Navigating MIP Resets

This is the simplest way to re-incentivise management when a MIP is underwater, as no actual restructuring is involved. A cash bonus, which can be linked to the investor’s return on an exit, is paid to management on exit for good performance. This is straightforward to implement with a bonus letter (as no amendments to the corporate documents or the existing MIP are required), and the simplicity of this approach makes it attractive because it is easy to communicate to management and can be put in place quickly. However, exit bonuses are less tax efficient than other options, as they will be subject to income tax and employee and employer national insurance contributions (NICs) when they are paid, most likely at a marginal rate of 47%. Also, management will not be entitled to any equity upside on exit (unless their bonus is directly linked to the company’s performance), which may make this a less attractive option.

Another option is to enhance the value of the existing MIP by amending its terms, for example by increasing the percentage of equity in the MIP, by changing the ratchet terms to make it more generous for management or by lowering the hurdle above which management’s return kicks in. As well as making the MIP more attractive to management, changing the terms of the MIP should be neutral from a capital gains tax (CGT) perspective and retain CGT treatment for management on an exit, so this approach will be more tax efficient than an exit bonus provided certain technical requirements are met. However, this approach needs to be carefully considered to make sure that certain tax rules governing “employment related securities” are not engaged, which could give rise to an upfront, unfunded (i.e. "dry") income tax charge. In addition, more complex amendments to the corporate documents will be required to amend the MIP. Also, this approach would not be suitable in situations where - based on financial projections - management’s equity would remain underwater despite the MIP being amended, because it is subordinated behind a significant amount of investor debt.

Another approach involves issuing new sweet equity to management which sits higher up the waterfall than the existing MIP shares. This can be simpler than amending the existing MIP terms, particularly if there are different participants in the “new” MIP. However, it can involve more complex amendments to the corporate documents, and the new MIP will still rank behind the investor debt (unless the new MIP shares are introduced further down the group structure, which creates complexities on an exit). Another factor to consider is that a valuation of the new MIP shares will be needed. This can add time and expense, but the value of the newly issued sweet equity is key in determining the price which management need to pay to subscribe for the shares (provided they do so, and certain requirements are met, there should be no upfront income tax charge when management acquire the shares, and they should be subject to CGT on an exit). A potential complexity connected with this is that – depending on how high the valuation is – management may not have the funds available to acquire the new shares. Therefore, they may require a loan from the company (or even a grossed-up bonus) to pay for their shares, which in itself may be expensive and inefficient from a tax perspective – not ideal in a situation where the company is already underperforming.

The value of the sweet equity can be increased by reducing the level of investor debt owed by the company (i.e. to reduce the return which needs to be paid out to the investor before the MIP shares are "in the money"). This can be done by either waiving the principal amount owed, or the interest accrued to date, or by reducing the interest rate payable on the principal amount outstanding (either permanently or temporarily). This approach should generally not trigger any upfront tax for management, and they should continue to be subject to capital treatment on an exit. However, the debt reorganisation will need to be considered carefully to ensure that no tax liability arises for the company as a debt waiver or amendment could result in a taxable P&L credit for the borrowing company unless a relevant exemption applies (e.g. the debt-for-equity swap or corporate rescue exemptions). Also, other lenders and creditors in the company may need to consent, which can add time and complexity. Alternatively, if the shareholder debt comprises preference shares, another way to achieve in effect the same result is to waive or reduce the coupon on those shares, which may be slightly more straightforward to implement.

Finally, the investor might consider assigning some of its debt to management, as the debt will rank ahead of other securities in the company therefore making it more likely that management will receive a return on exit. This is usually done by transferring the investor loan notes to a new limited partnership in which management become limited partners. This approach can be tax efficient, and the tax treatment of proceeds on a future exit will depend on the status of the loans for UK tax purposes. However, a valuation of the shareholder debt will be required which, as above, can add time and expense.