The escalation of the coronavirus (COVID-19) outbreak, including travel restrictions, social distancing measures and large-scale quarantines has had a significant and unprecedented impact in recent weeks not only on our daily life, but on the economy. Whilst companies struggle to deal with the many and varied issues arising as a result of COVID-19, including mitigation of the adverse effects of the crisis and contingency planning, it is natural to focus on the negative as a business owner or an employee.
Retain your workforce if at all possible
It goes without saying that a company’s workforce is its most valuable asset. We know that companies who reward employees with equity are more productive and profitable, particularly as those employees who understand the part they play in the company’s success tend to work harder to increase the value of the capital they hold in the business. At a time when employees in many sectors of the economy have been furloughed or are facing an uncertain future, most employees are feeling extremely vulnerable. Furloughing is enabling employers to retain staff who will be needed when they begin to rebuild their businesses, so that when the time comes, work can begin again with a critical core who have the necessary knowledge. The message is clear: the retention of key staff is vital to support businesses through this difficult time and when normality resumes. Rewarding employees who continue to work hard to support businesses through these difficult times is one way of reinforcing this message.
Which scheme is appropriate?
Many companies use some form of company share scheme to reward and retain key employees. These schemes take many forms, from Government ‘approved’ schemes such as the incredibly successful Enterprise Management Incentive Scheme (EMI) to more bespoke Growth Share arrangements. What better time therefore to incentivise and retain your employees who are providing invaluable support to your business through these difficult times, by rewarding them with share options or equity, particularly when most company valuations are low? Thankfully, we’re well-versed in implementing all forms of share schemes, including EMI, and supporting the valuation of the options/ shares to be granted/ issued with a detailed, contemporaneous valuation report.
Agreeing the right share value
When implementing an EMI Scheme, one vital component of the process is agreeing the valuation of the shares with HMRC prior to the grant of EMI options. This raises the difficult question of how to value shares in private companies in the midst of the global uncertainty in markets caused by COVID-19? Share valuations for tax purposes are notoriously fraught with difficulty at the best of times, so the answer is unfortunately not straightforward.
It is easy to think that with the downturn in the global economy, all company valuations are low, given the impact of the virus on a large number of businesses. There will inevitability be some businesses which are affected more than others, so clearly we need to look these on a case by case basis. However, there are a number of companies which are thriving (think Tesco or Sainsbury’s) so certain businesses are arguably attracting much higher valuations in the current situation.
In terms of company valuations therefore, I think that we have to ‘treat’ the virus (and excuse the puns here) from a valuation perspective as if it were an exceptional, ‘one-off’, event (which obviously which we hope it is). In arriving at company valuations in ‘normal’ times, we would usually look to recent years’ performance (and where appropriate expected future performance) in order to arrive at a ‘maintainable’ or ‘normalised’ profit, rather than looking at one year in isolation. There is no reason to change this approach to valuations in the current climate. In terms of profitability, we don’t think that we can argue simply because profitability is currently lower (or in fact higher) due to COVID-19, this will impact the ‘maintainable’ or ‘normalised’ profit of a company in a valuation sense on the assumption that in most cases, profitability should recover once things return to ‘normal’.
However, in terms of an appropriate valuation multiple to be applied, there will clearly be an impact on company values, given that in deriving an appropriate valuation multiple, we look to the quoted market and any public transactions in the marketplace as a source of an appropriate multiple. Overall therefore, it is reasonable to conclude, current valuations for most businesses will be lower than normal, though not just because of the current fall in transactions. We need to bear in mind, however, that for tax valuations, caselaw assumes a hypothetical sale is capable of taking place and that the parties to the sale are also hypothetical, so we cannot assume the shares cannot be sold. In the leading case of IRC v Gray the court stated, in an authoritative re-statement of the statutory hypothesis:‘It cannot be too strongly emphasised that although the sale is hypothetical, there is nothing hypothetical about the open market in which it is supposed to have taken place’.
This point is re-emphasised by the Judge in the case of Walton v Commissioners of Inland Revenue:
‘…the statute requires one to assume a sale but it should be assumed to take place in the real world’.
Valuations should have regard to the actual circumstances prevailing at the date of valuation, so in the current climate therefore need to reflect the reality of the impact of COVID-19.
Conclusion
There is likely to be a window of opportunity for several months to agree valuations with HMRC based on the lower price/earnings multiples which now apply in the market. Doing so could reduce the amount that employees need to pay to acquire equity or could reduce their income tax liabilities if they do not pay market value for their shares Whilst implementing an employee equity incentive scheme is unlikely to boost short term cashflow, doing so may well benefit your business in the longer term by ensuring that you have a well motivated team for when business growth returns.
Are HMRC open for business?
So, having established that it is a good time to incentivise and reward employees and take advantage of potentially low valuations, the other logical question to be answered is whether it is possible to get valuations (and in particular, EMI valuations) agreed with HMRC’s Shares and Assets Valuation. SAV have stated that they are still operating and processing all valuations (including EMI valuations) with staff working from home, but are currently unable to operate their helpline. They are currently working within their turnaround target of 10 working days for agreeing EMI valuations, but that doesn’t mean there won’t be delays going forward if circumstances alter and staff numbers reduce.
Should you have any questions or need any specific tax related advice please don’t hesitate to contact your usual contact at Claritas Tax.
