Investing in small companies offers big rewards

The need to boost small and medium enterprises (SMEs) has been a recurring theme in every Budget and Autumn Statement George Osborne has presented since he became Chancellor almost three years ago. He knows SMEs offer the best long-term hope for a return to sustainable economic growth.

But there is a problem: hampered by capital constraints, the UK's banks remain unwilling - or unable - to lend to SMEs. Without the oxygen of credit, many SMEs are unable to grow.

Tim Breedon, former chief executive at Legal & General, was asked last year by the government to investigate new sources of finance for SMEs. He found the funding gap to be massive. He reckons UK businesses face a shortfall of between £84 billion and £191 billion over the next five years unless action is taken.

The good news is that progress is now being made in both the public and the private sector as new initiatives encourage nonbank lenders and investors to fund SMEs. Many of these schemes offer retail investors new and potentially rewarding routes into a sector that has been frustratingly inaccessible to many investors attracted by the SME sector's risk/reward profile.

Tax tweaks

New public sector support for SMEs has included direct government assistance for SMEs through schemes such as Funding for Lending and the establishment of a "business bank". But the bigger story is the indirect support government has offered by tweaking the tax system to make investing in the smallest companies much more attractive for retail investors.

Last year's Budget extended the tax reliefs on offer to investors in venture capital trusts and enterprise investment schemes, and introduced a new version of the latter - the seed enterprise investment scheme - aimed specifically at boosting start-up companies.

At the same time, existing tax breaks have been left in place to further encourage support for small business. Business property relief is available, for example, to investors in most unquoted companies - HM Revenue & Customs includes AIM-listed businesses in this category - once they have held their stakes for two years.

The relief exempts SME assets from being added to the value of an investor's estate for inheritance tax purposes. This makes small businesses an effective way to mitigate inheritance tax liabilities. A number of financial advisers now specialise in helping investors build portfolios of investments that qualify for business property relief.

Crowdfunding regulation

Another government initiative is helping SMEs in a different way. In December last year, the Treasury announced it had begun investigating how to introduce crowdfunding sector regulation. Crowdfunding is a new industry that is making a growing contribution to SME debt and equity funding by acting as a bridge between businesses that need money and retail investors prepared to offer it to them in the hope of long-term returns.

Leading crowdfunding companies have been actively pushing for regulation because they think it will give their businesses greater legitimacy, potentially turning what has so far been a niche sector - backed by an enthusiastic but limited investment community - into a mass-market prospect.

It is possible that a regulated sector could benefit from tax advantages in future. The government has already provided some financial support for crowdfunding, and it made investments of its own on two websites at the end of last year. The Department for Business, Innovation & Skills, which had led the funding round, says it expects to earn the same returns on its money as private investors have enjoyed.

In time, it is likely that the growth of crowdfunding and other types of alternative investments will generate further innovation as investors' interest in private companies increases.

Asset Match, for example - a new platform on which investors will be able to trade shares in unlisted companies - takes its inspiration from similar platforms in the US, which have become very popular with investors. Another company, Second Market, offers investors a way into high-growth technology stocks before flotation. Facebook made its debut there.

Specialist innovator Abundance Generation was launched to enable retail investors to put money into small-scale renewable energy projects, on which the returns are attractive for those who have found a way to access them.

The internet has made the launch of such businesses more straightforward and opened up investment in smaller companies to a wider range of people. It is often possible to invest much smaller stakes in these businesses than normal without missing out on the tax breaks that have often been the preserve of high-net-worth investors in the past.

Business angels

Thankfully, traditional forms of SME finance have not been pushed aside in the rush to innovate. Last year saw the launch of the UK Business Angels Association, a new body led by the industrialist Sir Nigel Rudd. It hopes to significantly swell the ranks of the 18,000 or so business angels currently active in the UK, who collectively provide around £1 billion of funding to SMEs every year.

Business angels typically provide equity finance to growing businesses. Their investments are generally quite large - tens of thousands of pounds is the norm - but they also offer advice based on their own business experience as well as access to useful contacts. Many angels take seats on the boards of the companies in which they invest, typically as non-executive directors, to actively help the business grow.

In the past, business angels have generally acted alone, but a growing number of networks have enabled them to come together as co-investors in companies. The alternative is to work with professional investors, such as venture capitalists. Funds such as the Angel CoFund - some backed with government money - now seek out business angels to work alongside.

Most angels work under the Financial Services Authority's Financial Promotions Order, which enables them to receive business plans and make independent investment decisions. To do so, angels must certify themselves as either a high-net-worth individual - with net annual income of more than £100,000 or net assets, excluding their home and pension, in excess of £250,000 - or a sophisticated investor. The latter will typically be company directors, professional investors or people with an existing portfolio of angel investments.

No tax breaks are aimed specifically at business angels, but their investments will often qualify for favourable treatment under schemes such as the EIS.

Tax, however, should never be the prime consideration of anyone investing in small businesses. These incentives are in place to reflect the additional risk - compared with an investment in large quoted companies, say - that investments in small businesses represent.

In some cases, those prepared to take that risk will earn handsome rewards, but in many others they may lose their entire investment. This is a sector that only suits investors who can accept such risk, even with the tax incentives on offer.