Re-motivating management

Underwater shareholdings

There are an increasing number of private equity-backed companies that have no equity value due to high levels of debt in the company and the downturn in activity. For many investors, the servicing and repayment of the debt investment is their primary short term objective; a return on their equity investment is an altogether more distant prospect.

This state of affairs has disastrous consequences for management shareholders. Shares awarded to management are effectively underwater and no longer act as an incentive; the possibility of realising any equity value has become too remote. Managers who sold shares in a profitable company and were required to roll over a large proportion of their value into shares are in an even more unenviable position. The value they rolled over has now been lost as their new shares are in the debt laden company. These increasingly common situations can have a very negative impact on the morale of the management team at the very time when they need to be as motivated as possible to help the investor achieve any return on its overall investment.

In these conditions how can management be re-incentivised? As with any incentive plan the main issues to consider will be:

Cost to management and tax efficiency

The main objective is to ensure that future growth is taxed as capital gain (at 18%) and not income tax (40%, rising to 50% next year) whilst at the same time ensuring that the upfront tax and acquisition costs are minimised. This element is particularly important in the current climate; management will not want to make a financial outlay, particularly if they have previously lost money on a failed investment.

Level of complexity

The main objective is that the chosen incentive plan should be easy to understand and to operate; if management do not understand how the incentive works, it will defeat the purpose of its implementation. There may be a high level of staff turnover as new management teams are brought in; dealing with leavers and joiners will be important.

Targeted incentive

The main objective is that the incentive should provide a proper and targeted incentive. This may be more difficult to achieve where the ordinary share capital is underwater.

Where there is no prospect of real equity value being generated in the medium term, other ways have to be found of providing value in as tax efficient a way as possible. This presents a challenge and some creative thinking is required. A very workable solution involves an alignment of the management's interest with the repayment of the investor debt. This achieves all objectives and should hopefully provide sufficient incentive to re-motivate the team and drive the business forward. Other solutions may also be available depending on the particular facts.

Current trends in equity incentive plans

In these turbulent times, it is equally important for those companies with some equity value to also have an incentivised management team and now can be a great time to take advantage of low share values and make outright awards of ordinary shares to management. These awards can be made subject to leaver clawbacks and even performance related clawbacks. If the shares have a low value but there is a real prospect of growth this is a very straightforward solution. However if the shares have value at the outset then this will be a less attractive proposition because of the associated upfront tax charge or cost to management.

What other solutions are available? There are a number of other increasingly popular plans to choose from including:-

HMRC Tax Favoured Options

It is usually the case that private equity backed companies won't qualify for HMRC tax favoured plans (such as Enterprise Management Incentive Options) but this is not always the case so this should always be considered at the outset as they provide tax efficient and simple solutions.

Deferred Share Plans

A deferred share plan typically involves ordinary shares being issued to management at full market value but the obligation to pay is deferred until the manager realises his investment (although a similar result can be achieved simply by making loans to managers which are then used to acquire shares). All growth in value in the shares should be subject to capital gains tax at 18%. This can be a solution but there are other tax and commercial issues to consider.

ExSOP or Joint Ownership Plans

The ExSOP, frequently referred to as a joint ownership plan, is a share incentive arrangement developed by Pinsent Masons. Employees acquire ordinary shares jointly with an employee benefit trust. On an eventual sale of the shares the employee will be entitled to a share of the proceeds of sale equal to the growth in value of the shares since acquisition above a fixed target growth rate and this amount is subject to capital gains tax at 18%. The trust receives the balance.

'Growth Shares'

This solution (also known as 'Flowering Shares' or 'Value Shares') involves the creation of a new class of shares with usually no voting rights and often have limited rights to income. They do however have capital rights which entitle them to participate on an exit (which typically includes a sale, listing and winding-up of the company) but these only kick in once the main investor has achieved a specified level of return on their investment, usually calculated by reference to their Internal Rate of Return (IRR). Again all future growth in value should be subject to capital gains tax at 18%.

Conclusion

Now is a good time for companies to be thinking about reviewing existing incentive arrangements and putting in place new plans. Share values are low and, where there is a realistic prospect of future growth, now is a good opportunity to get shares into the hands of management without incurring much cost. Where existing arrangements are now defunct due to plunging equity values, action should be taken to ensure that there is a real incentive for management to perform by allowing them to participate in an improvement of the business, even if this does not necessarily deliver a real increase in equity values.

Rebecca.Power@pinsentmasons.com.

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