structuring exits effectively

Structuring Exits Effectively

Colin Kendon

Head of Employee Incentives & Benefits

Subject matter | Client details© Bird & Bird LLP 2012

Case Study – Company A - Fully Diluted Share Cap Table

Class % age by Nominal Value

VC Prefs 30%

Founder 1 Ords 20%

Founder 2 Ords 20%

Founder 3 Ords 20%

CEO Growth 4%

Option-holder 1 Growth 3%

Option-holder 2 Growth 3%

Growth shares participate pro-rata to holdings above £10 millionNominal base cost in all the shares


Deal Terms

Offer for £20 million initial consideration payable: ● £10 million to preference and ords pro-rata to holdings● £10 million to prefs, ords and growth shares pro-rata to holdings

Earn-out of up to £10 million payable to all employee shareholders pro-rata to holdings ● calculated as multiple of profits for FYs 1, 2 and 3 ● FYs run to 31 March● capped at 1/3rd of maximum (£3.333 million) per F.Y.● calculated and paid on 1 July following each FY

Completion occurs on 6 April 2013


Distribution of Sale ProceedsClass %age by NV Initial

Consideration £mEarn-out

£m

VC Prefs 30% 6.333 NIL

Founder 1 Ords 20% 4.222 2.857

Founder 2 Ords 20% 4.222 2.857

Founder 3 Ords 20% 4.222 2.857

CEO Growth 4% 0.4 0.571

Option-holder 1

Growth 3% 0.3 0.429

Option-holder 2

Growth 3% 0.3 0.429

Total 20 10


Consideration Payable to Each Founder

£4.222 m initial consideration● paid on completion on 6 April 2013

Maximum £2.857 m earn-out (£952.3k per FY) payable:● 1 July 2014● 1 July 2015● 1 July 2016

Assume:● nominal base cost● full lifetime limit of £10 million ER available to each Founder


Founders – Initial Consideration

Gain on sale for cash of £4.222 million

CGT payable by 31 January 2015 on disposal occurring in 2013/14

CGT at 28% = £1.82 million assuming no planning


Entrepreneurs' Relief – Do Founders Qualify?

Available for "securities" if for 1 year prior to disposal: ● trading company or holding company of a trading group● officer or employee of one or more companies in the group● sellers "personal company"

• holds at least 5% of ordinary share capital when tested by nominal value; and

• 5% of voting rights exercisable by virtue of the holding

Once conditions met, any disposal of securities qualifies (even if held less than a year)


Entrepreneurs' Relief – Common Traps5% Tests● calculated by reference to relative nominal value;● of "ordinary share capital" (all shares unless only a right to

a dividend at a fixed rate)

Preference shares will be OSC here but test met as nominal value of all classes is the same

Trading Company Test ● HMRC apply 20% indicators in CG64090 ● less than 20% of management time spent on non-trading● less than 20% of turnover from investments ● less than 20% of assets on the balance sheet non-trading assets


Loan Note Alternative (non-QCBs)

If initial consideration settled in loan notes structured as non-QCBs: ● Re-organisation treatment applies, loan notes are treated as having

been acquired when the original shares were acquired for the same base cost

● tax point arises on sale or redemption of the loan note

BUT founders will not qualify for ER on sale or redemption of the loan note (assuming they hold less than 5% of the OSC of the purchaser).

If settled in shares issued by the purchaser, same treatment applies as for non-QCBs

Sellers can elect to disapply re-organisation treatment causing the tax point to arise on completion so ER can be claimed (s169Q(4) TCGA 1992)


Loan Note Alternative (QCBs)

If the initial consideration is settled in loan notes structured as QCBs: ● gain is calculated on completion and held over until sale or redemption of the

loan note● held over gain brought into charge on sale or redemption of the QCB

Founders will not qualify for ER on sale or redemption (assuming they hold less than 5% of the OSC of the purchaser)

Sellers can elect to disapply hold-over treatment causing the tax point to arise on completion so ER can be claimed (s169R TCGA 1992)

Note: Before 23 June 2010 ER operated as a reduction in the gain so ER could be claimed for tax year of completion thereby reducing the held over gain achieving both deferral and an effective reduction in the rate to 10%

QCBs should now be avoided as position on default is less attractive than non-QCBs


Why Take Loan Notes?

If ER conditions not met, loan notes achieve:● deferral of tax point until sale/ redemption of the loan notes● reduction in tax by utilising annual exemptions in future tax years /

spouse transfers etc.

