A refresher on the ‘safe harbour’ provisions in the MoU relating to management equity – Part 2
Cases outside the MoU
In part one, we provided a quick refresher on the MoU and some of the logic behind the various conditions.
Where possible, it is desirable to ensure that the conditions of the MoU are satisfied but this is not always commercially possible. A frequent area of debate is where not all conditions of the MoU are satisfied – is it possible to put some reliance on the principles of the MoU? In other words, if the ‘spirit’ of the MoU is satisfied, can management rely on it?
Some firms take a black and white view on the matter – that the MoU is completely irrelevant if not satisfied in full. They view the MoU as a concession that can only be relied on if all conditions are met to the letter (similar to profits interests in the USA, which result in much more favourable tax treatment for US taxpayers if the conditions are met). This is the safest view – particularly in the context of risk management in larger professional services firms where tax advisors rather than valuers will often decide if the MoU is applicable – but overly cautious in many circumstances based on our experience of dealing with HMRC and the views of other firms.
As with everything valuation-related, it does depend on the specific facts and circumstances. There are also a range of circumstances from minor technicalities to fundamental differences, and the relevant risks must be judged accordingly.
Common examples of situations falling out the MoU include:
- Management acquire shares at a later date (even a day later) than the investor
- There is no new external debt in the funding structure to provide a benchmark of a commercial rate for preferred securities held by the investor and management (existing debt may be rolled over or the investor might need to move quickly and refinance at a later date)
- There is a ratchet arrangement that provides an enhanced return to management shareholders and they do not pay an amount based on maximum economic entitlement (the ratchet may only pay out in very stretching circumstances or the theoretical maximum might be impossible in practice)
- Management shares include a put right to provide a synthetic exit in the future (e.g. where the investor intends to hold for the long-term)
It is simple to assess the price that would have been accepted as the IUMV had all conditions of the MoU been satisfied. The critical thinking is to then determine whether the failed test could potentially result in a higher value. This might be a simple process in some cases (e.g. if a manager subscribes a day later) whereas it will be more challenging in others.
- The MoU does specifically deal with two of these examples:
Where there is no external debt, the guidance states: “This might be done by comparing the expected rate of return on the Preferred Capital with the returns on similar investments in the market, or by comparing the capital structure with the structures in similar transactions, or by some other commercial analysis or comparison.” In practice, this analysis is rarely carried out as it introduces an element of uncertainty
- Where there is a ratchet and management do not pay an amount based on maximum economic entitlement, the MoU states that the price paid may have been lower than IUMV, but HMRC will accept that the maximum difference is the delta between the amount paid and the amount payable based on maximum entitlement (and that it will generally be appropriate to discount this maximum by reference to the likelihood of the ratchet being triggered or not)
This guidance from HMRC indicates that the principles of the MoU are still important in situations where not all of the conditions are strictly satisfied.
Another question is whether it is reasonable to assess incremental value by reference to the MoU.
As outlined above, the guidance in the MoU on situations where management do not pay an amount reflecting maximum economic entitlement of a ratchet is a clear indication that an incremental value approach might be appropriate.
Another scenario is where the interest rate attaching to investor/management loan notes is lower than the most expensive third-party debt. One approach might be to calculate the “value leakage” from the loan notes to the ordinary shares over the expected period to exit to assess the amount subject to tax.
A final situation we consider in this article is where management acquire two classes of share: a class that ranks alongside the investor shares (commonly referred to as the “strip ordinary shares”) and another that provides additional returns if stretching conditions are achieved. In other words, the ratchet or similar economics are delivered through a separate class of growth share.
The strip ordinary shares might satisfy all conditions of the MoU, so management have comfort that HMRC will accept the price paid as IUMV. A valuation of the ratchet/growth shares is however required as the MoU cannot be relied on. Even though these shares generally provide lower economic returns than the strip ordinary shares, general valuation methods might result in a higher value. So the question is why this might be the case and is it justified in the circumstances – is the MoU resulting in a generous outcome for the strip ordinary shares or is the value of the ratchet/growth share driven by overly aggressive assumptions?
There is no easy or general answer in many of these cases, and it is rarely black and white. This is an area that is at times contentious and relies on depth of experience in the valuation of MIP shares and of dealing with HMRC in similar cases.
Parmentier Arthur has considerable experience in this area and can work with companies, investors or other advisors in relation to the valuation of management equity.
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