Given the ubiquitous nature of private equity in 2025, it feels difficult to imagine a world in which this monolith is still being built. However, it was only in 1983 that the UK private equity ecosystem had gathered sufficient critical mass that it could justify the establishment of its own industry body; the British Venture Capital Association (“BVCA”). In the four decades that have passed since then, the BVCA has been the voice of private capital in the UK, advocating for its ever-growing membership base in policy-making circles.
One of the BVCA’s many achievements was to reach an agreement with what was the Inland Revenue back in 2003 regarding the approach to valuing ordinary equity interests issued to employees in connection with a private equity backed leveraged buyout. The full name of that agreement is not particularly catchy to say the least; it is the “memorandum of understanding between the BVCA and HM Revenue and Customs on the income tax treatment of managers' equity investments in venture capital and private equity backed companies”. To those of us in the advisor community, it is simply the “MOU”.
In this post, we summarise the framework that is set out in the MOU, before considering some areas of interpretation where advisers seem to increasingly disagree with one another. First though, we think it’s important to revisit the typical structure of a private equity deal, as this is the foundation stone upon which the MOU is built.
1. Structuring of UK private equity deals
In a typical UK private equity sponsored transaction, the private equity investor will seek to partly fund the acquisition with third-party debt. This leverage approach effectively allows the private equity fund to acquire a larger number of assets, giving it an increased risk profile and therefore greater upside potential. The third-party debt forms the most senior instrument in the funding structure, and consequently, it carries the lowest rate of return. The interest on the third-party debt is normally settled in cash at regular intervals, and some of the original debt principal is usually repaid alongside those interest repayments. Consequently, the third-party debt leverage tends to diminish over the course of a private equity investment.
The funds deployed by the private equity fund are used to acquire a form of shareholder debt instrument and ordinary equity. The exact split of the private equity fund’s investment between these two instruments varies, but it is not uncommon to see a split in the region of 99:1. The shareholder debt instrument, which is junior to the third-party debt instrument, typically carries a higher rate of return reflecting the relative seniority of those instruments, and the fact that the return on the shareholder debt instrument is typically not settled until the time of a future exit event. Naturally, the ordinary shares are the most junior form of capital instrument, ranking behind both forms of debt. However, the potential returns on the ordinary shares are uncapped, unlike the debt instruments.
The combination of securities acquired by the private equity fund are commonly referred to as the “strip”. Each £100 of cash deployed by the private equity fund buys (say) £99 worth of shareholder debt instruments and £1 worth of ordinary equity.
The private equity fund is sometimes the only investor into the strip. However, it is common for key members of the management team of the target business to also invest into the strip, especially where those individuals had an ownership stake in the target business before it was acquired by the private equity fund.
The real driver of value for the private equity fund is an engaged and effective management team within the acquired business. It is therefore of critical importance that those individuals are strongly incentivised to grow shareholder value. To that end, a pool of ordinary equity is usually set aside for key members of the management team. This ordinary equity is commonly referred to as the “sweet equity”, because the entry cost for management into this element of the funding structure is relatively low, but the leveraged and uncapped nature of this instrument means that management can make outsized returns if they are able to sufficiently grow shareholder value.
2. Valuations and the birth of the MOU
Where management invest alongside the private equity investor into the strip as part of the initial buyout, there realistically can be no question that management have somehow received an employment-related benefit as a result of acquiring these interests at less than market value. Given that management acquire the same capital instruments as the private equity fund, at the same time and in the same proportions, there is a clear third-party benchmark price for management’s investment into the strip.
The same cannot be said for the sweet equity. This is acquired only by management and so there is no third-party benchmark price. In particular, the price paid by the strip investors to acquire the ordinary shares that form part of their ‘strip’ investment is irrelevant, as it comes with the obligation to invest a significant sum of money into an instrument carrying a fixed rate of return (the shareholder debt).
This presents a practical problem to the private equity model. Where employees acquire sweet equity for less than its prevailing market value, the difference represents an amount of employment income, which is usually subject to income tax and national insurance contributions (employee and employer) and where relevant the apprenticeship levy. Consequently, there is a need to value the sweet equity at the point of entry. This requirement is not an issue of itself, but the problem for the private equity industry is that valuations of this nature are naturally subjective and that subjectivity can create tax risk. Any form of risk can diminish returns on an investment and so this is not an ideal state of affairs. Further, it can be an unwelcome additional workstream when things are all but ready to be finalised with the sweet equity arrangements.
