Is Your Management Equity Plan Ready For An Exit?

One of the most common and effective methods to incentivise a senior executive team (Management) is by implementing a Management Equity Plan (MEP).

If your company is considering an exit within the next 12-18 months, this practical guide addresses common issues associated with MEPs.

MEPs can take many forms, ranging from simply issuing ordinary shares to Management to more complex arrangements, such as options granted under a tax-advantaged scheme, or the issuance of 'growth' shares. The latter benefit from the growth in value of the company above a predetermined hurdle.

The aim of any MEP should be to incentivise Management by aligning their interests with shareholders and fostering business growth. The sophisticated UK legislation provides a high level of certainty regarding the tax treatment of awards, amplifying the incentive impact of the MEP.

To achieve these aims, it is crucial to carefully consider the structure and terms of an MEP. These plans undergo close examination in any due diligence process, be it for sale of the company or an Initial Public Offering (IPO), and the level of scrutiny has intensified. Potential buyers may seek indemnities or request a price reduction if errors are uncovered.

Errors can occur during design and implementation of an MEP, which may lead to unintended and costly tax consequences. A significant proportion of any value realised upon exit may become subject to PAYE and NIC (including the apprenticeship levy, if applicable). PAYE and NIC rates are considerably higher than capital gains tax rates, with top rates of 45 or 47 percent plus 2 percent NIC for 2023/24 as opposed to the current capital gains tax rates of 10 or 20 percent.

An exit process is a demanding period that requires management alongside the regular day-to-day responsibilities. Conducting a pre-transaction health check on the MEP can help identify issues before this process starts. This should be done well in advance of a formal sale process. Below, we detail the common problems we observe when performing a health check or undertaking a due diligence process on MEPs.

1. Missing or no section 431 elections

A section 431 election is a document signed by both the Manager and the employer within 14 days of acquisition of the Manager's shares. It does not have to be filed with HMRC but should be kept in a safe place.

This election is a key document any advisor on a due diligence will ask for. Why? Because it helps ensure that all proceeds from a market value disposal of Management's equity are not subject to PAYE and NIC; instead, they should fall within the capital gains tax regime.

This key document can be easily misplaced, and the risk regarding the tax treatment of the MEP shares upon exit increases without it, even if formal valuation work was conducted when the shares were acquired.

It is crucial to check these elections, and copies should be readily available for handover to the due diligence team. If the elections are lost or were not made, efforts can be made to review the tax position on exit and prepare for a due diligence process accordingly.

2. Ambiguity on the valuation at acquisition of the MEP shares

The second document an advisor will request during due diligence is a copy of any valuation advice received when Management acquired their shares.

If Management pays an amount equal to the Unrestricted Market Value (UMV) of their shares at acquisition, no employment taxes will arise on acquisition or on a market value disposal of their shares.

In many cases, employers will obtain an independent third-party valuation of the shares to be acquired, ensuring they have made their 'best estimate' of the value for PAYE purposes.

A third-party valuation became even more important once HMRC stopped their post-transaction valuation check (PTVC) service. Additionally, HMRC expects a forward-looking valuation approach when valuing growth shares or shares in a highly leveraged company. Advisors on a due diligence will seek to understand if the valuation method was appropriate and in line with HMRC's guidance and practice.

Complexities arise if MEP shares are held by the founders of a business. HMRC specifically issued a statement declaring that founder shares fall under employment-related securities (ERS) legislation. This legislation can result in employment tax charges during the acquisition, holding and disposal of shares. It is crucial to understand what the founders paid for their shares and how this was determined. It may not always be as simple as acquiring shares on incorporation of a shell company. What if you are not the founder of the business itself but just the company? What if you transferred from a pre-existing business founded by someone else? Have you still paid UMV? In our experience, the topic of valuations and price paid by Management is usually the most debated area in the context of MEPs.

3. Fair market value paid to a departing Manager

Attaching leaver provisions to Management's shares (typically outlined in the Articles of Association) is standard market practice and helps companies retain their best Managers. If a Manager ceases employment (and exits the MEP) as a 'good leaver', they will generally be paid fair market value for their shares (ignoring any discount for size of the Manager's shareholding).

Commonly, a substantial minority discount to calculate fair market value for tax purposes should be applied, although the actual discount will depend on the facts and circumstances. Failure to apply this discount could result in the departing Manager receiving more than market value for their shares. This excess value would then be subject to PAYE and NIC rather than capital gains tax. This aspect is frequently overlooked and is likely to be flagged during due diligence.

4. Awarding more shares shortly before an exit event

There may be unallocated shares for the Management team (either unissued or held within a warehouse structure, such as an Employee Benefit Trust) that need to be allocated prior to an exit event. HMRC may challenge the valuation of acquisitions of unallocated shares near a realisation event, particularly if significant returns are made in a short timeframe. HMRC has contested the 'best estimate' position even when the employer obtained third-party valuation advice.

