Explanations of venture capital funds (VCTs).

Smart investors will always be on the lookout for the next breakout stock, and venture capital trusts (VCTs) offer a way to support small UK businesses with high growth potential.

However, with the prospect of high returns comes high risk, so VCTs also offer generous tax benefits as an additional incentive – as long as you stick to the rules.

Here Telegraph Money explains what you need to know about VCTs and the risks involved.

Venture capital trusts (VCTs) are a type of investment that supports small UK businesses and offers investors the opportunity to back potentially high-growth companies.

VCTs typically invest in a basket of 50 to 80 private companies, which are often difficult to access on listed markets.
These range from technology companies to consumer brands, including non-alcoholic beer maker Lucky Saint, fashion retailer ME&EM, skincare technology company Lyma Life and cycling clothing brand Le Col.

Many VCT-backed companies have become household names or are on their way to becoming household names.

To encourage support for growing start-ups in need of next funding, VCTs offer generous tax benefits for investors.

They allow you to offset 30% of your investment against income tax, plus you receive tax-free dividends and don’t have to pay capital gains tax (CGT).

The success stories include the 10 companies that have achieved “unicorn” status – private companies with valuations of $1 billion or more. These include the online car retailer Cazoo, the meal kit company Gousto, which is backed by Joe Wicks, and most recently Quantexa, the AI ​​start-up.

According to the Wealth Club, a total of £118 million has been invested in VCTs so far this tax year (ending September 22, 2024), up 59 per cent on the previous year.

The VCT itself is a fund in which you buy shares. The VCT manager selects companies to invest in based on where he believes opportunities lie.

Most VCTs target an annual dividend (sometimes around 5 percent) and may pay a special dividend if they have good exits – in other words, if they are sold or listed on the stock exchange.

Starting in September each year, VCTs raise funds by issuing new shares, allowing investors to pledge their savings. VCT shares are purchased on the stock market but can trade at a discount to the underlying value of the fund’s investments.

For long-term investors – who get most of their returns from tax-free dividends and underlying growth – this shouldn’t be a problem. But it’s another reason why these should be viewed as a long-term commitment.

To qualify for the tax breaks offered, you must hold the investment for at least five years.

Investing in VCTs can be risky but offers many benefits:

Tax benefits

The tax advantages are convincing. VCTs offer income tax relief of 30 percent – so for every pound you invest in a VCT you can get up to 30 percent tax relief back. They also offer tax-free capital gains and tax-free dividends.

The dividends can therefore serve as a useful source of income. However, if you do not need the income for the time being, reinvested dividends can also receive tax relief.

Generous thresholds

You can invest up to £200,000 in a VCT each year and get up to £60,000 back in tax – but you can’t claim back more tax than you owe.

Suitable for wealthy investors

VCTs, with their grant of £200,000 per year – compared to £20,000 for Isas and £60,000 for pensions – are a compelling option for wealthier investors. They are a tax efficient option if you have already maxed out your ISA and pension.

Potentially higher returns

You may be able to achieve higher returns with VCTs – especially when tax relief is taken into account. If a company held in the VCT is very successful and exits the VCT, either by being sold or listed on a stock exchange, special dividends will be paid.

Opportunity for diversification

Exposure to high-growth, smaller companies also offers the opportunity to diversify a traditional portfolio.

Support for start-ups

By investing, you will help support the next generation of British start-ups, drive innovation and create jobs.

Nicholas Hyett, investment manager at Wealth Club, said: “For experienced investors, particularly those who have already drawn down their ISA and pension allowances, VCTs offer an excellent next port of call.”

“The possibility of a 30% upfront income tax break and tax-free dividends is becoming increasingly attractive to tens of thousands of people drawn into higher tax brackets by frozen annual allowances.”

Of course, there are risks that you have to weigh against the benefits. VCTs invest in early stage companies that are much more likely to fail, and the companies they invest in can be harder to sell.

Most VCTs offer a buyback facility where they will want to buy your shares from you, but at a discount to their value. However, there is no guarantee that shares will always be sold upon request.

Additionally, dividend targets, while attractive, are not guaranteed.

