It’s a well-worn truism that small and medium-sized businesses (SMEs) are “the engines of the economy” but it’s a phrase that bears closer analysis – especially in the context of small business investing. It’s true that in an age of disruption, start-ups have the potential to explode out of nowhere to become the next Google or Amazon, but generally, it’s larger, established SMEs that are the main drivers of growth and job creation.

So why are tax breaks so focussed on investments in early-stage businesses, with fewer incentives available for investors in companies with longer trading track-records?

Fewer incentives for longer serving companies is illogical

This is because start-ups and early-stage businesses tend to be riskier prospects for investors, and so they should not be encouraged into this end of the market by tax incentives if that doesn’t fit comfortably with their risk appetite.

For another, all SMEs – whatever their size or longevity in the marketplace – need funding if they are to realise their growth plans and fulfil their potential. Since there’s little institutional investment in this space, these companies rely on private capital. If they are to secure it, it needs to be an attractive proposition for investors – and tax breaks play a key part.

EIS and Entrepreneur’s Relief: how effective are they in encouraging investment?

One of the main government sponsored tax-relief schemes is the Enterprise Investment Scheme (EIS). EIS does offer many selling points for investors, with appealing income tax breaks on the way in, CGT relief on exit, plus the comfort of loss relief should the business fail. And it is right that investments with a different risk/return profile to investing in the stockmarket should be taxed in a different way.

However, EIS is limited (except in a very few circumstances) to businesses of less than seven years old. This is short-sighted, leaving the vast majority of successful SMEs out of contention just because they have been in business longer. Moreover, given that the failure rate for early stage companies is typically far higher, from a taxpayers’ perspective the level of loss relief available to investors makes little sense, leaving the Treasury out of pocket when investments go wrong.

Entrepreneur’s Relief is better from a taxpayer’s point of view because tax relief is given only once value has been created, rather than at the outset. The downside is that there remains a lack of clarity over eligibility, which is hampering its usefulness as a tool to help encourage investment.

Further reading on tax breaks

• How can I reduce my company tax bill
• The five countries in Europe with the lowest corporation tax
• Taxing the robots – far sighted or fanciful?

Regulation: too hard or too soft?

When it comes to encouraging and enabling private investment into SMEs, tax breaks are just one piece of the jigsaw. Regulation is another.

Regulation must be light-touch enough that experienced investors, who understand the risks, can gain access to high-quality investment opportunities that suit their risk profile and enable them to diversify their portfolios. Equally, it should protect retail investors from unsuitable investments. Currently, I would question whether it is succeeding at doing either.

Crowdfunding is a classic example. Inexperienced retail investors can crowdfund a company with ease, often with a few button clicks on their smartphone. However, experienced investors often find themselves deterred from investing in other types of collective investment vehicles.

“There’s a strong case for arguing that online crowdfunding platforms may not be the best way to connect SMEs with private capital providers, because equity investing is just not that simple”

Deals like this require a huge amount of expertise and resources both prior to completion of the investment but also in managing that investment through to a successful exit.

Pre-investment due diligence must be:

• extensive to test the strength of the business model
• check that growth forecasts are realistic
• assess whether the management team is fully committed and capable and
• ensure that a suitable exit strategy exists.

Post-deal, investments can’t simply be expected to flourish without careful tending: ongoing oversight and management of the investment are essential to generate returns.

Crowdfunding platforms may claim to do some or all of this – but to what extent? In a highly competitive market where costs need to be kept as low as possible, do their business models really allow them to deliver top-grade scrutiny? Given that some crowdfunding platforms are loss-making themselves, their ability to oversee the rigour of other businesses’ balance sheets and growth models is a moot point.

Conversely, other types of collective investment schemes and structured investment vehicles may tick all of the boxes above, with robust structures and proper evaluation and oversight, and yet still be frowned upon by the regulator.

The way forward

There’s a real need for tax reliefs which are applicable to all high-growth SMEs not just a small sub-set, and for regulation that takes more account of the needs of different types of investors. Policy-makers should broaden their outlook and change the narrative around small business investing, to make sure that tax breaks and regulation are enabling and progressive, while protecting investors and the taxpayer. In so doing, not only will SMEs and investors benefit, so will the whole of UK plc.

Claire Madden is a partner at Connection Capital

Watch the below video on Entrepreneurs Relief