Can avoid CGT completely by redeeming loan notes after shedding UK residence BUT Snell v HMRC [20006] EWCH 3350 (CH) and John Coll and Marian Coll v HMRC [2010] UKUT 114 (TCC) illustrate the risks:● cannot take the notes intending to avoid tax otherwise re-

organisation treatment disapplied for 5% plus shareholders● disapplied for ALL sellers even if ONE seller has a tax avoidance

motive

If using loan notes – obtain clearance under s138 TCGA 1992 that re-organisation treatment applies from HMRC Business Transactions Unit


Claiming Entrepreneurs' Relief

Founders happy to pay 10% on initial consideration, don't want to move abroad so opt for initial consideration to be settled in cash

Tax due by 31 January 2015 for disposals in 2013/14

ER reduces tax on initial consideration of £4.222 million from £1.82 million to £422k saving £760k

Deadline for claiming ER 31 January 2016 (being first anniversary of 31 January following the tax year of disposal) but● claim ER with 2013/14 tax return so tax paid at 10% by 31 January

2015


Deferred Consideration

Usually a portion of the initial consideration is held back and paid net of warranty and indemnity claims

Full amount of deferred consideration is taxed for year of disposal under s48 TCGA 1992● no reduction for time use of money etc ● no reduction for possibility of warranty claims (s49(1) TCGA

1992) but tax can be reclaimed if warranties paid later (s49(2) TCGA 1992)


Earn-outs: Three Methods of StructuringFor tax purposes earn-outs can be structured in one of three ways:

1. Ascertainable treatment ● 10% rate on full earn-out but tax paid early and some ER can be

wasted

2. Unascertainable and capable of settlement in cash● "Marren v Ingles" treatment, blended rate between 10% and 28%,

some tax paid early and some ER may be wasted

3. Unascertainable and capable of settlement only in securities issued by the purchaser ● "paper for paper" treatment, tax paid after receipt of cash but at 28%

rate


Comparison of Earn-Out Methods

Total tax paid assuming maximum earn-out of £2.875 million pays out in full

Ascertainable Marren v Ingles Paper for Paper

£287.5k £598k £805k

10% 20.8%* 28%**

*Assumes HMRC agree NPV of earn-out on completion is 40% of maximum

**Assumes no reduction for AEs/ spouse transfers etc.


Ascertainable Method

Structure as a fixed amount of £2.857 million:

•Payable in cash in three equal instalments of £952.3k per FY

•Founder warrants that profit targets will be met

•Damages capped at £952.3k per FY for failure to meet targets.

Damages netted off against each instalment - founder receives the net amount on 1 July following each FY.

Subject matter | Client details

© Bird & Bird LLP 2012

Ascertainable Method (cont.)

Earn-out is ascertainable (£2.857 million) so founder taxed on the maximum for tax year of completion with no reduction for possibility of warranty claims (s49(1) TCGA 1992) ● any over-paid tax due to warranty payments can be

reclaimed (s49(2) TCGA 1992)● ER claims can be adjusted but only within deadline for making

the claim itself (i.e. by 31 January 2016)

Tax of £285.7k paid on 31 January 2015, earn-outs paid on 1 July 2014, 2015 and 2016 (so before receipt of cash for FYs 2 and 3).

ER claimed on FY3 instalment may be wasted as it is determined on 1 July 2016 (i.e. after the deadline of 31 January 2016 for adjusting ER claims).


Marren v Ingles Method

Structure as an unascertainable amount capable of settlement in cash capped at £2.875 million in total and £952.3k per FY

Earn-out is taxable on NPV on completion (Marren v Ingles [1980 STC 500])● ER can be claimed on this element● If the earn-out pays out more than its NPV, excess is subject to CGT● ER cannot be claimed on this element as the earn-out is a chose in action

not a security

If the earn-out pays out less than its NPV, tax paid on completion can be reclaimed (s279A-D TCGA 1992)

Tax of £115k paid by 31 January 2015 (assuming HMRC agree NPV of earn-out is 40% of the maximum and ER claimed)

Further tax paid on 31 January 2016, 2017 and 2018 of £483k (in total) if the earn-out pays out the maximum for each FY


Paper for Paper Method

Structure as an unascertainable amount settled by the issue of non-QCB loan notes issued by the purchaser

Tax point deferred to sale or redemption of the loan notes

- Sellers do not qualify for ER (assuming they hold less than 5% of OSC of the purchaser) so likely tax rate on sale or redemption is 28% (ignoring annual exemptions/ spouse transfers etc.)

Traps:

•Purchaser must issue loan notes for re-organisation treatment to apply

•Ensure indicators in ERSM110940 met so HMRC will treat as further consideration and not as a securities option

"Tax avoidance" test in S137 TCGA only relevant for 5% plus sellers

Total tax payable: 28% x 2.875 million = £805k


Ascertainable Method - Trap

Must be fixed amount, can be subject to contingencies but not many!

