The right share or equity schemes can help significantly to recruit and retain good teams by boosting involvement and ownership, says Nick Crosbie, partner in the leisure practice at Olswang LLP
Along with a scalable winning concept, another prerequisite of success in the F&B industry is a dynamic, passionate, experienced and appropriately skilled management team equipped to take the business to the next level and beyond. Businesses fail under poor management and corporate deals can break down if purchasers or investors have little confidence in the team.
The same can be said of businesses fortunate enough to have personnel who are fantastic but not appropriately incentivised. A salary below market rate can weaken someone’s enthusiasm, but there are also several other means by which a business can incentivise its management team at other stages in a concept’s life-cycle.
Start-ups: founder equity
In the life-cycle of a concept, start-ups come first. If individuals are fortunate enough to establish their venture from scratch using their own resources or limited third-party finance, they will appreciate all the advantages and risks. But this structure can also work well to incentivise established talent, such as when investors back chefs to launch new restaurant concepts.
Alongside a salary, being able to structure a new launch by giving key talent equity in their own business without the burden of all the costs can be a decisive factor if that talent has alternative options without equity on the table.
Share options
Offering management the right to acquire an equity stake in an established business is the most classic example of management incentivisation. If a business is eligible for any approved option regimes, some tremendous tax advantages are available.
A straightforward “vanilla” unapproved share option can be used on a discretionary basis. But the effective tax rate payable in respect of unapproved option gains is 50.28% for higher rate tax-payers [assum-ing the company’s National Insurance (NI) contributions liability is passed to the option-holder].
If a business is eligible for an approved scheme, the best known being the Enterprise Management Incentives (EMI) regime, the tax position for individuals can be much more attractive. For qualifying companies, gains on shares acquired by management can be subject to capital gains tax at a rate of only 10%.
In addition to employees’ tax-efficient perks, the issuing company should consider impact and availability of corporation tax deduction in respect of most share-based incentives. Subject to requirements, a corporation tax deduction is often available to companies equal to the amount by which the value of option shares on the date of exercise exceeds aggregate exercise price.
Value or growth shares
These are a new class of share which allow employees to participate only in any increases in value of the company occurring after the employee is issued the shares. They can be used to replicate (to an extent) the tax-efficient treatment of an approved option (with a market-value exercise price) in situations where businesses would not otherwise be eligible to operate an approved arrangement. They are often used when executives join a business where an exit is on the horizon or that executive is tasked with an ambitious growth or exit strategy.
These arrangements are structured with the intention that, on their issue, the value shares will have a low value (usually equivalent to nominal value of a share). If the employee pays at least this nominal amount (and enters into appropriate tax elections) he or she should have no income tax or NI contributions to pay when the shares are allotted.
On a subsequent exit, gains on a disposal of value shares to an unconnected third party will be chargeable to capital gains tax (at 18% or 28%, plus the benefit of a tax-free allowance).
Employee shareholders
The Government is finalising legislation regarding a new type of employment status. Under the “employee shareholder” regime, individuals can relinquish certain statutory employment rights in return for shares in their employer company (or a parent of their employer) on the basis that future gains from those shares will be exempt from UK capital gains tax.
Some concerns have been raised over whether these proposals will be effective in encouraging widespread adoption of this new status. However, offering employee shareholder status to select executives is something several companies are exploring. Senior management are likely to be incentivised by the possibility of highly tax-efficient gains and are not overly concerned with reduced employment rights. Such individuals are also in a strong bargaining position regarding agreeing terms relating to forfeiture and buy-back of shares.
Group incentive arrangements
The type of behaviour the incentive arrangement aims to encourage is worth considering. If the intention is to incentivise management to achieve company-specific targets, the majority of the above arrangements can link to these performance objectives. However, if the intention is, for example, to drive increases in the ultimate parent company’s share price, a group-wide equity incentive arrangement (whether share-based, option-based or a “phantom” equity arrangement) may link behaviour and outcome more effectively.
A more obvious reason for deciding to offer participation in a group arrangement is cost – an existing scheme with established administrative systems is far cheaper to roll out to the management team of a new acquisition than creating a new scheme.
Deal bonuses
The restaurant sector is seeing high valuations and increased levels of M&A activity. Great news if you own shares in a business being sold – but what happens if you don’t, yet are required to play a key role in securing a lucrative deal? Payments of deal bonuses to staff in such circumstances are a good way to ensure key non-owner executives participate in the transaction and know a successful deal will lead to reward.
However, this type of bonus is difficult to structure so as to be taxed under the capital gains regime – usually what individuals are seeking to achieve on an exit.
MBO rollover equity, loan notes and sweet equity
Almost all recent high profile deals in our sector (D&D and Drake & Morgan are among those my firm has advised on) involve management teams selling their shares in the target business and agreeing to roll over a significant portion of gains into shares and loan notes issued by the vehicle making the acquisition.
Private equity institutions are actively backing management teams in the sector and using all the classic tools to incentivise management to help secure growth and the potential lucrative secondary exit down the line.
Along with rollover equity and loan notes, the other known item is the sweet equity – a further class of equity share capital which management subscribes to, usually at a nominal price. Here, management’s equity benefits from a ratchet – a mechanism which can see management’s share of the capital increase if the private equity firm achieves a minimum IRR.
Conclusion
Pub veteran Clive Watson wrote in this publication in May 2013 of the importance of allowing the workforce to have ownership of the business for which they work. I cannot agree enough and therefore urge owners, investors and management alike to consider all their options to incentivise and empower their teams and reap the resultant benefits.
Nick Crosbie is a partner in the leisure practice at Olswang LLP. His recent experience includes advising on the sale of the D&D Restaurant Group. Nick wrote this article with the input of his colleague Annie Popplewell from Olswang’s share incentives team.
