EIS: don’t go chasing waterfalls?

This post is part of our Entrepreneurial team’s regular series of blogs.

What is a waterfall?

A liquidation preference, often termed a ‘waterfall’ provision, is usually put in place by third-party equity investors to minimise their downside risk. The preference works to ensure that the third-party investors receive their investment back first in the event of a sale, winding up, or liquidation, in priority to the other shareholder groups.

Although this is quite common, particular care must be taken if the investors participating in the waterfall include any Enterprise Investment Scheme (“EIS”) or Venture Capital Trust (“VCT”) funds or individuals hoping to claim (or who have claimed), to ensure that their ability to claim these relief is not prejudiced. The rules regarding EIS and VCT relief prohibit shares from qualifying if they carry “any present or future preferential rights to a company’s assets on winding up”.

This rule is in place to ensure that EIS and VCT investments remain ‘risky’. Investment through these methods must genuinely be ‘at risk’ and, therefore, should not be protected by any preference rights.

Although you may think that these rules remove the possibility of including a waterfall provision in the articles of a company, they are still very prevalent in high-growth companies… but how do they get around this?

How to implement a waterfall and remain qualifying

There are two main ways to ensure compliance with this while still delivering the protections desired by the investors.

  • The first option looks at the different types of exit that a company can make. The EIS rule specifically prohibits there being any present or future preferential right to a company’s assets on winding up. Importantly, the rule only specifies winding ups, meaning the use of a preference waterfall in the event of a sale of the company is permitted.
  • The second option looks to distinguish between the priority of when the assets are received, rather than the amounts received. It is widely accepted that HMRC only pay specific attention to the timing of when there is a right to receive assets, not the amounts to be received. This means that as long as each group of shareholder receives ‘something’ at each stage of the preference waterfall, there is no preferential right to the return of assets. This is usually executed by giving one group of shareholders the right to receive 99.999% of their issue price at the same time as the others receive 0.001% of theirs. The subsequent level of the waterfall would then reverse this. This mechanism provides the desired level of protection to the first group of investors.

These methods are generally understood to be accepted by HMRC, as they have not challenged it to date. However, with the way the legislation is currently written, it is still open to HMRC to change their view on what it means.

Much ado about nothing?

Although there are ways to implement preference waterfall provisions into return of capital provisions, the legislation is complex and there is always a real risk of prejudicing an investor’s EIS or VCT relief if care is not taken.  We suggest you get specialist tax advice before implementing such provisions.