Also, we discuss enforcing founders' service contracts. Investors need to be aware of service contracts, as trivial breaches do not necessarily mean that a founder/manager can be dismissed.
We also look at inconsistent terms and note that bespoke clauses in contracts can prevail over standard terms and conditions.
Recent trends in EIS and VCT transactions
How is the market changing?
Since the changes to the EIS legislation which took effect following the Finance (No 2) Act 2015, initial rounds of EIS investment have increasingly been provided to companies at a very early stage of their development. The type of company that typically benefits from EIS investment is changing too. The emphasis this year has been on entrepreneurial sectors such as software, tech and advanced manufacturing.
Recent reforms to the pensions rules now permit far greater freedom in retirement planning. Tax efficient occupational pensions are subject to ever more stringent financial limits. At the same time, new higher rates of SDLT (stamp duty land tax) have been introduced for investments in residential property, together with restrictions on tax relief for interest payments on buy-to-let mortgages.
As a result of these changes, VCTs have found a new market in investors seeking tax-efficient ways in which to diversify their portfolios, or whose pension funds have already reached £1.5 million.
How are the rules changing?
1. New law - Finance Act 2016
The Finance Act 2016 received Royal Assent and became law on 15 September 2016. This year's changes are intended to provide some much needed clarification in respect of the more substantive amendments made last year.
In 2015, an age limit was introduced for the business activities of investee companies. The limit is seven years in most cases, extended to 10 years for a "knowledge-intensive company". The period begins to run on the date of the first relevant trading transaction.
The definition of a 'knowledge intensive company' is complex. The extended age requirement is in part conditional on the company's operating costs. This year, there has been a welcome clarification of this condition. However, some uncertainty remains in relation to the definition of a knowledge intensive company and precisely how this may be interpreted by HMRC in particular circumstances. We will continue to watch the market and take note of any changes as HMRC's practice evolves.
The age limit does not apply if, for example, the total value of EIS or VCT finance investment made in the 30 days up to and including the investment date (including the investment in question), is at least 50% of the average turnover. The 2016 Act also determines more clearly the period over which average turnover is calculated. It will end immediately before the start of the investee company’s last accounting period.
These changes apply to all investments from 6 April 2016 and to investments between 18 November 2015 and 5 April 2016, except where the investee company elected to apply the previous rules.
2. New Reporting Requirement
A new reporting requirement has come into effect as a result of the EU State Aid enquiry into enterprise tax reliefs. From 1 July 2016, an investee company that receives any form of investment in excess of €500,000 that is considered to be state aid will be required to report this to HMRC. This includes both EIS and VCT investments.
For more information about SEIS (seed enterprise investment scheme), EIS or VCT relief, or for help and advice if you are considering being a party to a first or subsequent investment round in which one or more of these reliefs may apply, please contact a member of our enterprise tax team. We can assist with initial advice, transaction structuring, applications for HMRC clearance and subsequent reporting obligations.
Case on bad leaver provisions and directors' duties
A recent High Court judgment on (1) Paul Richards (2) Keith Purves v I P Solutions Group Ltd  EWHC 1835 (QB) offers key learning points both for private equity investors and for the founders of the businesses in which they invest. These relate in particular to:
- the need for management bonus arrangements to be as simple and transparent as possible;
- what constitutes "material breach" of a service contract; and
- the need for care in internal record-keeping.
The investment involved a standard structure, including new service contracts for the founders of the business.
The Newco (the "Company") articles of association contained usual "bad leaver" provisions. These allowed shares to be effectively removed from founders found to be "bad leavers" for £1. "Bad leavers" included those dismissed from employment for a reason justifying summary dismissal.
The service contracts entitled the founders/managers to bonuses for each quarter in which "surplus cash", as defined, was generated by the Company. "Surplus cash" was calculated using an extremely complex model (a spreadsheet with at least 12 tabs) constructed over a lengthy period during negotiation of the transaction. The only person who fully understood the model was the finance director (who left the business shortly after the investment completed). The contracts provided that the finance director had to certify the amount of surplus cash before the bonuses were paid.
The service contracts were terminable on notice from the Company for material or persistent breach or for material breach of a material statutory duty.
