In the search for top managers for the management of medium-sized companies, their owners are increasingly in competition with private equity funds. These offer their applicants not only attractive salary packages, but also the opportunity to invest in the company. Common goals are pursued with management participation in private equity transactions and with comparable management incentive structures. The fundamental aim is to bring together the parallel interests of management and financial investors and to align mutual interests.
Key characteristics of a management participation through private equity
In addition to financing with “real” equity capital (approx. 10 to 15%), the financial investor provides a substantial portion of the required capital in the form of shareholder loans or preferred capital (85-90%) to the holding company. Compared to real equity, shareholder loans have to be repaid with priority and do not grant any participation in hidden reserves, but only a fixed interest rate. Preferential capital is structured with a percentage dividend preference and also has a liquidation preference in the amount of the paid-up capital.
On the one hand, the managing director can acquire a share in the traditional equity capital. In addition, he can also give shareholder loans or subscribe to preferential capital. These financial instruments do not participate in the hidden reserves of the company, but only have a fixed yield of between 6-10% p.a. Voting rights are also regularly not associated with them. In the event of an exit, however, they have liquidation priority over traditional equity. If the manager does not invest in these senior financial instruments or invests in them at a lower ratio than the financial investor, his participation is at a higher risk. However, in the case of a successful exit, the higher risk corresponds to a (from an economic point of view) higher share of the proceeds in relation to the invested capital in traditional equity. Ultimately, this corresponds to any investment financed with debt capital.
In the case of an exit, the co-investors receive the proceeds from the sale of the equity instruments they hold. Current dividend distributions do not usually take place, as the credit agreements of bank financing usually do not allow this.
To acquire a management stake, investors and management traditionally conclude a co-investment agreement.
At the heart of the co-investment agreement are all the contractual terms and conditions, which provide for regulations on the exercisability and forfeitability of the rights granted (“Vesting Schedule”) as well as various legal consequences for the termination of the employment relationship or the appointment of the manager’s body in accordance with the reason for departure (“Leaver Scheme”).
The financial investors are entitled to exercise a call option on termination of the employment relationship (including release from work and expiry of the employment contract) or the appointment of the manager. Often, the financial investors can be granted additional call options, for example in the event of events that could influence the manager’s ownership position. This is the case, for example, in the private insolvency of the manager, when enforcement is carried out on his assets and also on his management participation. In addition, divorce also triggers a right to buy if the manager has not agreed to a separation of property or a modified compensation for gains (removal of the management participation from the statutory compensation for gains). In addition, financial investors sometimes demand a call option in the event that the manager commits serious violations of the co-investment agreement (e.g. violation of the non-competition clause, transfer of shares contrary to contract).
A typical feature of call options is the distinction between so-called good-leaver cases and so-called bad-leaver cases. The category in question determines at what price the call option can be exercised and whether management is also entitled to a put option. A typical bad-leaver case is, on the one hand, termination by the manager without good cause and, on the other hand, termination of the manager by the company for good cause in accordance with § 626 BGB. Classical good-leaver cases are death, occupational disability, retirement and termination of the manager by the company without good cause according to § 626 BGB. There are many variations in the buy-back prices. The most common variant of the buy-back price in the bad-leaver case is the lower of the acquisition cost and the market value of the management participation. In the case of the good leaver buyback price, vesting often intervenes. This means that the participation in the current market value depends on the time of exit after closing of the transaction. Typical vesting periods are 3 to 5 years on a monthly, quarterly or annual basis. The repurchase price for the invested portion of the management shareholding is then usually equal to the fair value and for the non-invested portion equal to the acquisition cost or the lower amount of acquisition cost and fair value of the management shareholding.
Tax facet of the Leaver Scheme
In 2016, the Federal Fiscal Court (BFH) finally confirmed the taxation of proceeds from management investments as capital gains. In the lower instance, the Cologne Tax Court had comprehensively assessed the facts of the case and did not see a sufficient connection to the employment relationship.
