High returns if start-up stars don't burn out

David Prosser explains the pros and cons of investing in venture capital trusts

Do you want to help Britain's fastest-growing young businesses? If so, the Government offers attractive tax breaks to investors prepared to risk their capital on small companies. While it is quite a risk, the potential returns are attractive.

It has been 10 years since Gordon Brown's Conservative predecessor at the Treasury, Ken Clarke, invented venture capital trusts (VCTs) to encourage investment in small companies. VCTs are collective funds, run by professional managers, which offer a range of tax breaks to investors prepared to back a portfolio of small, often unquoted companies.

Despite tax perks, the funds have not always found it easy to raise money. So Mr Brown announced that for the 2004/5 tax year, he would double the income tax relief on offer to investors from 20 to 40 per cent.

Patrick Booth-Clibborn, a director of one VCT sponsor, Noble & Company, claims this has transformed the sector's fortunes. The company reckons one in five of all those investors using tax-free investment allowances before the end of the tax year on 5 April is considering VCTs. The extra tax relief on offer has encouraged the industry to launch more than 40 new share issues this year. Together, they hope to raise £750m, though this is almost certainly over-optimistic.

The first step for investors is to decide whether VCTs are an acceptable gamble. It's true the generous tax breaks reduce some of the risks of the sector. But even so, the funds carry above-average dangers.

VCTs invest in small companies with often untested ideas and strategies. If managers back the wrong horses, the results can be disastrous. Also, the market for VCT shares is long-term and not liquid. You must hold your shares for at least three years or the initial tax relief has to be repaid. The real gains are unlikely to be made for five years or more. And since the best tax breaks are only available on new VCT shares, it may be difficult to find a purchaser for your holding in the secondary market.

Many fund managers offer buyback services, guaranteeing they will take your shares off your hands when you want to get out. But the price is likely to be 10 to 15 per cent lower than the market value.

Ben Yearsley, of independent financial adviser Hargreaves Lansdown, says VCTs are best suited to investors who already have a larger portfolio of shares: "VCTs should only represent 5 to 10 per cent of your shares portfolio." He also warns investors not to be distracted by tax breaks: "All the incentives in the world are no good if you lose all or most of your starting investment."

VCTs fall into three categories. Some funds concentrate purely on companies listed on the Alternative Investment Market (Aim), the junior stock market for smaller companies. In the VCT world, these funds represent the lower-risk end of the scale.

The next step up is a generalist fund. These VCTs invest primarily in unquoted companies with no stock market listing. But they try to buy different types of company, from different sectors, in order to diversify and reduce risk. The most racy VCTs are specialists, which invest in specific sectors or concepts. This year's specialist funds include Ingenious Music, which plans to invest in up to 20 pop stars, and has Simon Fuller on its board.

It is possible to invest in more than one VCT each year, in order to spread your risks. But it makes sense for investors with no VCT exposure to think about Aim funds first.

Justin Modray, of independent financial adviser Bestinvest, advises: "Steer clear of the trusts that seem to be struggling to attract investors." Managers of VCTs that raise only small sums from investors could decide to pull their launches and send cash back. Some investors may then find they do not have time to use this year's VCT allowance.

An even worse scenario, says Modray, is that the manager tries to run the VCT regardless. "These funds have fixed costs, such as directors' fees, which will eat into a small pool of capital," he warns.

David Knight, of IFA Allenbridge, adds quality of management is everything in a VCT. "You need a good flow of deals and a strong team approach rather than one star performer."

HOW VCTs WORK

Investors in new VCT shares claim 40 per cent income tax relief, so investing £1,000 costs £600. But shares must be held for at least three years, or relief has to be repaid.

* The maximum investment is £200,000 a year in both the current and the 2005/6 tax years.

* Sales of VCT shares are free from capital gains tax. There is no income tax to pay on dividends.

* VCT shares are not exempt from inheritance tax. Until last April, investors were allowed to invest the proceeds realised from other investments in VCTs and defer the capital gains tax that might otherwise have been payable. But this tax break is no longer available.

* VCTs must invest 70 per cent of assets in companies worth no more than £15m. These companies must be unlisted or quoted on junior exchanges such as Aim. A VCT may invest no more than £1m in one company.

* VCTs are not allowed to invest in companies where the main business is property development or financial services.