The BVCA took this problem up with what was then the Inland Revenue, and in 2003 the MOU was born. In short, the MOU is a concessionary framework, referred to in the agreement itself as a “safe harbour” which provides for an objective way to assign a valuation to the ordinary equity in a typical private equity deal. Consequently, where the relevant conditions are satisfied, the MOU should provide certainty to all interested parties when it comes to the valuation of the ordinary equity for UK tax purposes.
3. The MOU conditions
The MOU states that the price that management pay to acquire shares (“Manager Shares”) will be respected as being at least equal to the prevailing fair market value (for UK tax purposes) of those shares where the following 6 conditions are met. Note that this assumes that there are no ratchet arrangements in place (a deal can still comply with the MOU if there are ratchet arrangements, but additional criteria need to be satisfied which we will comment on another day).
- The Manager’s Shares are ordinary capital.
- Where leverage is provided by holders of ordinary capital, particularly the venture capital/private equity provider (“VC”), in the form of preferred capital, this is on commercial terms. It will be taken to be on commercial terms if the coupon or expected rate of return on it is not less than the coupon on the most expensive financing provided to the company by investors (including lenders) who do not hold ordinary capital (provided such investors are unconnected with the managers)
- The price paid by the managers for their Managers’ Shares is not less than the price the VC pays for its ordinary shares, being shares of the same class as the Managers’ Shares, or shares of another class but having substantially the same economic rights as the Managers’ Shares.
- The managers acquire their Managers’ Shares at the same time as the VC acquires its ordinary capital.
- The Managers’ Shares have no features that give them or allow them to acquire rights not available to other holders of ordinary capital.
- The managers are fully remunerated via salary and bonuses (where appropriate) through a separate employment contract.
4. From safety to where?
The ability of the MOU to provide valuation certainty is clearly valuable on a standalone basis, and that certainty was no doubt the BVCA’s primary objective in concluding this agreement with HMRC. However, there is no doubt that the value that is assigned to the Managers’ Shares per the MOU framework is, on average, lower than the figure that would be reached by applying an accepted valuation methodology (e.g. Black Scholes). Consequently, the MOU approach gives management a lower entry point into the ordinary equity of the business. This has undoubtedly been a key factor in the success of private equity in the UK in the last 20 years.
However, this means that the tax risks associated with the MOU are relatively high. If an adviser concludes that a deal is MOU compliant but HMRC successfully challenged that assessment later on, we would need to fall back on the ‘true’ valuation of the shares and the associated payroll tax consequences would usually be significant. For that reason, advisers in this space have always had some nervousness around the MOU and that nervousness has only increased in recent years as the focus on tax revenues has sharpened.
Conditions 1, 3, 4 and 6 of the MOU are either wholly or largely objective in nature and so advisers do not typically disagree on the application of those conditions through the course of a deal negotiation. Disagreements can often arise in respect of condition 2 where third-party debt is not present at the point of completion and condition 5 given how broadly that condition is written. The next section sets out some of the common disagreements we see in more detail and our views on them.
5. Points of contention
No third-party debt (condition 2)
Occasionally, a deal completes without third-party debt being in place on completion. This can be for a myriad of reasons, but most commonly it is where a deal is moving at speed and there simply isn’t time to get debt in place before closing. Often in those circumstances, there is an intention to get third-party debt in place in relatively short order post completion. However, this is not directly helpful to the MOU assessment, as the MOU is clearly a ‘point in time’ test, i.e. what were the key attributes of the transaction at the time of closing?
Condition 2 of the MOU is concerned with whether the shareholder debt (preferred capital in MOU parlance) provided by the strip investors is on commercial terms. The second leg of this condition gives a very objective way of making this assessment where there is third-party debt in place at closing; if the rate of return on the shareholder debt exceeds the rate of return on the third-party debt, then the shareholder debt is deemed to be on commercial terms.
If no third-party bank debt is in place, then we cannot access the second leg of this condition, and we are simply left with the need to determine whether the shareholder debt is provided on commercial terms. We have experience of other advisers expressing the view that it is virtually impossible to support an argument that a deal is MOU compliant without third-party debt being in place at closing, as the ‘bar’ for being comfortable that the shareholder debt is on commercial terms is so high. We reject that view, for the following reasons:
- The agreement clearly envisages that a deal can be MOU compliant without third-party debt being in place. Furthermore, in our view some comfort can be taken from the second line of condition 2 that the reference to ‘commercial terms’ is primarily a reference to the rate of return on the relevant shareholder debt instrument.
