Last year saw a record number of new UK businesses formed suggesting the start-up revolution shows no sign of ending anytime soon. Should investors tap into the growing trend?
Small businesses made up more than 99% of the UK’s private sector organisations last year, employing over 16 million people, according to the Federation of Small Businesses. The number of small businesses (along with their associated employees) is growing rapidly year-on-year.
This is, undoubtedly, in part due to the rapid advancement of the digital world where it is now easier than ever to be connected to clients and colleagues remotely. Far from being a fashionable fad, shared offices and temporary workspaces have become a major force in recent years as firms seek more flexible office arrangements that don’t tie them into long-term leases.
While the Brexit ‘deal or no deal’ negotiations amble on, Britain’s newest entrepreneurs seem unperturbed and are building their own futures and creating jobs too.
However, despite the importance of small companies to Britain’s economy, early-stage companies often struggle to get funding for their future growth from traditional lenders. Venture Capital Trusts (VCTs) are helping to solve this problem by connecting young firms in need of funding and guidance with investors looking for a higher risk/reward strategy in a tax-efficient structure.
As it stands, UK fund managers can only invest up to 10% of their portfolio in unquoted businesses. Indeed, even open-ended UK small-cap funds mainly focus on listed stocks. This limit exists to protect investors from the risks associated with start-up companies. These stocks can undergo a change and volatility at the early stage of their development and are not able to provide prospective investors with the same level of financial and operational information as larger, listed companies.
VCTs offer a compelling opportunity for those willing to take on the higher levels of risk associated with early-stage investing in exchange for the potentially higher returns they can offer. The specialist trusts use a closed-ended private equity investment style to create a portfolio of holdings centred around unquoted firms. The UK government also grants generous tax incentives to VCT investors as a further bonus for funding the country’s entrepreneurial spirit.
Numerous rules dictate what VCT’s can invest in. For example, to qualify for VCT investment, a business must have fewer than 250 employees, gross assets of less than £15m, and must usually be no more than seven years on from its first commercial sale. Furthermore, no more than 15% of a VCT’s total funds can be invested in any one company, spreading risk and ensuring diversification for end investors.
Adapt and grow
Aside from the tax incentives provided by a VCT, a good reason for buying young growth stocks is the opportunity for significant returns. Small organisations may lack the liquidity of their larger counterparts, but it is much easier for smaller firms to double business and become an acquisition target or instead start paying a dividend.
By their nature, small firms are also flexible and nimble so are able to quickly respond to market trends, adapt their offerings accordingly and offer something genuinely different to larger peers, which are often restricted by static, complex business models.
Start-up successes include writer, TV host, model, and fashion designer, Alexa Chung’s eponymous clothing brand. The business is taking the fashion world by storm with a creative take on basic garments which it refers to as ‘daily luxuries’. Another example in this space is Heist, which is reinventing the bodywear industry with its range of luxury, seamless tights which have been winning plaudits across many of the foremost fashion and lifestyle magazines.
Likewise, technology firm Blaze has taken on the cycling and mobility market. Its flagship ‘Laserlight’ is a front light for bikes that tackles the blind spot by projecting the symbol of a cyclist down onto the road ahead of the bike, preventing drivers ahead from turning across their path. This technology has now been adopted by all of the 12,500 rentable bikes in London and they are also in the Citi Bikes in New York. The devices also collect data from the bikes and Blaze is developing more ‘smart’ fleet technology for bikes. It also ships consumer cycle lights around the world.
There are of course risks to investing in young firms but quality VCTs, mitigate these by building a team with vast sector-specific investment experience to select the best opportunities. These investment calls are backed up by significant due diligence to ensure valuations are appropriate. A good VCT provider will usually continue to work with its investments to increase their chances of success – often through board representation and use of their network of contacts.
Andrew Wolfson is managing director of Pembroke VCT