Marson (Inspector of Taxes) v Marriage [1980] STC 177 ● only case on border between ascertainable and unascertainable

consideration ● sale of land for fixed amount if planning permission achieved or 50% of

compensation if land compulsorily purchased, compensation possibility made consideration unascertainable

HMRC say at CG14887: "The consideration will be unascertainable if events which establish the AMOUNT do not occur until after the date of the disposal"

Make adjustments through warranties to minimise contingencies


CEO – Breakdown of Consideration

£400k Initial consideration payable 6 April 2013

£571k max earn-out (£190.3 per FY)

Assume nominal base cost in his growth shares

The CEO does not qualify for ER as his growth shares represent less than 5% of the OSC when tested by nominal value and he has less than 5% voting rights

Note: The growth shares could have been structured so he meets the 5% tests without giving him 5% economic rights


CEO – Initial Consideration

Initial consideration ● part cash● part loan notes structured as non-QCBs

Allows spouse transfers / use of annual exemptions in future tax years so effective rate below 28%

Traps loan notes must be:● incapable of redemption within 6 months (so not a "proxy for cash") ● issued by the purchaser for re-organisation treatment to apply

Note: Tax avoidance test in s137 TCGA 1992 not relevant to less than 5% sellers


CEO – Earn-out

Paper for paper treatment, s138A TCGA applies if:● only capable of settlement in securities issued by the

purchaser ● unascertainable

Ensure conditions in ERSM 110940 met so taxed as further sale consideration not as a securities option, main ones:● employee and former employees shareholders participate on

same terms (OK to exclude non-employee shareholders such as the VC)

● earn-out can be forfeitable for cessation of employment but not beyond a reasonable period (up to 3 years generally acceptable)


Option-Holder 1 – Qualifies for ER

Initial consideration £300k

Earn-out max £429k (£143k per FY)

Personal company test inapplicable for EMI shares

One year holding period still applies● Satisfied if he acquires option shares on 6 April 2012 and

and completion occurs on 6 April 2013

Same position as founders so can take initial consideration in cash + claim ER

Earn-out structured using ascertainable method


Option-Holder 2 – Can he Qualify for ER?Assume he exercised his option immediately before completion.

ER not available as he holds his EMI shares for less than 1 year prior to disposal BUT

Better position than CEO● he should be able to exchange EMI option shares for loan notes and

claim ER on sale / redemption of the loan notes 12 months following completion

● earn-out can be paper for paper for the same reason

Note: This assumes the legislation will be altered to allow ER on securities exchanged for EMI option shares (Finance Bill No. 2 to be published in the Autumn)


Options – Some Practicable Points

Powers of Attorney ● Require option-holders to sign PoAs (preferably as a condition of grant) ● Avoids using drags in articles ● Attorney can exercise options on exit, sell option shares, use proceeds to

pay exercise price, costs, PAYE / NIC (if any) + pay net proceeds to OH

Corporation Tax Deduction ● Attorney can exercise options on exit, sell option shares, use proceeds to

pay exercise price, costs, PAYE / NIC (if any) + pay net proceeds to OH ● Employer qualifies for CT deduction equal to spread on exercise ● Conditions in Part 12 CTA 2009, usually exercise immediately pre-change

of control when target still "independent" to qualify● Appears as a deferred tax asset in completion statements, negotiate

whether reflected in sale price


ESOPs

Objective: Close the trust asset and debt free post-completion● Usually avoid the ESOP being a party to the SPA – indemnity in trust deed

means any warranties / indemnities in the SPA are valueless to purchaser

If all shares used to satisfy options …● Sale proceeds used to repay debt● Repay surplus debt using contributions to avoid income tax charge on loan

write-offs

Surplus shares…● Gift / sell shares to beneficiaries so trustee not a party to the SPA (unless

purchaser will give credit for trust assets in the purchase price)

Surplus Cash…● Bonus the cash pre-completion (unless purchaser will give credit for that

assets in the purchase price)

Thank youColin Kendon, Partner

Head of Employee Incentives and Benefits Group

Email: [email protected] Dial: 0207 905 6312Bird & Bird is an international legal practice comprising Bird & Bird LLP and its affiliated and associated businesses.

Bird & Bird LLP is a limited liability partnership, registered in England and Wales with registered number OC340318 and is regulated by the Solicitors Regulation Authority. Its registered office and principal place of business is at 15 Fetter Lane, London EC4A 1JP. A list of members

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structuring exits effectively

Documents

loan notes

growth shares prorata

original shares

ords prorata

employee shareholders

trading company test

fixed ratepreference

loan notebut founders