With sweet equity, growth shares and EMI options increasingly used to incentivise management teams, a robust valuation is important at implementation for tax purposes and further down the line when buyers, investors and advisers scrutinise the arrangements.
Share-based management incentive schemes, including sweet equity, growth shares and EMI options, are becoming an increasingly common way for businesses to align management teams with future growth and value creation. These arrangements can be highly effective, but they also rely on a clear and supportable valuation basis at the point of implementation.
Independent valuation reports are important not only in assessing the short-term tax impact for both the company and the recipient of the share incentive, but also in supporting the position if the business is later subject to an exit, investment process or other transaction. In practice, buyer and investor due diligence will typically examine whether the valuation can be defended, whether the methodology applied was appropriate in the circumstances, and whether the scheme has been documented and administered in a way that is consistent with the intended commercial and tax treatment. Where these points are not clearly supported, they can become areas of challenge, delay or negotiation during a transaction process.
Historic Valuations Can Come Under Review
Whether a business undertakes a sale, receives investment, completes a management buyout or embarks on a restructuring, reviewing management incentive arrangements frequently form part of the due diligence process.
Investors, buyers and their advisers may seek to understand:
- Why a particular incentive structure was adopted
- How hurdle rates were determined
- The methodology used to value the company
- The basis on which growth shares or options were valued
- Whether discounts or adjustments were appropriate
- Whether the arrangements were implemented in a manner consistent with the intended tax treatment
In addition to commercial and financial due diligence, management incentive arrangements may also be reviewed as part of tax due diligence. In these circumstances, advisers are often seeking to understand not only how the scheme operates, but also the basis on which shares or options were valued at the time of grant and whether the supporting documentation aligns with the adopted tax treatment.
An independent valuation prepared at the time the scheme is implemented can help address these questions, often years after the original decisions were made.
Agreeing the valuation with HMRC at the time the shares/ options are granted gives clarity and reduces risk around the tax implications for the company and the individual.
Documenting the initial valuation, having supporting legal documentation, signed S431 elections if applicable and correctly completed and submitted Employment Related Securities returns are all factors that would be looked at as part of a tax due diligence process.
Reducing Transaction Friction
Transactions are often most successful when potential issues have been anticipated and addressed well in advance.
Where a management incentive scheme has been implemented without sufficient documentation, advisers can find themselves attempting to reconstruct valuation assumptions and commercial rationale years later. This can create additional work, lengthen due diligence processes and increase uncertainty at precisely the point when management teams are focused on executing a transaction.
By contrast, where an independent valuation was obtained and supported by clear documentation, the due diligence process can often proceed more efficiently.
The transaction itself may trigger immediate tax liabilities if options are exercised/ shares sold or restrictions lifted. A buyer or funder will need to understand and quantify the potential tax liabilities for the employer and the employee. Having the correct documentation including a documented valuation helps support this process.
Final Thoughts
Growth share and EMI schemes are designed to align management with the future success of a business. Given that their value is often realised through a future transaction, it is sensible to consider from the outset how those arrangements may be scrutinised by investors, buyers and their advisers.
An independent valuation provides a point-in-time assessment of value together with a contemporaneous record of the commercial rationale, methodology and assumptions underpinning the scheme.
Businesses that invest in getting these foundations right at the outset are likely to be better positioned when that future transaction eventually arrives.