Another disadvantage is the high fees. According to data provider Morningstar, average annual fees are 2.6%, and most also charge performance fees.

There are three types of VCTs that you should be aware of:

Generalist venture capital funds

Investing in a generalist VCT gives you access to a wide range of companies in different sectors of all shapes and sizes. The goal is to maintain a balanced portfolio so that you don’t invest all of your money in one area.

Popular generalist VCTs include Mobeus VCTs and Pembroke VCT.

Specialized venture capital trusts

This term is not used as much anymore. However, it referred to VCTs where the manager focuses on finding and investing in companies operating in a particular sector or industry, such as technology or healthcare. One example is Octopus Future Generations VCT, which focuses on sustainability.

Target of venture capital funds

Some VCT managers focus on companies listed on the London Alternative Investment Market (Aim), sometimes referred to as the UK’s “junior” exchange.

Aim is home to thousands of innovative, fast-growing companies led by entrepreneurs in industries such as technology and healthcare. Octopus AIM VCT is an example. Its largest listed holding is the building materials group Breedon plc, which the company backed in 2010 and which recently expanded into the USA for the first time with a $300 million acquisition.

If you are still interested in investing in VCTs, you need to follow the following steps:

1. Find a broker

First you need to find a VCT broker and register or create an account. There are a number of online VCT brokers including Wealth Club, Chelsea Financial Services and Bestinvest.

2. Make a choice

Find out about the VCTs offered at the time. A prospectus is usually available a few weeks before the VCT opens for applications. As soon as the required amount is reached, the time window closes.

In some cases you have to be quick as the most popular offers sell out quickly. For example, Unicorn AIM VCT’s £20m fundraise in February 2024 was only available for a week before it was oversubscribed.

3. Dial again

You may want to select more than one VCT to support. Since they represent high risk, it is better to spread your investments across multiple managers.

4. Make sure you understand the risks

Take the time to read the information and research what is being invested. Information is provided to help you assess risk. You may be required to answer a series of online questions to ensure you understand the riskier nature of VCTs.

There are similarities between VCTs and the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS), but also some key differences.

Like a VCT, an EIS provides 30% income tax relief and the tax return is capital tax free. SEISs allow you to offset 50 percent. VCTs and SEIS have a lower annual limit of £200,000 compared to up to £2m for EIS.

The tax treatment varies. VCTs provide tax-free income from dividends – this is not the case with EISs and SEISs. VCTs (and SEISs) do not allow you to offset losses against capital gains made elsewhere, as is the case with EISs.

The way they invest is different. Whilst a VCT may hold up to 80 companies, an EIS or SEIS fund may only hold 10 to 12 companies, representing a smaller pool.

EIS and SEIS target much smaller and younger companies, which tend to be riskier.

VCTs must be held for five years to benefit from the tax benefits, unlike EIS and SEIS which require you to hold them for three years.

There is no inheritance tax benefit with VCTs. EIS and SEIS investments can be exempt from inheritance tax if they have been owned for at least two years.

What is the average return of a venture capital fund?

According to Wealth Club, the average generalist VCT returned 22.2 percent over the five-year period ending December 2023 (based on 36 individual VCTs managed by the top 10 VCT managers). Meanwhile, the average AIM VCT lost 14.7 percent over the five-year period ending December 2023.

Most VCTs target an annual dividend, which can be around 5 percent, although some may pay significantly more and others less.

What is the 5 year rule for VCT?

To qualify for the tax relief offered for investing in a VCT, you must hold the investment for at least five years.

What are the disadvantages of VCTs?

VCTs are considered high-risk investments and therefore it is important to look beyond the tax benefits. VCTs invest in early-stage companies, which are more likely to fail than larger companies, and the companies they invest in can be harder to sell when you need access to your money.

Unlike most traditional funds and stocks, the minimum amount you can invest is comparatively high – often £3,000 or more.

If you cash in your investment before the end of five years, you will lose the tax benefits.

It is also worth noting that investments in VCT schemes are not protected by the Financial Services Compensation Scheme, the industry’s safety net.