Management accounts for Quarter 1 were prepared in March 2015 by the original finance director and showed surplus cash ahead of target. The amount of bonus due was confirmed in an email exchange between one founder and the investor director, copied to the other directors. The bonuses were then paid, without there having been any formal certification by the finance director as provided for in the service contracts.
However, when the new finance director re-ran the model a few weeks later, it showed surplus cash below the target figure. The Company was failing to meet the revenue targets set for it.
At trial, the founders gave evidence to the effect that they had offered to offset the bonuses paid in error against subsequent bonuses. This was disputed by the investor but ultimately accepted by the court.
Relations between the founders and the investor then quickly worsened. Attempts by the founders to re-negotiate the bonus terms were flatly rejected, with the result that they came to feel that they were not being given the rewards that had been promised in return for their efforts to build up the Company's business. The investor, on the other hand, came to the view that the founders were prioritising their own interests over those of the Company:
- by resisting a change of auditor from a local to a national firm; and
- by opposing the engagement of external sales consultants.
The court found that, by April or May 2015, the investor had determined to remove the founders. Having taken legal advice, the investor arranged a board meeting at which the founders were voted off the board and given letters of summary dismissal. The bad leaver provisions were enforced.
The Company argued that it was entitled to dismiss the founders on three grounds:
- receipt and retention of bonuses to which they were not entitled;
- favouring, or threatening to favour, their own short-term interests in obtaining a bonus over the longer-term interests of the Company; and
- claiming expenses for personal expenditure.
The court disagreed. While there were technical breaches of both directors' duties (in that they were obliged to account to the Company for amounts paid to them in error) and of the service contracts (in that the surplus cash amount had never been formally certified), those breaches were not material.
The payments had been made openly and in good faith, with all parties believing them to be payable. The certification provisions in the service contracts were regarded by all as a technicality. When the error had been identified, there had been ongoing discussions over offsetting against future bonuses, but the Company had never, in terms, made a demand for repayment.
The founders had never favoured, or threatened to favour, their own short-term interests in obtaining a bonus over the longer-term interests of the Company. While accepting that the witnesses giving evidence for the investor had come to believe this to be the case, the court found that their belief was distorted by the "lens" of their settled plan to remove the founders. This was shown in correspondence making references such as "building the case" against the founders and getting the independent board chair "onside" with this. There were good commercial reasons to defer a change of auditor in the early days post-investment, and the external sales consultants had never in fact been appointed, even after the founders' departure.
The founders had made expense claims for personal items, but this merely continued the practice pre-investment and the amounts claimed were immaterial when set against the amounts due to the founders from the Company on directors' loan accounts.
The court found that in the run-up to the founders' dismissal, the investor had deliberately delayed the preparation and issue of board minutes prepared by them (which were found not to be wholly accurate) so as to issue them the day prior to the dismissal, in the hope that the founders would not read them or realise that material concerns were being raised. This was described as a regrettable failure of trust and openness towards the founders. The founders had been wrongfully dismissed.
Although the issue was not fully argued, the court also expressed a "tentative" view that, following the Supreme Court judgment in Cavendish Square Holding BV v Makdessi, the bad leaver provisions were not a penalty and were enforceable in principle.
There were no doubt good and valid reasons why the agreed bonus arrangements were so very complex. But it is inevitable that the greater the complexity, the more likely it is that a dispute will arise. The danger is greatly magnified where the personnel who construct the original arrangement leave the business.
Key learning points from the case are:
- Keep bonus and other formulae (such as ratchets) as simple and transparent as possible. Where simplicity is not possible, it may be helpful to produce a number of worked examples to show how the relevant formula is intended to operate. This may be an unwelcome task for someone in the midst of deal negotiation, but it may well help to avoid a very expensive and damaging dispute post-completion.
- "Material breach" means what it says. There must be more than a trivial or technical breach in order for the breach to be material. Where an investor, through its representative director, effectively consents to short cuts in contractual compliance (here the absence of formal certification of the bonus numbers), the company may not be able to insist on compliance with the full letter of the contract on other occasions.
- Where there is a possibility of a dispute leading to litigation, the parties must be aware that internal files and other records will be subject to disclosure. Assume that everything may become public at some stage, including inaccuracies and other material which may affect how a party's actions are viewed.