In the context of private equity investments, the management of the company to be acquired plays a prominent role. In order to ensure that the interests of management and investor are aligned for the duration of the investment, the management is regularly involved in the success of the company. This is done either by acquiring a genuine equity stake or in a purely virtual way, as a mere profit-sharing without any personal investment.
Management equity participations
When acquiring a company, the private equity investor usually sells between 10 and 15 percent of the shares in the holding company to the management. The financing of the transaction, and thus also of the holding company, is carried out in the amount of approximately 10 to 15 percent through normal equity capital and in the amount of 85 to 90 percent through preferred instruments in the form of shareholder loans or preferred capital. The preferential instruments do not grant any participation in the hidden reserves of the company, but are designed with a fixed return of between 8 and 10 percent per annum. Compared to normal equity capital, they also have a liquidation preference in the amount of the paid-in capital.
If the manager invests disproportionately less in these preferred instruments, his investment is at a higher risk, as these are the first to be served in the waterfall of revenue distribution. However, in the case of a successful exit, the higher risk corresponds to a higher share (in relation to the total investment) of the proceeds on the classic equity capital. This creates a leverage effect similar to that of an investment financed with outside capital.
High purchase prices increase risk of loss
However, the currently high purchase prices increase the risk of loss for the management from a management investment, because the limit for the realisation of a loss is often reached even with slight deviations from the business plan or the valuation multiple. This can be reduced by a higher share of the management’s investment in preferred instruments. However, due to the lower leverage, the upside to be achieved is then also reduced.
To simplify the administration of a management participation (e.g. when voting rights are exercised, etc.), the investment is held through a partnership or trust from a certain number of persons. In the event that the managers leave the company before the exit (so-called leaver), the main shareholder usually has a purchase right. It should be possible to offer the investment to a successor in the position.
From a tax point of view, such participations are genuine equity investments. This means that sales proceeds (in the case of an investment of less than one percent of the share capital) from such investments are subject to the definite withholding tax of 25 percent (plus solidarity surcharge and church tax) and not to income tax. This only changes if the management participation is too close to the employment relationship and appears to be a hidden salary payment.
In connection with a management shareholding, the Tax Court of Baden-Württemberg (ruling dated May 9, 2017 – 5 K 3825/14, final and effective) ruled that the disproportionate subscription of ordinary and preferred shares by a managing director does not indicate that the investment income has to be reclassified as wages. The respective capital instruments were to be considered individually in their return. A comparison of the total return on the investment of the manager and the investor was an inadmissible ex post consideration, because with a lower profit of the investor the manager would have borne a higher risk of loss in comparison.
However, another senate of the same court (ruling of 26 June 2017 – 8 K 4018/14, rev. pendant VIII R 21/17) decided in a comparable case for a consultant that the granting of the investment could certainly qualify as an additional performance-related remuneration for the consulting activity, among other things because of the associated chance of achieving a disproportionately high return within the framework of the overall consideration. The decision of the Federal Fiscal Court in this matter remains to be awaited.
The wage tax risk that exists when income from management participations is reclassified has become the focus of insurance companies that want to develop a new business segment. Against payment of a corresponding premium, the insurance company covers the tax difference between capital and wage taxation as well as necessary defence costs. In return, however, the policyholder must disclose all information and opinions relevant to taxation. It remains to be seen whether and how the market for such insurance in Germany will develop.
If the company valuation or the capital structure of the acquisition vehicle does not permit a genuine equity investment, it is often set up in the form of a virtual management participation. This is also the case if, for example, management has lost money in a previous management equity participation and is not prepared to invest new money. Even in the case of very large international management teams with more than 200 participants, often only the first level of management is involved via a genuine equity participation and the second and third levels receive a virtual participation for reasons of simplification.
In the virtual participation program, the management is placed in the same position as if it were participating in the company’s equity via a bonus agreement. Payment is made at the time of the exit. So-called “leaver rules” apply to the virtual participation in the same way as to the real equity participation. The disadvantage of a virtual participation is that the management has no “skin in the game” due to the lack of an own investment.
For tax purposes, virtual participations are subject to wage tax and are fully taxable at the recipient’s individual tax rate. However, the tax disadvantage is offset by the flexibility in the possible structure of such a virtual participation. Disproportionate revenue agreements or minimum returns for the investor can be easily agreed from a tax perspective.
Management participations within the framework of a buy-out process by private equity investors are now the absolute standard. Whether this is done either through a genuine equity participation or a virtual participation depends on the specific starting position and tax developments.
This article was first published in: Unternehmeredition & GoingPublic Magazin, Spezial Mitarbeiterbeteiligung 2019, 40-41