Certain equity incentive schemes which have 'hurdle' features are very popular, but without any mechanism for prior HMRC approval there is risk inherent in assessing the value of such awards at issue. The best mitigation available is to adopt an appropriate valuation approach.

Growth shares (as well as similar equity instruments such as sweet equity issues in private equity deals) that feature ‘hurdles’ to be cleared before participation in any of the economic benefits of ownership, are very popular methods of incentivising management. Such hurdles will most frequently consist of some form of target valuation of a company (usually upon an ‘exit event’, typically the sale of the business) which is set at a level above the current assessed value of the business. The growth share, typically, would then simply share in a set percentage of the proceeds achieved above this hurdle.

For a relatively straightforward example, growth shares may be issued in a company which collectively give the holders a 10% interest in the equity value achieved over a £50m hurdle. If the business is then sold for £65m, the growth shares collectively would be entitled to £1.5m (or 10% of the £15m achieved above the hurdle threshold).

Say, however, in this example that the equity of the whole company at the date of the award of growth shares is valued at £40m (and that the only other shares in issue at the time were ordinary shares)? Surely, in this instance, the ordinary shares are collectively worth £40m – because if the business was sold today, the ordinary shareholders would get £40m – meaning that there is no residual value attributable to the growth shares?

Issues with the Current Value Model

The above approach – which in simple terms looks at the current valuation of a business and apportions that value across the share classes in issue in line with what they would receive on an imminent sale of the business – is often referred to as a Current Value Model (CVM).

Inherently, this approach is not forward-looking, and so is considered limited owing to its inability to capture potential future outcomes, in particular business growth expectations ahead of a targeted exit. Going back to the example above, under a CVM you would assess the growth shares to be basically worthless as at the date they were issued, with the equity in the business currently valued at £40m and the hurdle threshold at £50m. However, getting from £40m to £65m cited in my example over a period of, say, four years would require annual growth of c.13% - which is clearly not a wildly unfeasible outcome – returning the growth shares (as a class) the £1.5m. If I was personally awarded those growth shares, I wouldn’t say that I would be happy to let them go at the date of their issue for next to nothing given this potential upside!

It is for this reason that the CVM should only be used in certain situations. The International Valuation Standards (IVS, as published by the International Valuation Standards Council) states that the CVM should only be used in very limited circumstances, such as when a “liquidity event” is imminent or there is no reasonable basis for estimating the amount and timing of any future benefit (more on this below).

This view is almost certainly one that would be shared by HMRC when it comes to the assessment of tax liabilities around growth shares and any other management incentive schemes. The Share Valuation Worked Examples Group (which is a committee of share valuation specialists that has been pulled together to collaborate with HMRC on specific employee share scheme valuation issues, and which also comprises senior representation from HMRC) has issued an Exposure Draft document that reiterates the wording contained in the IVS. Anecdotally, I have also heard HMRC challenging nil or nominal valuations by questioning why the shares are being issued at all (and all the associated costs being incurred in drafting the documents) if they are genuinely considered to be worthless? Which is a pretty good point, to be fair.

Risks of flawed approaches

Unlike awards being made under the Enterprise Management Incentive Scheme (EMI), or one or two other approved schemes, it is not possible to approach HMRC to ask for prior approval for growth share or sweet equity schemes. The obvious risk therefore is that HMRC issue a retrospective challenge against the values that have been determined at the date of issue, with the possibility not only of the company incurring additional liability (along with the potential for fines) but also the potential additional cost of fighting the challenge.

An additional risk however – with a greater likelihood – arises on the exit event that is generally envisaged in such scenarios: an acquirer would most likely, through their due diligence processes, uncover the potential for such a challenge, and seek to cover themselves during negotiations either through indemnities or chipping at the provisionally agreed deal value.

What approaches are applicable?

One of the most critical, and often time consuming, stages in a transaction is legal due diligence. The lawyers analyse every aspect of the business, including the following (which is by no means an exhaustive list):

• Corporate structure and governance documents (e.g. articles of incorporation, shareholder agreements, board minutes etc.)

• Material supplier and customer contracts

• Loan agreements, debt terms, and credit facilities

• Intellectual property

• Employment matters (e.g. management team contracts, compliance with labour laws, employee benefit schemes etc.)

• Real estate - property ownership / rental agreements

• Any ongoing or prior litigation

• Compliance with GDPR and other cybersecurity laws