Following the introduction of the employment-related securities legislation in the Finance Act 2003, there was significant uncertainty in relation to the tax implications for management acquiring shares in venture capital (“VC”) and private equity (“PE”) backed companies. This led to the memorandum of understanding which was agreed on 25 July 2003 between the Inland Revenue (“HMRC”) and the British Venture Capital Association (“BVCA”) on the income tax treatment of managers’ equity investments in VC and PE backed companies (the “MoU”)
Provided the conditions are met, the MoU gives management and their employers comfort that HMRC will accept that the initial unrestricted market value (“IUMV”) has been paid for their shares.
Why is this such a big issue where management pay the same as the investors for shares with similar economic rights?
The key point is that PE investors will usually split their equity investment into debt-like preferred securities (loan notes or preference shares) and ordinary shares. The total equity will generally be a benchmark of an arm’s length value. If management invest on the same terms and in the same proportions of preferred and ordinary equity, the position should be simple – but the split between preferred and ordinary equity can be arbitrary and there are often variations in proportion and terms.
Typically, the ordinary equity will only represent a small percentage of the total equity and this puts a lot of pressure on the valuation of these shares as they have limited downside and take most of the upside. In short, ‘pure’ valuation theory (as commonly used in the USA for example) would often suggest the value of these ordinary shares is much higher than the price paid.
What is the thinking behind the MoU conditions?
The 6 conditions set out in the MoU (7 where there is a ratchet) blend valuation principles and pragmatism. The need to have clear and objective tests means that they vary in how onerous they are. For example:
- Management are required to pay no less than the investor for their shares, but it could be argued that the value is lower than the investor’s, which generally come with control or significant influence through voting power and/or enhanced rights (notwithstanding the fact that minority investors generally invest at the same price as the majority shareholder)
- Similarly, the condition in relation to ratchets requires that management pay a higher amount based on maximum economic entitlement, which will often be unrealistic – but it is the only way to have an objective test in the MoU
- Management are required to subscribe for shares at the same time as the investor, even though facts and circumstances might be the same a day, a week or a month later (in contrast, the memorandum of understanding relating to carried interest does allow delays)
- One potentially ‘soft’ test is the requirement that the shareholder preferred securities carry a commercial rate of interest, which is measured as being not less than the most expensive third-party debt. Where leverage is very high, a true commercial rate may be significantly higher than that attaching to senior debt.
In practice, it should be clear whether or not all of the conditions in the MoU are satisfied. In part two, we’ll move on to situations where not all conditions are met.