Initiating discussions well before any formal exit process about any unallocated shares could be beneficial in this respect. Issuing unallocated shares should occur as early as possible, as the UMV is likely to be lower the further away the award of shares is from an exit event.

Alternatively, the decision may be made that a cash bonus plan payable in the event of a successful exit is a simpler way to reward the Management team. If a cash bonus is to be paid, consideration should be given to whether any corporation tax deduction will be available.

5. Enterprise Management Incentive (EMI) options

Tax advantages arise when shares are offered to employees through an HMRC 'approved plan'. Enterprise Management Incentive (EMI) option plans are by far the most common approved plans, providing significant tax benefits. These include no employment tax on the exercise of a market value qualifying EMI option and the opportunity to benefit from a 10 percent capital gains tax rate on the sale of EMI shares (up to the first £1m of lifetime gains).

Several requirements must be met for options to qualify as EMI options, and these schemes undergo close scrutiny during due diligence.

It is crucial that Management be prepared for the risk of potentially paying employment taxes if their options do not qualify as EMI options. Consequently, we observe many bidders urging target companies to obtain clearance from HMRC on aspects of their EMI scheme. These aspects have included a business operating in an area that falls within "excluded activities", amended performance targets and inadequate disclosure of any restrictions attached to the shares under option.

A&M were among the firms that discussed with HMRC some of the practical (and minor) issues that led companies to inadvertently breach the EMI qualification requirements. Following these discussions, legislation was introduced with effect from 6 April 2023, which removed the statutory requirement to:

• include details of restrictions attached to MEP shares within the option agreements; and
• sign a working time declaration confirming that the option holder meets the required working time qualifying condition (albeit the condition still needs to be met).

HMRC were also advised that many companies found it difficult to prove they had notified HMRC about granting options within 92 days. Failure to do so results in disqualification from EMI tax reliefs. From 6 April 2024, the deadline for notifying EMI option grants to HMRC will shift to 6 July following the end of the tax year in which the options were granted. Aligning both the notification and reporting date for EMI options should reduce the risk of late notification, and hopefully make notification easier to substantiate.

6. Company Share Option Plan

If the company does not qualify for EMI options, you might want to consider an alternative tax-advantaged plan — Company Share Option Plans (or CSOP). While the tax relief is not as generous, CSOP options still enjoy exemption from employment taxes upon exercise, provided certain conditions are met.

The CSOP legislation was updated in 2023 to allow granting of options of up to £60,000 worth of shares, doubling the limit of £30,000 that had been in place for many years. Additionally, there is no longer a requirement for options to be granted over 'open market' or 'employee control' shares. These changes are designed to make CSOPs more accessible to companies, including those that have grown beyond the scope of EMI.

7. ERS annual share plan reporting (formally known as Form 42)

It is quite surprising how often target management teams fail to provide evidence that the annual share plan reporting has been completed, even when they are confident that the returns were submitted on time (i.e. by 6th July each year). How does this happen? The HMRC portal does not allow you to view the Excel spreadsheet you uploaded, so you need to ensure that you have saved it safely before uploading it.

The due diligence team will request copies of annual ERS returns, and if you cannot confirm timely submission, it will be flagged in the due diligence report. Penalties for late filing may seem insignificant, but penalties for inaccuracies can be substantial (£5,000 per error). Although we have not seen many inaccuracy penalties levied by HMRC, it is advisable to ensure that all annual returns have been submitted and copies retained on file.

8. Do you know your waterfall?

This may seem obvious, but we often see unintended economic consequences arise on an exit when MEPs have been issued over a long period of time and/or new investors have acquired shares. This is the challenge with a very complicated waterfall (e.g. multiple growth shares with multiple metrics for the hurdle). Even with careful modelling and drafting on implementation, it is not always easy to predict the future when your variables include restructuring, material capital contributions and/or distributions.

It is always advisable to do a fresh modelling of the economics prior to an exit event to ensure that there are no surprises on an exit.

9. The due diligence process

The due diligence process itself is time consuming and occurs when the pressure is at its peak. Management still needs to do their day job! We have discussed some of the problems you may encounter when preparing for this process.

When the detailed due diligence questionnaire lands on your desk, it is easy to overlook certain details. The right preparation, which takes time, will enable you to present your responses in the most appropriate way and result in a 'clean' bill of health. A clear presentation of answers and documents are key — if your responses are unclear, the questions will only increase.

Conducting a health-check of your MEP before the due diligence process begins can be highly helpful in identifying and possibly resolving issues. It is far better to prepare in advance than to have potentially expensive problems uncovered during a formal due diligence process.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.