A private equity sale often looks very different from a straightforward cash exit. Sellers may receive cash, roll part of their value into the new structure, remain involved in management and acquire additional ‘sweet equity’. Understanding how each element works is important before the commercial terms are fixed.
Rollover equity
Private equity investors commonly ask existing owners or management to reinvest part of their sale proceeds. Where the relevant share-exchange conditions are met, Capital Gains Tax on the rollover element can often be deferred so that the historic gain follows the replacement shares.
That is normally a deferral, not a permanent saving. The future tax rate and available reliefs may differ when the replacement shares are eventually sold. Sellers whose original shares qualify for Business Asset Disposal Relief may also need to consider whether an election is appropriate where the new shares would not independently qualify.
Sweet equity is different
Rollover represents value the seller already owns. Sweet equity is generally an additional management incentive designed to provide greater exposure to future upside.
Management shares often sit behind debt, preference capital or a preferred investor return. That can make their current value much lower than the headline percentage of the company suggests, but it does not make them automatically worth £1 or nil. Future potential, hurdles, ratchets, debt, leaver provisions and expected exit timing all influence value.
Why valuation matters for management
Continuing founders and managers are usually employees or directors, so their shares can fall within the employment-related securities rules. If an employee acquires shares worth £100,000 for £20,000, the £80,000 undervalue can potentially be treated as employment income rather than investment growth.
The valuation at acquisition is therefore critical. Genuine subsequent growth after shares have been acquired at an appropriate value will generally fall within the Capital Gains Tax regime.
The management equity safe harbour
HMRC has a long-standing Memorandum of Understanding with the private capital industry, originally agreed with the body then known as the BVCA, now UK Private Capital. Where a conventional management equity arrangement meets the detailed conditions, the framework can provide greater certainty over the value paid by management.
It is not a blanket HMRC valuation agreement. Bespoke hurdles, ratchets, different economic rights or unusual financing can take a transaction outside the framework, making a separate valuation necessary.
Restricted shares and elections
Management shares commonly contain leaver, transfer or voting restrictions. A joint tax election can often be used so that the initial tax position is calculated by ignoring certain restrictions, helping genuine future growth remain within CGT. The election has a strict 14-day deadline from acquisition, so it needs to be considered at completion.
Understand the economics, not just the percentage
A seller rolling 20% of their proceeds does not necessarily own 20% of the future economics. Investor debt, preference capital and exit priorities may sit ahead of management. The exit waterfall should show how much the business needs to be worth before rollover and sweet equity produce the expected return.
Private equity can offer owners liquidity today and exposure to a second period of growth, but tax, valuation and economics need to be considered together while the heads of terms and management package are still being negotiated.
The same applies to leaver terms. Management should understand what happens to both rollover and sweet equity if they leave before the next exit, because good-leaver and bad-leaver provisions can materially change the value eventually received. That commercial outcome should be modelled alongside the tax position.
Sellers should also understand what additional funding might be required after completion. Private equity investors may have protections if more capital is needed, and management can face dilution or different economic outcomes depending on the terms of the documents.
