The most important facts in brief:
- Sweet equity is a form of management participation.
- Sweet equity gives management the opportunity to acquire shares in the company without incurring high costs.
- With sweet equity, it is important to ensure that it is structured at standard market conditions. Otherwise, high taxes may be incurred.
What is sweet equity?
Sweet equity is defined as the participation of managing directors and board members in companies on preferential terms. Owners of a company, in particular private equity funds, want to ensure that the managing directors pursue the goal of increasing the value of the company as much as possible. The aim is therefore to ensure that the interests of the owner and the management are aligned. In order to achieve this goal Management participations are used. The managing directors also acquire part of the company so that they also benefit from increases in value and high profits.
Sweet equity is one way of implementing management participation. There are a number of challenges when structuring management participations:
- DonationIt does not make sense to donate the shareholding to the management. The reason for this is that the shares would then have to be taxed as salary. This would result in very high taxes, which the managers would have to pay from their salary (so-called dry income).
- PurchaseThe managers could also buy the shares at the market price. In such a situation, however, there is the problem that the managers often do not have enough money to pay the purchase price. In principle, it is possible to take out a loan to finance the purchase price. However, this approach carries a high risk for the managers if the company value should fall.
One solution to these challenges is sweet equity. With sweet equity, the managers benefit from the increase in value as co-owners of the company without having to take out a large loan privately. At the same time, the shares are not gifted to the management so that no taxes have to be paid when the shares are received.
What options are there for structuring sweet equity?
There are various options for structuring sweet equity. The form of structure chosen depends on the specific transaction and the respective circumstances. The following options are common for structuring sweet equity:
- Acquisition companyThe management acquires the shares in the company via a company (e.g. a GmbH or GmbH & Co. KG). The company is mainly financed by a loan from the owner. In this way, the managers only have to raise a very small proportion of the purchase price themselves, as a large part of the purchase price is financed by the loan.
- Shareholder loansAn alternative option is for the owner to finance the company primarily through a shareholder loan. In this way, the management's share of the company's equity increases so that the management also participates more strongly in increases in value.
- Share classesThere is the option of structuring the shares in a company differently. For example, the participation in profits or increases in value can be structured differently between the various share classes. It is possible, for example, to issue shares which, similar to a loan, receive a fixed return and are serviced on a priority basis. If the company value rises sharply instead, the remaining company shares will receive a higher profit.
When structuring sweet equity, it is very important to ensure that it is structured at standard market conditions. For this reason, care must be taken to ensure that the terms, interest rates, etc. for all of the above-mentioned forms are at standard market conditions.
What are the alternatives to sweet equity?
Sweet equity is not the only way to allow managers to participate in the company's value growth and thus create an alignment of interests with the owners. In addition to sweet equity, there are also the following forms of management participation:
- Sweat equityWith sweat equity, the management has the option of acquiring shares in the company at a later date. The shareholding must therefore still be acquired (hence the term "sweat"). For this form of management participation Options are used. In the case of an option, the price at which the shares can be acquired later is determined today. If the value of the shares increases, the management can buy the shares at a favorable price and resell them immediately.
- Virtual options / bonusVirtual options do not allow management to acquire real shares. Instead, the management receives a bonus that corresponds to the increase in the value of the company. It is also possible to base the bonus on criteria other than the value of the company.
- ParticipationThere is also the possibility that the management buys the shares at the market price. However, such purchases are more likely to take place in small companies if it is financially viable for managers to buy the shares without a loan.