- The MOU contains a useful worked example. That example considers a deal which is partially funded by third-party debt. However, the following paragraph is included at the bottom of that example: “In this example borrowings from an unconnected bank were used to fund the investment and the coupon on these formed the benchmark ‘most expensive financing’…. if there were no other finance provided by an unconnected investor…then there would be no benchmark rate. In such a case, in order for the tax treatment [in this agreement] to apply, the question of whether the condition in the first sentence of [condition 2] is satisfied would need to be determined some other way. This might be done by comparing the expected rate of return on the preferred capital with the returns on similar investments in the market, or by comparing the capital structure with the structures in similar transactions, or by some other commercial analysis or comparison.”
Taking these two points together, we think its clear that the MOU envisages a sensible, commercial analysis being perfectly acceptable in such situations. Corporate finance firms operating in this space have stacks of real-world data that can assist with such an exercise and often there are indicative lending terms available from the anticipated third-party debt providers which can support the position.
Additional rights (condition 5)
Unhelpfully, the MOU makes no distinction between ordinary shares acquired pursuant to a strip investment and ordinary shares acquired pursuant to a sweet equity investment. As noted earlier in this article, the real target of the MOU is sweet equity valuations, as there is no realistic prospect of HMRC successfully arguing that a manager has acquired strip securities at a below market value price given the existence of a third-party benchmark price.
However, the lack of an explicit distinction can cause problems where there are deviations between the rights attaching to strip ordinary shares and sweet ordinary shares, which is a common occurrence in our experience. In recent times, we have noticed advisers becoming concerned about the common scenario in which the strip ordinary shares carry votes but the sweet ordinary shares do not. The argument goes that some of the Manager’s Shares (the strip ordinary shares) carry rights (votes in this case) that are not available to other holders of ordinary capital (the sweet equity ordinary shares), implying that condition 5 is therefore failed and the deal is not MOU compliant.
In our view, this is a very legalese way of reading a document that is not law. The MOU is a principles-based framework, largely focussed on the economics of the deal, and it should be read as such. In this context, we note the following wording in the introduction to the agreement: “ HMRC will not be bound by this memorandum if the main purpose, or a significant purpose, of the arrangements is avoidance of liability to tax or national insurance, or to the extent there are material deviations from the structure described below [in the MOU]."
Clearly, the intention of the wording above is to ensure that the MOU has a narrow scope of application. However, if you turn the final sentence on its head, you can quickly see that HMRC envisage that a deal can be MOU compliant where there is some deviation away from the conditions that are laid out, provided that deviation is not material.
Is the lack of voting rights on the sweet ordinary shares a material deviation? In most deal settings, we struggle to see how this could be considered the case. Regardless of the voting rights attaching to any individual share class, a private equity deal is typically governed by a comprehensive investment agreement which gives the private equity investor all of the controls that they need to confidently make their investment. If the sweet ordinary shares carried votes, the investment agreement would compensate for this such that the private equity investor had all of the desired protections from a governance perspective. On that basis, how can this be a material deviation?
6. Looking to the future
The MOU is still with us almost 22 years after it was introduced. There is always the risk that it will be withdrawn by HMRC, as it sets out a concessionary approach to a question of tax valuation, and HMRC could always decide to take a different policy direction.
However, whilst the MOU remains in place, it is hugely valuable to the UK private equity industry. Whilst we understand and appreciate the nervousness that some of the adviser community has in applying the MOU, we believe that we must be as helpful to our clients as we can be when giving an opinion on its application. When we are giving advice in respect of the MOU, we believe we should always be guided by the following two principles:
- The MOU is not legislation and it should not be read as such. Whilst the MOU is concessionary in nature, which means that we must not try to push its boundaries, we must recognise that the agreement explicitly envisages deviations and we must always be guided by commercial principles.
- The MOU focuses on the economics of the deal and commercial assessments should be made by reference to market norms. This is not an esoteric concept – there is a lot of UK deal activity from which market norms can be gleaned and the MOU clearly envisages such an approach.