Innovation capital: Driving higher returns for UK private investors

By Steve Phillips, CFO, and Somil Goyal (pictured, far left with Philips), Investment Lead, at GovGrant – After the turmoil of 2020, there are signs of growing optimism in markets. Accelerating vaccination programmes are feeding investor hopes of a return to normal life and business activity in 2021.

By Steve Phillips, CFO, and Somil Goyal (pictured, above left with Philips), Investment Lead, at GovGrant – After the turmoil of 2020, there are signs of growing optimism in markets. Accelerating vaccination programmes are feeding investor hopes of a return to normal life and business activity in 2021. The path out of the downturn caused by Covid-19 is not going to be a smooth one, however, and pressure on businesses is likely to persist.

Against this backdrop, start-ups and small and medium-sized enterprises (SMEs) in the UK are missing out on millions of pounds of incentives, such as R&D tax credits and Patent Box corporation tax reductions, that could help them weather the uncertainty ahead and can boost investor returns by many percentage points.
 
In early 2021, global public market benchmarks are in record territory. Even the UK’s FTSE 100, hit by the twin concerns of Brexit and Covid-19, has clawed back half the lost ground from its March 2020 low. Private equity activity has also been strong. According to Preqin Data, global buyout investment hit USD157.8 billion in the last three months of 2020, making it the best quarter since 2007. 

But not all parts of the market are benefiting from investor confidence and capital. In the UK, there is a concerning divergence in investment between large companies and small.  While our data analysis has shown stabilisation and even improvement in medium-sized and larger private deals, the number of investments per quarter under GBP5 million fell from over 600 at the start of 2020 to under 400 by the end of the year. Total quarterly value slipped from about GBP900 million to less than GBP600 million – a fall of a third on both counts. 
 
So even as markets fire into life and fuel high expectations for the IPOs for UK-based companies like payments group Transferwise and online greetings card maker Moonpig, smaller companies are struggling to access funding. For many of these businesses, tax breaks can be a critical source of cash. This is a benefit which many companies – as well as their private equity and venture capital sponsors – fail to tap or use to their full potential.

There are two major schemes available schemes available to companies in the UK: 

• Research and Development tax credits for developing or improving products and services 
• Patent Box incentives for companies creating and registering new intellectual property 

According to UK government data, there were about 60,000 R&D tax credit claims for the 2018-19 tax year for over GBP5.3 billion of tax relief. In contrast, for the 2017-18 tax year (the latest full-year government data available) there were only 1,300 claims under the Patent Box scheme for a total of GBP1.1 billion in relief. Just ten financial services companies accounted for over a third of the tax relief claimed. But surprisingly for an innovative sector like Information and Communication, tax relief Patent Box claims were counted only in the tens of millions, while some industries were almost absent from the figures – Agriculture sector claims did not even reach GBP1m.

While many SMEs are using R&D tax credits, awareness of the scheme could be higher. We find that as many as half the companies and sponsors we talk to – small, medium and larger groups – are not familiar with the scheme and up to four out of five are not maximising their benefits. When it comes to Patent Box, very few small businesses and their investors know about the scheme, and most fear the costly and complicated process to register patents.

The financial implications of these incentives can be sizeable. Tax credits effectively provide operating capital, extend cash runways and, in some cases, help companies avoid enforced hibernation or even failure. For loss-making businesses, these incentives translate into cash in business accounts. 

The benefits also flow through to the sponsors. Our modelling on a typical fast-growing start-up shows that applying R&D tax credits and Patent Box could improve the return on investment by 24 per cent. For a larger SME with more stable growth, the benefit is smaller but still meaningful. These schemes improve the investment returns even before private equity and venture capital teams roll up their sleeves to create operational improvements. 

Much remains uncertain about the UK’s path to economic recovery. Covid-19 is continuing to impact many businesses, while the operational changes post-Brexit are only starting to become evident. What is clear is that start-ups and SMEs are crucial to the country’s long-term development. With the right support, they can be the success stories of the next five to ten years. Using tax breaks and credits optimally will give them funding to survive near-term uncertainty and thrive in the long run.