According to the decision of the Federal Court of Finance, employee profit-sharing does not generate wages because the profit-sharing can only be acquired by a certain group of employees. This is inherent in employee share ownership. In the opinion of the BFH, employee share ownership is a special legal relationship which can exist independently and detached from the employment relationship. The BFH also clearly rejects the argument of the tax authorities regarding the allegedly non-existent risk of loss due to insider knowledge. The mere causality of the employment relationship for the acquisition of the shareholding is not decisive if, as has been undisputedly established, the shareholding is acquired and sold at the market price and there is an effective risk of loss. Also, the existing buy-back rights in the event of termination of an employment relationship are ultimately an expression and consequence of employee participation and, contrary to the opinion of the tax authorities, do not in themselves justify the assumption that the employee is paid wages by being granted an opportunity to participate. The Federal Fiscal Court thus confirms that the agreement of a so-called leaver scheme in the event of termination of the employment relationship and also the vesting provided for in this respect are not detrimental to the tax qualification of employee participation. This is of great importance for the consulting practice because the tax authorities have recently switched to using the existence of a so-called “Leaver Scheme” as a reason for taxation as wages. In this respect, it relied on another BFH judgement, which had determined that in the case of a profit participation right, the differentiation of the reimbursement price depending on the reason for which the employment relationship was terminated was a clear indication of the existence of wages.
However, this decision of the 8th Senate cannot be applied to the taxation of a classic management participation, as has now been confirmed by the 9th Senate. On the one hand, a so-called Leaver Scheme only establishes the option to buy back shares upon termination of employment and does not constitute a mandatory compensation of the management participation. On the other hand, standard compensation clauses in partnership agreements also provide for a differentiation between book value compensation and market value compensation. The present compensation provisions in the case of a leaver merely take this into account.
Legal facets of the Leaver Scheme
Since the repurchase price on transfer based on call options, as well as payments for a retired share, represent compensation for the loss of shareholder status, the contractual arrangements must be in line with established legal principles on compensation.
The amount of the compensation payment is related to the risk distribution which is decisive for the justification of the exclusion clause. For clarification, it should be noted that the agreement of an unreasonably low severance payment does not affect the effectiveness of the exclusion clause. However, the control of the exercise of the agreed exclusion right is important, among other things, for the correction of a severance payment which is already grossly unfair when it is introduced. In this case, the contractual severance payment that is void under Section 138 (1) of the German Civil Code is replaced by the market value.
For management participation models in private equity transactions, these principles may be relevant for the described regular structuring of the buyback price. However, even if the acquisition costs should have to be recognised according to this comparison, the severance agreement is not invalid per se. This is because in this case, the interest of the Company in preserving funds is given priority over the interest of the shareholder in an appropriate compensation, so that deductions from the fair market value are permissible. Furthermore, the assessment of appropriateness takes into account circumstances of the specific case such as the duration of the membership, the share in the development and success of the company as well as the reason for the exclusion.
However, a new ruling of the Munich Regional Court from 2019 must be taken into account here, in which the court held that the purchase right of the financial investor against a managing director holding 25% of the share capital is null and void under § 138 BGB. The court justified this by stating that this was not only a minority shareholding, that the managing director had already held a share in the company before the financial investor entered the company, that this was a substantial investment by the managing director and that the shareholding could therefore not be regarded merely as an annex to the position of managing director. This would constitute an inadmissible termination clause. The case certainly has its peculiarities and therefore cannot generally be applied to the participation of managers and corresponding purchase rights. In practice, however, it is advisable to deal more closely with the exact structure of purchase rights and the case law on cancellation clauses in the future.
The participation of the managing director in his company is seen more and more often in practice even without the participation of financial investors. A leaver scheme with buyback options for the financial investor is inherent in every management participation. In this case, however, tax regulations must be taken into account in order to ensure capital taxation on profits, at least for the genuine capital participation. The provisions of recent case law on cancellation clauses must also be observed under civil law in order to avoid legal uncertainty.
This article was first published in: Euroforum, EBook GmbH Managing Director 2020, pp. 15-17.
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