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Investing in smaller companies can increase diversification, help with a client’s tax planning and boost the UK economy – and now is a great time for advisers to learn more, says Jessica Franks
Head of Retail Investment Products, Octopus Investments
Larger companies will typically make up the majority of a client’s pension and ISA investments.
But exposure to smaller companies within a diverse portfolio can deliver valuable benefits.
What’s more, now could be an ideal time to invest and back the next generation of pioneers. That’s because these businesses have a great opportunity to shape the future of the UK economy following the shock of a global pandemic.
Nimble and adaptable
Smaller company investing comes with more risk. Because these companies are less established, they have a higher rate of failure and the shares can be less liquid than the shares of larger businesses.
However, this doesn’t mean all smaller companies aren’t resilient. In fact, early-stage companies can often adapt best to shocks.
The pandemic, for example, has caused disruption to long-held beliefs and traditional approaches. This has created new opportunities and markets that dynamic early-stage companies are perfectly placed to address.
Smaller companies are great at being nimble, far more so than larger businesses which typically struggle to turn the ship or adapt as quickly.
New businesses tend to operate on more modern, technology-driven business models, meaning they can react better to shocks, and are potentially in a stronger position to come out the other side of the pandemic.
Growth potential
One way to increase personal wealth is to make an early investment into shares of a small business that goes on to achieve significant growth.
Smaller companies have the potential to grow earnings faster than larger companies, injecting growth into a client’s portfolio. Over the long term, it’s typical for small companies to outperform large ones.1
Uncorrelated to market volatility
Where a client is investing in small unquoted companies, these are also less affected by market sentiment. That’s because their share prices are calculated based on the underlying performance of the business. They are less susceptible to the volatility caused by the emotions of the herd, as seen with listed stocks.
However, it’s important that clients go in with open eyes. Smaller company investing is high risk and investors need to understand those risks. For example, liquidity may be an issue.
Thriving environment
Right now, the UK is a thriving place for early-stage smaller companies. Some recent examples of businesses Octopus has sold stakes in, on behalf of investors, include Depop and WaveOptics – both delivering excellent outcomes for investors this year.
Depop, a second-hand fashion app, was bought by global e-commerce platform Etsy for $1.6 billion, while augmented reality innovator Waveoptics was snapped up by Snapchat for more than $500 million.
Octopus was also an early investor in car retailer Cazoo, the UK-based ‘unicorn’ which floated on the New York stock exchange this summer.
The UK is now the world’s fourth most prolific developer of ‘unicorns’ – private businesses valued at more than $1 billion – and taking innovative tech firms from start-ups to the public market or sale to global businesses.2
How to invest in smaller companies
Investing at an early stage is key to achieving the greatest growth, as this often occurs at the fastest rate before a company reaches IPO or is sold. However, this has typically been the realm of venture capital firms, or private equity investors.
It is near impossible for individual investors to source the diamonds from the coal. With so many fledgling companies out there, it is not easy to spot those worth exploring further, let alone to undertake detailed research into their potential risks and rewards.
Access to these types of investments is limited, however, certain types of investments offer a gateway into this world. Some of these also come with tax benefits to counterbalance the higher risks involved.
Two great ways clients can access smaller companies are through Venture Capital Trusts (VCTs) or supporting a company that qualifies for the Enterprise Investment Scheme (EIS).
VCTs are pooled investments comprising a diversified portfolio of early-stage companies at different positions on the growth curve. To encourage support of these young businesses, a range of tax benefits is offered, with relief on investments up to £200,000 each tax year.
VCT investors can claim up to 30% upfront income tax relief, provided they hold the investment for five years, with no tax to pay on any dividends received or on any capital growth.
Another option for experienced investors is a portfolio of EIS-qualifying investments. Up to 30% income tax relief is available on an investment, provided investors hold shares for at least three years and the company remains EIS-qualifying. Because of the risks involved, investors can also benefit from tax-free growth, loss relief, capital gains tax deferral and relief from inheritance tax.
Risk and reward
Small, early-stage companies have the potential to grow significantly.
Where tax benefits exist, however, these tend to compensate for some of the additional risks taken by investing in small companies.
The value of the investments discussed, and any income from them, can fall as well as rise. Investors may not get back the full amount they invest.
VCT shares and the shares of smaller companies are by their nature high risk, their share price may be volatile and they may be hard to sell.
Tax treatment depends on individual circumstances and tax rules may change in the future. Tax relief depends on portfolio companies and VCTs maintaining their qualifying status. Relief from inheritance tax is assessed by HMRC on a case-by-case basis when an estate makes a claim.
Where to learn more
If you’d like to learn more about the types of clients who could benefit from VCTs or EIS, please watch the Tax Planning Show on demand here. You’ll receive 90 minutes of CPD too.
1Lipper, taking the average return by investment horizon of the FTSE All-Share TR and IA UK Smaller Companies TR, over a 1, 3, 5 and 10-year period.
2Tech Nation, 17 June 2021 https://technation.io/news/the-uk-hits-milestone-of-100-uk-tech-companies-valued-at-1bn-or-more/
VCTs and EIS investments are not suitable for everyone. Any recommendation should be based on a holistic review of your client’s financial situation, objectives and needs. This communication does not constitute advice on investments, legal matters, taxation or any other matters. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London, EC1N 2HT. Registered in England and Wales No. 03942880. Issued: November 2021. CAM011515
