselves or as business angels where they can add both their financial capital and considerable knowledge, mentoring and assisting the teams they then back,” Macpherson says. “A continuous self-fulfilling cycle of investment and growth can be created.”

However, many entrepreneurs and business owners remain ineligible, Macpherson notes. To qualify for entrepreneurs’ relief, you must hold at least 5% of the share capital of the company. “There remains a slightly ridiculous situation whereby an employee with 4.9% of the businesses on exit could pay 28% CGT, whilst those with 5% or more pay 10% on the first £10 million of gain,” Macpherson says.

“This would appear to penalize those who join entrepreneurial businesses and work to help facilitate their growth. Often these people are the second or third most senior in an organization and are the people who become inspired to strike out on their own to create a new business.”

Britain for Business

Three-quarters of firms polled by PricewaterhouseCoopers believe the measures make Britain a more attractive place to do business, compared with 19% that said so after the 2010 Emergency Budget.

A separate poll by Investec Corporate and Institutional Treasury, which is part of Investec Bank, shows that 53% of senior executives feel the Budget has done enough to enable British businesses to grow over the coming year. They rate the 2% reduction in corporation tax this year as being the most effective initiative, followed by the promise to strip out £350 million ($571.5 million) of business regulation and raising the EIS and VCT qualifying company limits.

The cut in corporation tax arguably has the least effect on small high-growth businesses as the cash they generate is often reinvested to maintain growth rates. However, it will enable larger, more established businesses to build reserves and be in a position to make acquisitions, Macpherson says.

“It will create the general environment for business and reverse the disturbing trend of large businesses, such as WPP, relocating abroad,” he says. “It encourages a culture of enterprise and entrepreneurialism in the U.K., which is definitely welcomed.”

A week after the Budget, the government launched “StartUp Britain,” backed by such corporations as Google, Barclays and Virgin Media. The program will offer new businesses £1,500 ($2,449) worth of vouchers for IT, online advertising and similar services. More information is available from the website at www.startupbritain.org.

“The most important thing is to encourage people who have the ability and passion to startup businesses,” says Clark at Fidelity Growth.

Per Larsen, director of Huddlebuy.co.uk, a group buying website for businesses that is backed by Alex Chesterman, co-founder of LOVEFiLM and Zoopla, hopes it will prove an invaluable resource.

“StartUp Britain should be a useful resource for entrepreneurs, and the people backing the initiative have impressive credentials, but I hope this doesn’t just become an online library of articles and links,” Larsen says.

“If the brains behind it use their experience to advise the government, politicians could have an impact on the overall business environment. There’s a huge amount of business knowledge out there and anything which brings all this knowledge together to benefit the small companies that need it the most is welcome.”

Problems Persist

All that said, only 28% of those surveyed for PricewaterhouseCoopers are confident that the chancellor’s plans to bring the country’s deficit under control are realistic and achievable, compared with 60% who thought so last summer.

The Office for Budgetary Responsibility downgraded U.K. growth predictions for 2011 from 2.1% to 1.7% and raised its forecast for inflation, warning that the worsening trade-off between growth and inflation would hurt tax receipts. The dire forecast means the government will borrow a total £43.4 billion ($70.9 billion) more by 2015-16 than previously planned.

Despite that, Chancellor Osborne raised growth forecasts for 2014 and 2015 to just under 3%—at the top end of pre-crisis estimates of Britain’s long-term sustainable rate of economic growth.

Economic and political commentators express doubt. “The Budget was clearly directed towards business with the intention of shoring up support from the market towards the government’s strategy and it appears to be well received,” says Michael Portillo, former chief secretary to the Treasury.

“However, growth figures for 2011-12 were disappointing and inflation figures pose problems for future levels of public spending,” Portillo says. “Higher growth forecasts for 2014 should be taken with a pinch of salt. It looks as though we’ll be facing several years of sluggish growth.”

BUDGET AT A GLANCE

Beginning April 6, 2011…

• Entrepreneurs’ relief doubled to £10 million

• Small firm R&D tax credit increased to 200% of qualifying expenditure

• EIS tax relief raised from 20% to 30%

Beginning April 6, 2012…

• EIS investment limit doubled to £1 million

• Ability for EIS and VCTs to invest in bigger companies

• R&D tax credit increased to 225% of qualifying expenditure

By April 2014…

• Corporation tax cut from 28% to 23% (falling by 2% in 2011 and 1% every year thereafter)