Venture capital trusts allow you to make the most of new businesses. By Rachel Fixsen
Putting money into small businesses is notoriously risky, but those who have dared have sometimes made staggering returns. The trouble is, how can you pick the winners and avoid those destined to sink without trace?

Investing in a venture capital trust (VCT) is one way to leave the decisions to the experts. VCTs were introduced four years ago as a way of providing capital finance for small expanding companies. Like investment trusts, they are quoted companies and investors participate by buying shares in them.

Each VCT invests in a number of smaller companies - mostly existing companies or management buyouts, and some early stage companies. Some may include companies quoted on the alternative investment market (AIM), the "junior" stock exchange.

VCTs are high-risk, but the risk is spread. "The diversity of 20 or 30 unquoted companies severely limits the risk," says David Thorp of the British Venture Capital Association. Inland Revenue conditions state that no VCT holding in any company may represent more than 15 per cent of its investments.

Another safeguard is that the London Stock Exchange has to approve every VCT prospectus, so only the experienced can launch funds.

VCTs carry amazing tax perks. Personal Equity Plans and Individual Savings Accounts may keep your investments free of tax, but the taxman actually pays you to invest in VCTs.

You can invest up to pounds 100,000 each tax year in VCTs and you get tax relief of 20 per cent on your original investment. This means someone investing pounds 10,000 will receive pounds 2,000 in tax relief. A condition of this is that, unless the investor dies, the investment must be held for at least five years. If the shares are sold earlier then the relief must be repaid.

There is no tax to pay on any income paid out by VCTs to shareholders, and no restriction on how much income can be paid out. There is also no capital gains tax to pay on any gains made on the sale of shares.

Arguably the best tax advantage is that anyone with capital gains in the 12 months before or after the shares are issued in a VCT can roll this gain over into a VCT. If they do, then they can defer any capital gains tax payable, and with careful tax planning may be able to avoid it altogether.

This ability to defer capital gains means that 40 per cent of your investment may in effect be an interest-free loan from the government.

This, coupled with the tax relief, means the investor may only have to stump up 40 per cent of the value of the investment.

"If you're only putting in 40 per cent, that does wonders for your rate of return - the VCT would only have to perform in a mediocre way to give a good overall return," says Martin Churchill of independent performance analysts the Allenbridge Group.

Tax breaks aside, is the underlying investment a good one? After all, if you lose money you don't get tax-deductible losses, says Mr Churchill.

Willie Stewart, a father of four who lives in Edinburgh, has invested twice in Northern Venture Trust and is confident that his investment will pay off. He had been thinking of making investments in small unquoted companies, but saw the Northern Venture Trust as a better option.

He says: "It's difficult to find good unquoted companies unless you put a fantastic amount of time and effort in." A VCT allows you to spread the risk of investing in unquoted companies while having experts source and manage the deals, he says.

So far, the investment success of VCTs is hard to gauge because there is very little market for VCT shares once issued. No one wants to lose the tax relief so they hardly ever sell in the first five years, which means the shares barely move.

Anyway, VCTs are definitely long-term investments. It takes years for the trust to become fully invested. The idea is that when the shares of the companies in the trust become quoted, there will be big profits, says Andrew Jones of independent financial advisers the David Aaron Partnership.

So how do you pick a VCT? Because tax relief is only available if you invest in a VCT by subscribing for new shares, it only makes sense to buy shares at a new offering. Find out which VCTs are open for new investment. Try the BVCA or see Allenbridge's website (see contacts below).

"You have to read the prospectus carefully and look at the experience of the manager concerned," says Andrew Jones. "Some of the managers do have quite long track records."

VCTs now tend to fall into two categories - the generalists, which invest in unquoted companies, and the ones based on companies already listed on AIM.

"I think the generalist ones are preferable to AIM, as I believe there is more scope for high rates of return," says Mr Churchill. "Most venture capitalists look to the AIM market as an exit point rather than an investment entry point. They can also do more in-depth due diligence on an unquoted company and be represented on the board," he says.

Look at the size of the VCT and the charges it makes. Some argue that a smaller VCT will not be able to buy enough holdings to spread its risk adequately. Charges are higher than for conventional investment trusts because of the large amount of work each investment involves.

"Deal flow" is important too. This is the rate at which the manager has closed investment deals. Managers have to have 70 per cent of funds invested in qualifying companies within three years of launch, and if they are too slow, they might have to rush into poorer investments later on.

Of those VCTs currently being offered, Mr Jones recommends Matrix TriVen. It will be the largest VCT yet, and it will be looking to raise pounds 60 million to invest in three different areas, each with a separate manager.

To share in the growth potential of the technology sector, Mr Jones points to the British Smaller Technology Companies VCT run by Yorkshire Fund Managers.

Allenbridge publishes Tax Shelter Report which rates VCTs according to a number of factors. Of the general VCTs still open to investment, Baronsmead VCT 2 gets the highest rating, followed by Quester VCT 2 and Northern 2.

Anyone investing in a VCT must understand the risks involved, and should not simply see them as the next investment after a PEP or ISA, advisers say. However, there is no reason why VCTs should only attract the truly rich. "A younger person who's willing to invest for the longer-term could do very well indeed," says Mr Jones. Typically, a minimum investment could be pounds 2,000 to pounds 3,000 he says.

British Venture Capital Association has a list of VCTs seeking funds: 0171 240 3846; David Aaron Partnership publishes a guide to VCTs: 01908 281 544; Allenbridge Group: 0171 409 1111 or:

`The Independent' is offering a free Guide to High Risk/High Reward Investment, outlining the commonest ways savers can get higher-than-average returns, including venture capital trusts. The guide, sponsored by Whitechurch Securities, is available by calling 0845 2711003