3 questions to smart minds

Sweet equity always sweet for managers?

For this 3 questions to Dr. Gabriele Fontane

Photo: Dr. Gabriele Fontane
27. July 2021

Every employee needs an incen­tive. For the manage­ment of a company held by finan­cial inves­tors, this is the equity invest­ment. In order for this to be sweet and not bitter, it is important not to lose sight of a few important details.

For this 3 ques­ti­ons to Dr. Gabriele Fontane, Attor­ney at Law and Part­ner at OPPENHOFF

1. Manage­ment parti­ci­pa­tion in private equity invest­ments is still very popu­lar, mainly because of the taxa­tion of capi­tal gains accor­ding to the partial income method and the attrac­tive entry condi­ti­ons usually offe­red. But does­n’t gran­ting sweet equity also create risks for taxation?

Yes, this may well be the case, and not only if the mana­ger is offe­red to acquire the invest­ment at a purchase price that is lower than its fair market value. Any arran­ge­ments that limit the econo­mic risk of a manager’s invest­ment may result in the tax autho­ri­ties ques­tio­ning the acqui­si­tion of bene­fi­cial owner­ship of the invest­ment. This applies, among other things, to “non-recourse” purchase price defer­rals, i.e. agree­ments that a defer­red portion of the purchase price is only paya­ble to the extent that the future exit proceeds are sufficient.

Until recently, at least a risk note was indi­ca­ted if the inves­tor and manage­ment inves­ted dispro­por­tio­na­tely in diffe­rent equity instru­ments in order to increase management’s return.

2. Can you describe approa­ches to solu­ti­ons from your practice?

In the case of the dispro­por­tio­nate invest­ment of private equity house and mana­ger, the BFH has helped us with a long-awai­ted and recently published decis­ion: The dispro­por­tio­nate allo­ca­tion of the capi­tal invest­ment of private equity house and mana­ger to diffe­rent invest­ment vehic­les has no impact on the taxa­tion of the exit proceeds as capi­tal income. In prin­ci­ple, mana­gers can thus be offe­red, without any tax risk, to use their capi­tal exclu­si­vely for the acqui­si­tion of shares and not to invest in share­hol­der loans or, in the case of diffe­rent share clas­ses, to acquire only shares of the share class with the highest yield.

I gene­rally advise against non-recourse purchase price defer­rals. In addi­tion to the tax risk that the tax autho­ri­ties will deny the manager’s assump­tion of entre­pre­neu­rial risk due to the capi­tal loss limi­ta­tion and will not treat the capi­tal gain — at least in part — as a capi­tal gain, the right incen­tive is not set here. Other legal opti­ons for limi­ting perso­nal liabi­lity are, of course, available.

3. There are hardly any M&A tran­sac­tions left where the conclu­sion of a S&I insu­rance policy is not at least conside­red. Does S&I insu­rance offer manage­ment parti­ci­pa­tion bene­fits, then?

Abso­lut­ely. Espe­ci­ally if the manage­ment is alre­ady invol­ved and has to provide its own purchase contract guaran­tees on the seller side. If a guaran­tee issued by manage­ment turns out to be incor­rect, a claim for dama­ges against manage­ment will sever­ely disrupt the share­hol­der rela­ti­onship with the private equity inves­tor. Purcha­sing S&I insu­rance miti­ga­tes management’s hand­ling of a breach of warranty.

For the subse­quent exit, it faci­li­ta­tes the assump­tion of purchase agree­ment guaran­tees by manage­ment and can lead to the always desi­red — but previously often non-nego­tia­ble — result that the private equity inves­tor can focus on the acqui­si­tion of legal title guaran­tees and the buyer has a recourse debtor for the guaran­tees issued by manage­ment for the opera­ting busi­ness with the S&I insurer. Wealth Confe­rence 2021

About Dr. Gabriele Fontane
Gabriele Fontane has been advi­sing on M&A/private equity and corpo­rate law since the mid-1990s, with a focus on MBO/LBO tran­sac­tions. Her prac­tice also includes advi­sing on acqui­si­tion finan­cing and manage­ment equity invest­ments. Gabriele Fontane acts for finan­cial investors/private equity funds, mana­gers inte­res­ted in inves­t­ing, stra­te­gic buyers as well as entre­pre­neurs conside­ring the sale of their company.

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