Structuring Exits
Effectively
Colin Kendon
Head of Employee Incentives & Benefits
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 million
Nominal base cost in all the shares
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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
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Distribution of Sale Proceeds
Class
%age by NV
Initial Consideration
£m
Earn-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
Optionholder 1
Growth
3%
0.3
0.429
Optionholder 2
Growth
3%
0.3
0.429
20
10
Total
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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
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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
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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)
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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
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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)
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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 nonQCBs
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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 reorganisation treatment applies from HMRC Business Transactions
Unit
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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
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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)
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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
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Comparison of Earn-Out Methods
Total tax paid assuming maximum earn-out of £2.875 million pays
out in full
Ascertainable
£287.5k
10%
Marren v Ingles
Paper for Paper
£598k
£805k
20.8%*
28%**
*Assumes HMRC agree NPV of earn-out on completion is 40% of maximum
**Assumes no reduction for AEs/ spouse transfers etc.
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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.
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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).
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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
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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
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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
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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
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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
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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)
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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
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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)
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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
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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)
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Thank you
Colin Kendon, Partner
Head of Employee Incentives and
Benefits Group
Email: colin.kendon@twobirds.com
Direct Dial: 0207 905 6312
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