Growth shares – what if there is no growth?

However, in circumstances where the equity is "underwater’" following a downturn or market disruption caused by Covid-19 for example, it may be necessary to reset the terms of the incentivisation arrangements in order to ensure that they continue to operate as intended.  How this is done may give rise to adverse tax implications, so it is important to consider how best to achieve this commercial aim of ensuring that management continue to be appropriately incentivised.

As portfolio companies look to recover from the impact of recent market turbulence, we are seeing incentive structures which need to be reset in order to be fit for purpose.  It is not uncommon in these situations for the debt within the structure, whether external or shareholder debt, to outweigh the value of the business. This can result in a shift in focus from driving value and growth into the equity to simply trying to obtain a return for investors on the debt instruments in place within the structure.

The question then becomes: how do you incentivise management, in an efficient way, to improve the performance of the business and return debt to an investor?

To do this, an investor might propose that the management team shares in a percentage of any value delivered on the repayment of the debt instruments above the existing value break. However, providing an incentive via the holding of shares in “Topco” may not be an appropriate way to achieve this, for one of two reasons:

• the hurdle to reach the value necessary for management to participate would be commercially too challenging to achieve, because the entire amount of the debt would need to be fully repaid before any value would flow into the share capital; or
• if the value of management’s equity were calculated according to a formula irrespective of the underlying equity value of Topco, HMRC may be inclined to suggest that returns on those shares are greater than their market value and therefore should be subject to income tax (and potentially NIC charges).

If the value of the debt instruments is low, it may be possible and appropriate to simply transfer a percentage of the debt to management for market value. However, if the value of the debt instruments to be transferred is not negligible, an investor might (rather than “tranching” the debt in some way, which may be complicated) consider using a subsidiary growth share plan instead.

To do this, a new class of growth shares would be issued below the level of the debt instruments. The growth shares would contain rights which entitle their shareholders to receive returns which correlate to a proportion of the future returns on the debt instruments, as commercially agreed.

The key benefits of this approach are:

• growth shares issued in these circumstances tend to have a relatively low value, so are likely to be affordable for management; and
• it is difficult to argue that the returns on those shares are greater than their market value because the growth shares will only pay out where value has been (or is capable of being) distributed on the subsidiary shares to “Topco” to repay the debt instruments.

As such, they may provide an attractive solution in otherwise challenging circumstances.