The biggest rewards go to the earliest investors

Venture capital trusts are one of the least understood investments around, and they have a healthy dose of tax advantages

Imagine having invested in the next Yahoo! or ARM before it comes to the stockmarket: early stage investment in high-growth companies is where fortunes can be made. Yet, by and large, access to such companies is restricted to an elite club of wealthy "business angels" and financiers known as venture capitalists.

Imagine having invested in the next Yahoo! or ARM before it comes to the stockmarket: early stage investment in high-growth companies is where fortunes can be made. Yet, by and large, access to such companies is restricted to an elite club of wealthy "business angels" and financiers known as venture capitalists.

Venture capitalists supply young enterprises with the oxygen of cash to get them started and steer them on the path to a full stockmarket quote or sale.

One of the best ways that a private investor can join in the action is through a Venture Capital Trust (VCT). These allow investors to benefit from the skills of professional venture capitalists, while reducing the inherent risks. VCTs are one of the least understood investments around, yet for the right investor they are also one of the most attractive investment schemes on the market.

A VCT is effectively an investment company whose shares are quoted on the stock exchange. They will invest in a variety of companies that have been chosen by an experienced team of venture capitalists. This fund approach makes them less risky than direct investment in early stage businesses.

But risk is further reduced by a generous cocktail of incentives for taxpayers. In fact, the combination of tax reliefs available make VCTs more generous than any other tax efficient scheme.

Firstly, if you invest in a VCT at its launch you will be issued with a certificate enabling you to claim a 20 per cent income tax rebate on your investment subscription. In other words, you are getting £1 worth of investment for a cost of 80p. However, the income tax rebate is just the tip of the iceberg.

The real tax attraction of VCTs is for investors who have a capital gains tax liability, particularly if they are a top rate taxpayer. If you have a CGT liability then you can defer payment of it by investing in a VCT. If you are a top rate taxpayer that means you can defer 40p of your tax for every pound you invest. Combined with the 20 per cent income tax rebate, investors in this category get £1 of investment today for just 40p.

It is important to appreciate thatthe capital gains tax liability does not disappear, the payment is simply deferred until you sell the VCT shares. Under current rules these must be held for a minimum of three years. Effectively the Inland Revenue is giving you an income tax rebate and loaning you (interest free) your CGT payment money to make an investment. Even though the original CGT liability will reappear when you sell the shares, all of the returns on them are free of tax like a PEP or ISA.

One of the biggest misconceptions about VCTs is that they are high risk. They are, in fact, no more risky than many unit trust funds, though certainly less flexible.

For starters, if you are fully benefiting from all of the tax advantages this offsets many of the risks. Additionally, the VCT rules state that a fund must be at least 70 per cent invested in "qualifying companies" by the end of its third year. That means, in practice, most VCTs will initially hold high positions in very low-risk investments - such as cash and bonds - as the managers search around for attractive companies to invest in.

Companies that are "qualifying" for VCT investment are subject to a range of criteria, which exclude "asset backed" businesses such as property companies or financial companies. The scheme is designed to help small UK companies with gross assets of no more than £16m once the initial injection of money takes place. They can't be subsidiaries, they must not have substantial overseas operations and they must be unquoted.

However, there is a catch here because the Inland Revenue regards companies listed on the Alternative Investment Market and Ofex - two exchanges for small companies - as "unquoted", so these companies can qualify.

In fact, VCTs broadly fall into two camps: those that concentrate on AIM companies and those that focus on companies with no listing whatsoever. The advantage of investing in AIM companies is that there is some potential to sell a holding in an investment if it no longer looks attractive, though this is an illiquid market and even modest-sized transactions can change a price.

Funds which concentrate on pure unlisted companies are much more akin to traditional venture capital, and the managers involved are likely to get their hands dirty and provide considerable assistance to their investee companies.

While VCTs are no riskier than a typical smaller company fund, they aren't suitable for many investors. If you don't pay tax then VCTs should be ignored. In fact, VCTs are really only a strong option if you are deferring capital gains tax.

They are also inflexible investments because you must hold them for a minimum of three years to keep the tax benefits, though in practice you should have a long-term view with VCTs. Trading in VCT shares after launch is not active so the share prices tend to trade at very big discounts to the value of the assets they are invested in. The most suitable exit, therefore, is for the trust to vote to wind up rather than to sell the shares in the open market. Most VCTs have wind-up votes after seven years.

Over the last eighteen months many investors have made huge returns off their share trading activity and now face the prospect of paying capital gains tax for the first time. If you are lucky enough to find yourself in this club, then a VCT could be well worth looking at as a way of deferring the tax and getting a tax-free exposure to small high-growth companies.

But a final word of warning: never go overboard because of the tax benefits. Even the most aggressive portfolios should have no more than 25 per cent of their assets in UK smaller companies, so any investment in VCTs should be set in this context.

Jason Hollands is deputy managing director of the brokers Best Investment