Let’s say you want to get started with £20,000 in capital. What’s the best way forward?

Start a business or start investing

I should start this article with the usual caveats: nothing here is advice on any level. Your investment and personal finance decisions are your own, and I can only speak to personal experience.

But I wanted to take a few minutes of your day and ask you to consider the financial predicament that the first-time UK entrepreneur might find themselves in within modern Britain.

Let’s dive in.

The business dilemma

Imagine you are in your mid-20s. You’ve gone through university, and amassed that humongous pile of debt, now at an interest rate and on terms so draconian that effectively makes it for life. And you are looking at starting your own business.

Having saved up £20,000 — a challenge given the cost-of-living, but not insurmountable over a few years given support — you have a choice ahead of you. You may invest this sum of money, usually earnt through blood, sweat and tears in some godforsaken barely-above-minimum-wage hellhole (we’ve all been there), in a nice S&P 500 tracker, FTSE 100 insurer, or similar — or you can invest in yourself, and start up a new microbusiness.

No more alarm clock. No more boss. No more keeping to an arbitrary set of time or rules. (Spoiler: self-employment simply means more work, typically concentrated around when others are available and a Cadbury selection of mini bosses who you invoice rather than have them work out your pay for you).

I digress.

The point is that you have a skillset, a business idea, and a can-do attitude. You want to work for yourself. The problem is that it simply does not make any sense.

Let’s say you invest £20,000 into a business. It doesn’t particularly matter whether you’re opening a café on a shoestring, a window cleaning start-up, or a new website. You’re prepared to risk your £20,000, but you’re not prepared to throw it away.

To start with, Fundsquire — the global start-up funding network — considers that 20% of all small businesses fail within their first year. 60% fail within three years. Like marriage in the 1990s (the stats have improved over the past 20 years in this regard, with marriage numbers falling but the remaining ones more successful), if you start a new business, you are more likely to fail than not.

And there’s always the chance of a curveball as well. The pandemic closed a significant portion of the economy for two years — and limited company directors (which you would be) got diddly squat in support, other than, for some, a £50,000 bounce back loan that has become an anchor to recovery.

But let’s assume you’re smarter or luckier than most. Of the 40% of businesses that survive, how many are profitable enough to make it worthwhile? Let’s consider the minimum wage: for 21+ years old, this will be £11.44ph effective from April.

If you put 50 hours per week into the business and take six weeks off per year, then you would need to earn £26,312 per year to make the equivalent in minimum wage. Obviously, you want to do better than that, but that is £26,312 a year in PROFIT, not revenue. In fact, you need to consider what you could earn in full-time employment —because unless you properly plan how to scale, working for yourself for less money and benefits is a bit of a fool’s errand.

Remember, there’s no holiday pay, sick pay, wellbeing days, paternity, or maternity pay. You fund it all. And I know countless people burning themselves out on a pipedream of building a business, when they could have been earning double as an employee, while learning valuable skills.

But let’s assume that you are one of the lucky businesses to survive, and that you consistently generate an annual profit that is more than what you could earn working for somebody else.

And let’s say for the sake of argument that you made £80,000. We will use this figure to exclude the impact of VAT — go over the £85,000 threshold and not only does it get more complex, but you also have to charge clients an additional 20%, making your business unviable in many instances. Indeed, there is a humongous VAT cliff edge for this very reason, where companies simply stop taking work at the £85k mark.

I digress once more. Let’s say you escape the VAT shenanigans and after paying your accountant you are sat on £80,000 of profit.

First up, HMRC comes along and charges you corporation tax. This has recently risen. It used to be a flat 19%, but now rises to as much as 25% for higher-revenue companies. Got to pay for that pandemic somehow.

Anyway, you would have paid £15,200 under the old regime, but this now stands at £17,450, leaving you with £62,550. You might want to withdraw some of that to live on. Let’s say all of it.

Your dividend tax has risen, where an employee’s National Insurance was frozen. And then cut. Dividend tax now stands at 8.75% up to £50,000, and then 33.75% above (there’s an additional rate if you have a good year). Oh and the dividend allowance has been cut to a measly £1,000. Remember, you are paying that dividend tax having already paid the corporation tax.

However, anything over £50,000 also demands the High-Income Child Benefit Charge if you dared have any children, and anything over roughly £25,000 attracts that additional student loan repayment at 9% of your income (15% if you decided to get a postgraduate qualification). Remember, even earning £60k post-corporation tax, a new grad is never wiping that loan out.

Anything you take out beyond circa £50,000 is being taxed at well over 50%. Anything under £50,000 taken out works out as being slightly more advantageous than employee income — but this gap is shrinking fast.

There is a point to all of this, so bear with me.

Let’s say you create a company of value. You plan to sell it and take advantage of Business Asset Disposal Relief. This essentially means you only pay 10% Capital Gains Tax on disposal of a business asset for the first £1 million gained (this was chopped from £10 million several years ago).

You obviously choose to sell before the business has hit full potential because £1 million of revenue taken through dividends is taxed at more than 50%. £1 million generated through selling the company is taxed at 10%. Sounds tremendous for growth, right?

Congratulations! You won capitalism! Thousands of others have failed.

But let’s say you are one of the many, many people who fail. There is no shame in this; many of the best entrepreneurs try several times before they get anywhere. But for whatever reason — maybe you’re not actually as capable as you thought/the business plan was deficient/you lacked the experience — you are part of the large majority of failures.

Your £20,000 is gone. It’s not coming back. In a best-case scenario, you walk away debt free and a little battle scarred.

The alternative

Instead of investing in starting a business, you continue to work full time. And you put your hard earnt £20,000 into an ISA. Put it into a Lifetime ISA over five tax years, and the government will give you £5,000 to put towards a house deposit/retirement. For free.

Well not for free. Government funding is always national debt or taxpayer money.

Pick a decent S&P 500, World Index, or FTSE 100 insurer tracker and then sit back and watch your money increase by 10% a year — compounding.

All of the returns are free from dividend tax. Capital Gains tax. Any kind of tax at all, excluding the standard 0.5% stamp duty.

Put it in a SIPP instead, and the government will give you tax relief to the tune of thousands of pounds.

And you can continue to work full-time as an employee, making a full-time wage.

The bottom line

This may feel like a personal complaint, but it’s really not. I am lucky to work for myself and be relatively successful. The problem is that the UK’s economic growth is sluggish — and one of the reasons why is that the reward for starting a company has continued to shrink over the years.

It feels like the risk is huge, and that the rewards on offer no longer make backing yourself worthwhile. There seems to be a continued push towards equalizing tax paid by employees and the self-employed — but while this may feel fairer, it’s not. Even the new budget, scheduled for 6 March, sets out the stall for a 1% cut to employee national insurance.

Here’s the problem: starting a company is very risky, and investing your money in your own venture usually generates less income than simply investing in an index fund. To make it worth your time, the tax system should recognise this.

At present, you pay no tax investing in other businesses — and crippling taxes investing in your own.

And until this changes, growth will remain slow.

This article has been prepared for information purposes only by Charles Archer. It does not constitute advice, and no party accepts any liability for either accuracy or for investing decisions made using the information provided.

Further, it is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

Charles Archer is an experienced financial writer specialising in monetary law. With a background in stock market and private equity analysis, he’s worked for many years as a freelance investment author,...

Leave a comment

Your email address will not be published. Required fields are marked *