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Structuring Exits Effectively. Colin Kendon Head of Employee Incentives & Benefits. Case Study – Company A - Fully Diluted Share Cap Table. Growth shares participate pro-rata to holdings above £10 million Nominal base cost in all the shares. Deal Terms.

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structuring exits effectively

Structuring Exits Effectively

Colin Kendon

Head of Employee Incentives & Benefits

case study company a fully diluted share cap table
Case Study – Company A - Fully Diluted Share Cap Table

Growth shares participate pro-rata to holdings above £10 million

Nominal base cost in all the shares

Subject matter | Client details

deal terms
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

Subject matter | Client details

distribution of sale proceeds
Distribution of Sale Proceeds

Subject matter | Client details

consideration payable to each founder
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

Subject matter | Client details

founders initial consideration
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

Subject matter | Client details

entrepreneurs relief do founders qualify
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)

Subject matter | Client details

entrepreneurs relief common traps
Entrepreneurs\' Relief – Common Traps
  • 5% 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   

Subject matter | Client details

loan note alternative non qcbs
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) 

Subject matter | Client details

loan note alternative qcbs
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

Subject matter | Client details

why take loan notes
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

Subject matter | Client details

claiming entrepreneurs relief
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 

Subject matter | Client details

deferred consideration
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)  

Subject matter | Client details

earn outs three methods of structuring
Earn-outs: Three Methods of Structuring
  • For 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    

Subject matter | Client details

comparison of earn out methods
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.   

Subject matter | Client details

ascertainable method
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

ascertainable method cont
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).   

Subject matter | Client details

marren v ingles method
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 

Subject matter | Client details

paper for paper method
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

Subject matter | Client details

ascertainable method trap
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

Subject matter | Client details

ceo breakdown of consideration
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 

Subject matter | Client details

ceo initial consideration
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

Subject matter | Client details

ceo earn out
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) 

Subject matter | Client details

option holder 1 qualifies for er
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

Subject matter | Client details

option holder 2 can he qualify for er
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)

Subject matter | Client details

options some practicable points
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

Subject matter | Client details

esops
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)

Subject matter | Client details

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Colin Kendon, Partner

Head of Employee Incentives and Benefits Group

Email: [email protected]

Direct Dial: 0207 905 6312

Bird & 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 of Bird & Bird LLP and of any non-members who are designated as partners, and of their respective professional qualifications, is open to inspection at that address.

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