By Elodie Duchêne, Partner Corporate M&A, Baker McKenzie
What are the advantages of the set-up of an incentive scheme?
Rewarding management has proven to be a key element at allowing funds and companies to get the odds on their side as to the success of their business and to retain talents. Management incentive plans permit to give the management a slice of the cake, thereby aligning investors’ and executives’ objectives of performance and growth in the value of the assets while strengthening their relationship.
Although such schemes are often tailor made and specific to the relevant business and the result of negotiations between the investors and the management team, there are several common factors and considerations to take into account when implementing a management incentives program such as the general structuration of the deal, the type of instruments in place, as well as, the tax treatment of the instruments used.
To meet its objectives of motivation of the fund’s overall performance and of retention tool, the incentive plan shall not be overcomplicated and shall clearly enable the management to see the likelihood of payout and the possibility to get a share of the value created and a valuable return.
Choice of the instruments: equity, cash, others?
The management can either invest along with the main investors through the same instruments which are generally composed of shares and debt instruments or be incentivised through cash, equity like instruments or contractual arrangements. Luxembourg law offers a wide range of tools and instruments for incentive schemes.
The grant of shares is a common option used in Luxembourg to incentivise the managers and executives, whilst the holding of equity type of instruments may present tax advantages compared to cash income, the subscription for shares also implies challenges.
One of the constraints lies in the fact that the beneficiaries shall pay the acquisition or subscription price of the shares which may cause complexity. However in practice several options exist to solve this issue such as, without being exhaustive, the set off of the subscription price against certain fees payable to the beneficiaries, the grant of loans at a favourable interest rate by the main investors in the fund to the executives and managers investing, etc. Luxembourg law allows for the issuance of free shares but only to certain individuals (employees or management of the issuing company and affiliated companies), such instruments can therefore not always be used.
Another challenge with the equity structuration is to define the political and economic rights attached to the shares, and this may lead to intense negotiation to agree for example on the vesting and good/bad leaver conditions. Luxembourg law offers a high flexibility to structure the economic rights and the way the proceeds will be distributed among investors and management and the ranking between them. The distribution waterfall is a central element in the setting up of an incentive through the grant of shares and needs to be well structured at inception. At exit, main investors are usually entitled to receive in priority the return of the invested capital and a preferred return until a certain threshold is achieved (e.g. IRR, hurdle rate) then the right of the carried interest / promote holders and of the others investors will come into play.
Various types of shares can be issued by the Luxembourg companies to tailor incentives schemes to their needs such as, among others, preference shares with minimum guaranteed return paid in priority compared to ordinary shares or tracking shares enabling to base the incentives on the performance of certain assets only, which may be of interest to compensate specific executives working exclusively on an investment.
In terms of political rights it will be important to define the degree of involvement of the management in the governance and decision making process. Here again Luxembourg companies have at their disposal various tools to restrict the involvement of the management if so desired. The shares granted to the management are often subject to transfer restrictions and/or lock up to ensure that the investors will keep the control on these shares but also as retention tools, these shares may also be non-voting. Incentive schemes also generally includes call and put options mechanisms.
Instead of subscribing for a specific class of shares of the investment vehicle, the scheme may also be structured through a special purpose vehicle and the management will receive shares of this vehicle which is in turn a shareholder of the investment company. This structure has the advantage to avoid the administrative burdensome of convening each separate beneficiaries to the shareholders meetings of the investment company, the beneficiaries being pooled in a separate vehicle.
Rather than equity, certain group prefer using other types of instruments allowing management to receive a share in the value depending on the success of the investment without being a direct shareholder in the structure and without participating to the share capital. For instance we can mention phantom shares, warrants, debt instruments, convertible bonds, beneficiary shares, the latter are not part of the share capital and can be issued against performance of services and freely tailored in terms of political and economic rights. Incentives may also be granted in the form of sweet equity such as options, performance rights or right to acquire further shares at a lower price to motivate the management team.
Taxation is a crucial and essential criterion in the structuration of incentives as mitigating the tax burden for the beneficiaries is key, and the type of instruments or vehicles used may have a significant tax impact for them. The beneficiaries may be domiciled in various jurisdictions, therefore, the tax treatment of the incentive scheme should be assessed in each jurisdiction. Thus, the choice of the instrument or vehicle will also depend on the country of residence of the beneficiaries. Capital gains generally enjoy a better tax treatment than any other type of income in most jurisdictions. This may explain why the grant of share like instruments is so popular in terms of incentives. Nonetheless the quality of the beneficiaries (employee / manager) might impact the qualification of the grant of shares that could be considered as a deemed employment income or directors fee. Many jurisdictions have developed set of rules aiming at requalifying certain schemes into ordinary income taxable at higher rates. Free shares awarded to managers may be considered as taxable income (in-kind).
Back in July 2013 when transposing the Alternative Investment Fund Manager Directive, Luxembourg had also implemented a preferential tax regime for carried interest for Luxembourg resident beneficiaries. The regime appears to be ineffective since it requires a number of conditions to be met in order to benefit from the preferential treatment which seem incompatible with the reality of PE/VC players.
The 2018-2023 agreement of the government of coalition was foreseeing an assessment of the current regime to determine whether some improvements could be made in order to increase attractiveness of the Luxembourg market to front office functions of the PE/VC industry value chain. A structural tax reform to take place in 2021 was announced by the Minister of Finance, Mr. Gramegna, in July 2019. The Covid-19 outbreak has obviously influenced the market conditions leading to the postponement of the announced structural tax reform, that could have included new measures aiming at the improvement of the existing regime, to a later stage.
Thanks to its toolbox, Luxembourg remains an interesting jurisdiction that offers the possibility to accommodate multiple needs from foreign countries perspectives while mitigating inefficiencies.
When implementing incentive schemes?
Given the benefits of incentive schemes as to the performance of the funds and attainment of a successful exit, as well as, their benefits for the management it is always the right time to implement an incentive scheme.
Due to the economic downturn caused by the sanitary crisis, one could think that it is not a good time to implement incentive schemes. However, it is certainly more important than ever to retain key people especially in view of the end of the crisis and the expected economic upturn. Funds and companies need to ensure they have the right people and that they can retain them to face the next challenges.