The current threat to the UK economy has been covered extensively in the media. In early May, the European Commission projected that the UK economy would contract by 8.3% this year, and the Eurozone by 7.7%.
There is uncertainty over the length and depth of the impending recession, but what is clear is that COVID-19 will impact different businesses in different ways. Some companies, like those in tourism and leisure, are being hit hard, while others are performing strongly, such as food retailers and delivery companies. This will likely have an impact on management incentive plans that were implemented before the lockdown, and the value of the shares issued under these plans.
In some instances, it could be a good time now for companies to issue any pending or warehoused shares to management teams, as the value of the shares may be relatively low. The valuation analysis, however, may not be straightforward and concluding that values are low does not mean they will not fall further.
For some companies, the impact might be so severe that targets or hurdles that had previously been set under a management incentive arrangement are no longer realistically achievable. Unless these targets are sufficiently long term that they can be achieved after an economic recovery has begun, it may be worth resetting incentive arrangements. On the other hand, it could be a good time for businesses that do not currently have management incentive plans to incentivise key staff for the road ahead.
There are a range of ways that management incentives can be offered through equity, including granting share options or through employees acquiring shares outright. Incentive plans often involve the creation of a new class of share, the economic rights of which are linked to rewarding future growth. Valuation is important because employment-related securities legislation sets out a number of tax charges associated with acquisitions of shares by employees and directors.
While the tax analysis on the acquisition of shares is not straightforward, it is often the case that If an employee or director acquires shares at less than their unrestricted market value (UMV), then a tax charge arises at that point in time, based on the difference between the UMV and the price paid. The tax analysis for share options is different, but there is usually still a need to establish the market value and UMV of the shares under option.
If the intrinsic value of the shares is being considered and the valuation methodology includes a capitalisation of earnings analysis, typically employing EV/EBITDA or PE multiples, it may be problematic to ascertain what multiple should be used at the present time. One source of data that is used in assessing an appropriate multiple is that from other recent M&A transactions involving similar companies. There has currently been a significant slowdown in deals, limiting the availability of contemporaneous data.
On the other hand, quoted company multiples may be skewed by high share-price volatility and out-of-date financial information. We are at the point where close to half of listed companies have chosen not to provide guidance on short-term forecasts, due to the level of uncertainty. It should also be noted that while the share prices of listed companies have been volatile, shares in private companies are more stable.
Management incentives equity, and in particular growth interests, are often valued by reference to an expected returns analysis, which usually proceeds by reference to estimating an exit value in the future. This poses a number of challenges:
Valuations often take into account the evidence of value provided by previous transactions in shares, or by previous offers received from potential purchasers as part of aborted takeover discussions. The extent to which pre-COVID-19 transactions and offers provide evidence of the current value of a business obviously needs to be considered.
For more information about forecasting and modelling during the lockdown, read our other articles on this topic:
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