FYB 2018 — Dr Benedikt Hohaus, P+P Pöllath + Partners / Prof. Dr Alexander Götz, Blättchen & Partner GmbH
Management participations are standard in management buyout (MBO)/leveraged buyout (LBO) transactions carried out by financial investors. The goal of financial investors is to homogenize interests with the management . Employees are to become entrepreneurs. The implementation of
Management participation has become increasingly professional over the last 20 years. However, in practice, mistakes are often made both in the process and in the concrete structuring, which can lead to the fact that the positive effectiveness of management participation is not brought to bear or can even turn out to be negative. Tax issues In its decision of 4 October 2016 (IX R 43/15, BStBl. II 2017, 790), the Federal Fiscal Court finally confirmed the taxation of management shareholdings as capital assets. This will put a stop to the increasing tendency in the tax authorities to qualify such income as wages. This decision should now remove the basis for the tax authorities’ frequent practice in recent years of qualifying profits from management shareholdings as wages. This applies in any case to the extent that the structure of management participation schemes corresponds or comes close to the case decided. In the opinion of the Federal Fiscal Court, the following criteria are essential for qualification as capital assets: n Purchase and sale of the management participation at market price.
Many typical management investments are likely to be covered by this ruling. However, if a management participation contains deviating elements that may have a further connection to the employment relationship, caution is still required. The question of the demarcation of salary and
Capital income will continue to be decided on the basis of an overall assessment of the facts. This overall assessment may still lead to qualification as a wage. When structuring management participations, careful contract design continues to be important in order to avoid negative tax consequences. Furthermore, the management participation should be strictly separated from the employment relationship. In particular, the employment contract should not contain a commitment to grant a management participation. Furthermore, employment and management participation issues should be regulated in two separate term sheets. The impression should always be avoided that the Management Participation is a remuneration component under the employment contract. Since the tax authorities are now also being asked by private equity investors
If the investor requests presentations on the management shares offered, these should be carefully examined with regard to the presentation and the language used. Terms such as “remuneration”, “incentive” and “sweet equity” should be avoided so as not to give the impression that the management participation represents remuneration. Ultimately, management shareholdings are capital investments with a risk of loss and no remuneration whatsoever.
Problems from IFRS 2
Even if all this is taken into account, problems from other sides can threaten. A phenomenon that has so far received little attention — because it is rather new in concrete terms — is the treatment of management participation programs in international accounting according to IFRS. IFRS 2 regulates the accounting treatment of share-based payments. Traditionally, real and virtual option or share acquisition programmes are covered by IFRS 2, as companies grant their employees share-price- or TSR (total shareholder return) based remuneration as a long-term incentive.those who do not deal with IFRS 2 on a daily basis are somewhat surprised — and also rather new — by the treatment of management participation programmes in international accounting under IFRS. IFRS 2 regulates the accounting treatment of share-based payments. Traditionally, real and virtual option or share acquisition programmes fall under IFRS 2, as companies grant their employees share-price- or TSR (total shareholder return)-related remuneration as a “long-term incentive”. Anyone who does not deal with IFRS 2 on a daily basis will also be somewhat surprised if the acquisition of an interest in a company on the same terms as the main shareholder (financial investor) is qualified by the auditors as share-based payment under IFRS. As already explained above, a capital investment with a normal market risk of loss is not a remuneration but an investment. However, this consideration is not relevant for the purposes of IFRS 2. Rather, it is sufficient that the investor is an employee of the company and the participation programme provides for a so-called Leaver Scheme, i.e. purchase rights of the financial investor in the event of termination of the employment relationship of the manager. Since experience shows that this is the prevailing opinion among auditors, the CFO concerned must accept this qualification. In fact, for many years this point of contention was also rather a symbolic one, because it is undisputed that no personnel expenses for an investment programme have to be recognised under IFRS 2 if the manager has acquired the investment at fair value. If the manager acquired the investment at the same price as the financial investor, the equity compensation plan was mentioned in the notes to the financial statements as share-based payment, but with the statement that no personnel expenses are to be recognized because the manager acquired the investment at fair value. (The non-IFRS expert would conclude that this in itself means that there can be no share-based payment). In recent years, however, it has become common practice for some, especially the larger auditing companies, to have their auditors engage the internal auditing units of the auditing company without prior consultation to conduct a special audit for which a fee is charged. After complex simulation calculations, the valuers then came to the conclusion in quite a few cases that the managers had acquired the shares below market value, which is why personnel expenses would have to be recorded in accordance with IFRS 2. This is a surprising assumption, since the structure of the financial instruments is not only subject to intensive tax scrutiny, but is also negotiated between the shareholders. It should be possible to limit the problem by communicating two things to the auditor: The company will not accept a valuation report from the auditing firm.
as a special project. The company values the financial instruments itself. The auditor’s task is then to check the valuation of the company for plausibility.
Seniority in management meetings
Discussions about potential management participation are discussions of principle and should be conducted in this way. The initial negotiations with management traditionally take place on the management side at the CE level. This means that managing directors or board members negotiate management participation for “their” managers from the 2nd and 3rd levels. In this respect, it is important that the negotiating partner on the private equity investor side is on an equal footing. On the side of the private equity investor, too, the talks should therefore be conducted by (senior) partners. In practice, one often experiences that negotiations and talks are delegated to younger colleagues as an annoying evil. In this context, it should not be underestimated that for managers conducting a buy-out for the first time in their lives, such a process is associated with many uncertainties and unknown situations. This uncertainty is intensified if the management team does not feel valued by the counterpart. However, the first step in building trust is to treat your counterpart as you would like to be treated yourself. This means that the management as a negotiating partner should be treated with appreciation and respect. A sign of appreciation is in particular that the private equity investor’s partner conducts the discussions with the management. Our experience also shows that eye level always has something to do with age and experience. This is not necessarily true, but a conversation between people of the same age and experience will be easier than between people with a significant age difference.
Timing / clarification of the management
Management plays an important role in M&A processes with potential private equity investors as buyers. Private equity investors need the management to lead the company to be acquired. The seller needs the management to facilitate a structured sales process and to present the company for sale in the best and most comprehensive way possible. In this respect, the management is often referred to as the third party in the sales process. This makes it all the more important for the seller to involve a (particularly inexperienced) management team in good time and prepare it for the future.