Dr McDeal title MBO Tax issues for management

I am considering a buy-out and my private equity backer has been talking to me about how she requires a minimum “money multiple” before she makes an investment.What is that?

Private equity investors have historically focused on internal rate of return (IRR) as the primary benchmark for determining the return they would like from an investment. More recently, however, they have focused on the actual cash return they achieve on a successful transaction. Ideally, they want to double or triple the cash value of their investment over a three to four-year period.

That’s fine. But I don’t understand why she talks about my money multiple being 30 to 40, when she only needs two or three.

Ah, the beauty of leverage. Your prospective investor will be investing just a small proportion of her overall investment in equity, with the vast majority (90 to 95 per cent) being invested in a loan-type instrument that pays interest. Your backer’s return is based on getting her loan repaid and making “big” money on her equity investment. Your investment will purely be in equity and, assuming a successful exit, your returns could well be 40-50 times your original investment.

So my original £100,000 investment could make me £3m to £4m.That sounds too good to be true?

If the original deal was structured correctly, and you have achieved everything that you set out to under your original business plan, and you are able to complete a favourable exit (now doesn’t that sound easy!), then achieving those returns is a realistic objective. But remember: at this point, one of those two certain things in life comes along - taxes.

I never like taxes, but all the financial press talks about is paying a ten per cent tax rate on a capital gain on the sale of a business. I don’t mind paying that.

The books were right until the 2003 Finance Act, although lately things have got a little bit more complicated. Generally, if you had held your shares for more than two years and followed relatively simple guidelines, achieving an effective tax rate of ten per cent on your capital gain was achievable. Unfortunately, the Inland Revenue has decided to make things a bit more complex of late.

Sound ominous - what’s changed?

Last year’s Finance Act introduced new tax rules for shares held by employees or directors, with the most important change being the introduction of a new set of rules for “restricted shares”. These restricted shares are common to most buy-outs as they include restrictions such as “tag-along” rights (which give the managers the right to sell their shares if the private equity provider sells its shares), “drag-along” rights (which require the managers to sell their shares if the private equity provider sells its holdings) or an obligation to sell or forfeit shares if the manager retires early or under a cloud.

So what’s the potential effect on me?

At the time of the initial buy-out, the Inland Revenue will compare the value of the restricted shares with what their market value would be without that restriction. The percentage by which the restriction devalues the shares will be the percentage of the eventual sale price for the shares that will be charged to income tax on their disposal. For example, if restricted shares are issued to the management at 50p per share, this price reflects their value taking into account the applicable restrictions. But without these restrictions, the shares would be worth £1 each. In this case, 50 per cent of the value of these shares on exit will be subject to income tax and National Insurance when they are sold (with the remaining 50 per cent being subject to capital gains tax).

Oh – could be nasty!

It could well be. Instead of achieving ten per cent effective capital gains tax rate on the total gain, you would have to pay income tax at 40 per cent and National Insurance on half of your gain. Fortunately, over the last few months detailed, and complicated, guidelines have been agreed with the Inland Revenue. If followed to the letter, these may mean that restricted shares issued in a management buy-out may not fall under the income tax regime at a later date.

So why is the private equity industry up in arms?

Private equity investors rely on your investment - and subsequent shareholding - in Newco as the most effective means of incentivising you and
your team to deliver on your business plan. If the eventual effect of the Finance Act 2003 is to make management’s investment hopelessly tax inefficient, the incentivisational aspect of your equity will become hopelessly diluted. Worse still, existing forms of Inland Revenue approved share schemes (such as EMI schemes) only serve to deliver relatively small values of equity into managers’ hands.

What are these guidelines?

Broadly speaking, there are six key conditions as set out in the following Inland Revenue clauses:
i. Management shares must be ordinary shares;
ii. Any shares ranking ahead of the ordinary shares must be on “commercial” terms;
iii. Management must pay the same price for their shares as other investors;
iv. Management must acquire their shares at the same time as other investors;
v. Management shares must not have any rights over and above other ordinary shareholders;
vi. Management must continue to receive “regular” remuneration through salary and bonuses.

All seems a bit complicated. Which of the conditions cause the most problems?

Numbers ii and v are the tricky ones. The Inland Revenue (on clause ii) defines “commercial” terms as being at least as high as external debt. Therefore, in theory, venture capitalists must be paid at least the same level of
interest as the bank. This is not always possible unless the business has strong cash-flow because the banks won’t allow it. Clause v makes it difficult for the management to achieve a “ratchet” i.e, if the business beats the business plan, the management gets a greater shareholding.

How can I protect my position?

This whole area is still taking shape.You must take tax advice from a specialist tax adviser familiar with the buy-out market or you could have a very large tax bill on exit. If you are unsure where to turn, call Gordon Blair on 020 7405 4709 or e-mail gordon.blair@livguarantee.com