At the time of writing, the Government is suggesting that the peak of the COVID-19 pandemic in the UK has passed. As the lockdown measures begin to be lifted, businesses can look to the future but it is still too early to say whether the bottom of the market has been reached or where things will level out.
One thing we can reasonably predict is that many existing share-based management incentive plans (“MIPs”) in private equity backed businesses and other growth-based incentive plans are likely be heavily ‘underwater’ due to combination of increased borrowings and reduced business. If so, they will have little or no perceived value to management teams.
A key feature of most MIPs is that they only participate in the growth in value from date of investment and rank behind loan notes/preference shares that form a significant proportion of total equity.
As we saw in the years following the financial crash in 2008, once the dust settles, it may be necessary to “re-set”, “re-base” or “re-cut” MIPs so that they reflect the new normal and an appropriate/achievable level of stretch.
Examples of how a MIP might be re-set
This re-set can take several forms depending on the capital structure of the company and wider tax/legal/commercial considerations, but examples include:
- Rights of existing growth shares being amended, or a new class created, to reflect lower entry/ratchet hurdle
- Loan notes/preference shares being written off to bring the MIP shares closer to the money
- Loan notes being split into different tranches and ranked in priority so that management can receive a proportion of value in the more junior tranches
- Jointly owned securities (ordinary shares, loan notes or preference shares) with the hurdle set closer to the current enterprise value of the company
- A new class of shares that rank in priority to other share classes to give management 100% of the initial tranche of value once all shareholder debt has been repaid.
Employment tax and valuation consequences of re-setting a MIP
Where new MIP securities are issued, there will typically be a UK income tax and possibly NIC charge based on the difference between the price paid and unrestricted market value. Where changes are made to existing MIP shares, the employment-related securities legislation (Part 7 ITEPA 2003) generally provides that the employee will be taxed on the uplift in market value as a result of those changes. For most private equity backed companies, these employment tax charges will be subject to PAYE, so it is the primary responsibility of the employer to withhold the appropriate amount of tax based on a “reasonable best estimate” of the value/change in value of the MIP securities.
What would HMRC expect to see in the valuation of the new MIP securities
Even if they were not originally growth-based securities, the new/modified MIP securities may be entirely dependent on the future growth in value of the company before they are entitled to any returns. In these situations, HMRC typically argues that the information reasonably required by the hypothetical purchaser would include forecasts which the company regards as confidential. HMRC would probably also expect the valuation methods used to take into account the potential future returns on exit, not just a snapshot of the value if the company were to be sold today. Opinions vary on the level of information that might be reasonably required in these circumstances and – if it is available – how much weight should be placed on what might amount to a highly risky turnaround plan.
What this means in practice
The first step will usually be for the investor, remuneration committee and key management team to determine the commercial objectives/parameters so that a term sheet can be created based on tax and legal advice. The key unknown would then be the quantum of the potential employment tax charge, and that is where specialist valuation advice comes in.
The valuation methods are often complex for growth-based securities and an in-depth knowledge of the issues relevant for UK tax purposes is also required. In addition, the economics of the re-set are often subject to subtle nuances. Whilst this complexity may be unavoidable and needs to be considered, the valuation specialist can cut through this and assist you in arriving a manageable but robust conclusion that will stand up to HMRC scrutiny. In some cases, the commercial parameters might have to move to make the new MIP palatable from a tax perspective.
There is no facility to agree these values with HMRC – before or after the MIP re-set – so the key will be to ensure that there is contemporaneous documentation to support the position taken.
With 45 years of experience of share and intangible asset valuation for UK tax purposes, Parmentier Arthur is well placed to work with companies and its tax and legal advisors in quantifying the valuation implications on re-sets.