Incentivising key employees whilst navigating the complexity of PE investment

As part of a private equity investment, one of the key objectives is ensuring that management, as senior employees, are incentivised to deliver results and grow the business whilst under PE ownership. Awarding management equity offers a number of benefits to both the PE investor and the management, such as providing “skin in the game” to help incentivise them to contribute to the future growth of the business and participate in a future exit.?

This article focuses on the provision of equity to management via “growth” shares or normal equity in the business as these are most common for a PE investment where a majority stake in the business is being taken.??

There are also included some high-level details on tax implications of an Enterprise Management Incentive (“EMI”) or Company Share Option Plan (“CSOP”) scheme, as these can be tax efficient routes but are only suitable where there the PE investor does not have a controlling stake.??

Provision of equity to management??

Management equity can take the form of a separate class of growth shares with a hurdle, or ordinary shares of the same class held by the investor.?

There will be an upfront cost to management in subscribing for the shares, but it should result in capital gains tax rather than income tax when the shares are sold, with the taxable gain by reference to the growth above the upfront value (subject to meeting certain conditions).??

Growth shares – future value?

Growth shares should rank behind the ordinary shares as a separate class of share with an equity-based hurdle. This means the shares benefit from the growth in value of the company above the hurdle, but do not benefit from the value of the company below that hurdle. The hurdle is often set at a premium above the market value of the company at the date of the shares being granted. This allows a PE investor to protect the growth in value from when their initial investment was made.?

The growth shares can also be subject to further hurdles as desired commercially (provided they can be measured and are forward looking), which could be based on EBITDA/profit/IRR/enterprise value etc. These hurdles have an impact on the day one valuation of the shares being issued to management – this generally results in the initial value of growth shares being much lower than ordinary shares – meaning that it is easier for management to either pay for the shares at a low value or have a low initial tax charge where acquired for nil consideration.?

Further details on growth shares can be found at the linked BDO article: Growth Share Plan - BDO.?

Ordinary shares?

Management may also be given the opportunity to subscribe for ordinary shares, but as noted above without a hurdle attached to the shares the day one valuation will likely be higher. Consideration therefore needs to be given to how the acquisition of the shares by management (or the tax charge on the market value) will be funded. Potential funding routes include:?

1. Cash bonus – a grossed-up bonus could paid so that the net amount is sufficient to cover either the market value of the shares or the income tax and NIC amounts due by the employee.??
2. Loan – a loan could be made by the company to the employee for either the market value of the shares or the income tax and NIC amounts due by the employee. Under this route a corporate tax charge under the loan to participator rules for the company at 33.75% of the loan value typically arises for the company where it is “close” for tax purposes (which would be the assumption where controlled by a PE investor).??
3. Partly paid shares – the employee could pay a notional amount with the remainder of the market value left outstanding. This would be treated as a notional loan with the employee having been treated as having paid market value, therefore no tax should arise on acquisition of the shares.? The loan to participator charge that arises for ii above should also not apply following the RKW judgement [RKW Limited v HMRC [2014] UKFTT 151 (TC)].??

Tax considerations?

There are several tax considerations in relation to the award of growth shares and ordinary shares:?

• It is important that it can be demonstrated that shares are being subscribed for at market value for tax purposes – typically this will involve a third-party valuation unless the conditions of the HMRC Memorandum of Understanding between the BVCA and HMRC are met. For growth shares a valuation should always be undertaken.??

• To the extent that the tax market value of the shares exceeds the price paid then income tax on the difference will be due, potentially via PAYE (with NIC also being due) if the shares are deemed to be Readily Convertible Assets, which is typically the case for an investment where the PE investor has a controlling stake.??

• It is recommended that joint s431 ITEPA 2003 elections are entered into by the individuals and their employing company within 14 days of the shares being acquired. Failure to do this can result in unexpected income tax and NIC charges on exit.??

?EMI share options?

EMI options are share options which can be granted under an HMRC approved scheme provided certain conditions are met, which are summarised in the linked article (Enterprise management incentives (EMI) - BDO).??

The main condition from a PE investment perspective is that the company granting the EMI options must not be under control of another company and there cannot be “arrangements” under which the company could come under control of another company. This means that EMI options are typically unsuitable for majority private equity investments.??

Where there is a minority private equity investment the control test might not be breached meaning EMI options might be possible, however the share rights for the PE investor, such as swamping rights, should be carefully considered as this is an area under increasing scrutiny. Advance assurance can be sought from HMRC where there is deemed to be any uncertainty as to whether this condition could be breached.??

CSOP?

A CSOP scheme is another HMRC discretionary share option plan which allows companies to issue options to employees / full time directors. Unlike EMI share options, there are no limits on company size, number of employees or type of trading activities. From April 2023, the options can be over any share class (including a separate class of management shares), making it more attractive as the options can be over growth shares for example.??

However, the scheme has several requirements which makes it more restrictive than EMI, which are summarised in the linked article (Company Share Option Plan (CSOP) - BDO).??

The main condition from a PE investment perspective when considering a CSOP scheme is that there are similar independence conditions to an EMI scheme – again limiting the scheme relevance to PE minority investments instead of where the PE investor takes a controlling stake.?

Ongoing compliance?

Where share plans or shares are issued to employees there will be ongoing annual reporting requirements please see Share Plan Reporting - ERS - BDO for further details on these aspects.?

How BDO can support you?

Our team of experienced tax professionals can provide the necessary support with implementing a management incentivisation scheme or undertake a review of existing arrangements in place.?

Tax risks are often identified on exit where schemes are not properly implemented or certain actions are not taken (as noted in our “Five tax issues to address in advance of due diligence” article Five Tax Issues for Due Diligence | Corporate Tax Advice - BDO). It is therefore important that suitable tax advice is obtained and retained on file to support the position on a future exit.?