Growth shares: the economics behind the incentive

But alignment is not created by the label on the shares. It depends on the economics behind them.

A growth-share arrangement can look attractive in a term sheet yet deliver little value to management in practice. Equally, it can transfer more value than investors intended if the hurdle, participation rights and wider equity structure are not properly calibrated.

The legal documents define the rights. Financial modelling and valuation help determine what those rights mean economically.

The commercial purpose

Growth shares are commonly used where a business already has meaningful value, but its owners want to incentivise management to create further value. Rather than issuing ordinary shares that participate in the existing equity value, a company can issue a class of shares that participates only once a specified hurdle has been exceeded. This can limit the value transferred to management at the outset while providing an opportunity to benefit from future growth.

That can be an effective structure. But the headline hurdle tells only part of the story. The economics also depend on factors such as:

• The percentage of value allocated to the growth shares above the hurdle.
• Third-party and shareholder debt, including shareholder loans and preference shares.
• Liquidation preferences and conversion mechanics.
• Future funding rounds and the resulting dilution.
• Option pools and other management incentive arrangements.
• Transaction costs and the timing of an exit.
• The range of possible exit outcomes and the likelihood of the hurdle being exceeded.

Two arrangements with the same headline hurdle can produce materially different outcomes for management. The difference lies in how value is allocated once the relevant threshold is reached.

Why the headline hurdle can mislead

Consider two hypothetical growth-share arrangements. In both cases, the business is sold for an equity value of £180m. Management holds growth shares with a £100m hurdle and is entitled to 20% of the value above that hurdle.

Structure A: There are no other claims ahead of the growth shares. They participate in the full £80m above the hurdle, so management receives £16m.

Structure B: The hurdle and the 20% are the same, but investors also hold preference shares with a £30m claim that must be paid first. This effectively lifts the hurdle to £130m, so only £50m is left to share. Management receives £10m. The difference is £6m, even though the headline hurdle and participation rate are identical.

This is a simplified illustration. In practice, the result depends on the rights attaching to each share class, the treatment of debt and preference claims, and the precise operation of the equity waterfall. The point is that the headline hurdle does not tell the whole story. To understand the incentive, the economics must be modelled across the relevant exit scenarios.

IRR, MOIC and behaviour

The choice between an internal rate of return (IRR) hurdle and a multiple of invested capital (MOIC) hurdle can also affect the incentives created by a structure.

An IRR hurdle incorporates the timing of returns. All else being equal, achieving a given return earlier produces a higher IRR. Depending on the wider structure, this can strengthen the incentive to realise value sooner. A MOIC hurdle focuses on the multiple of invested capital returned. It does not directly measure the time taken to achieve that return, although timing may still affect the economics of the overall investment.

Neither approach is inherently better. The appropriate structure depends on the investment strategy, the expected holding period and the outcomes the investors want to encourage. The important question is whether the incentive behaves as intended across a range of plausible outcomes.

For example, does an earlier exit generate a disproportionately attractive outcome for management, even where investors might prefer to wait? Conversely, could the structure leave management with insufficient incremental upside to justify pursuing a more ambitious exit? These questions cannot be answered by looking at the headline hurdle alone. They require the growth shares to be modelled against alternative exit values, timings and distribution mechanics.

The valuation perspective

At the outset, growth shares are forward-looking instruments. Their value is not determined solely by the current equity value or by the difference between that value and the hurdle. It also reflects the rights attaching to the shares, the range of possible future outcomes, the allocation of value between different classes of equity and the timing and uncertainty of future returns.

A hurdle can make growth shares worth less than ordinary shares at the outset, but it does not automatically make them worth little or nothing. Their initial value depends on the economic substance of the rights acquired and the assumptions and methodology appropriate to the valuation.

This is why valuation should be considered alongside commercial structuring rather than treated solely as a subsequent compliance exercise. If the relevant tax valuation produces a value higher than anticipated, that may affect the consideration required to acquire the shares and the tax consequences of the acquisition. The precise implications depend on the applicable tax legislation, the consideration paid and the circumstances of the arrangement.

The objective is not to engineer a low valuation at the expense of commercial coherence. It is to understand the value of the proposed rights, assess the intended incentive and ensure that the structure is considered appropriately from both commercial and tax valuation perspectives.

The wider point

Growth shares can be an effective way to align management with investors, but the existence of a hurdle does not, by itself, create an effective incentive. The outcome depends on how the hurdle interacts with the wider equity waterfall, the allocation of value between shareholders and the range of outcomes the business might achieve.

The headline terms describe the incentive. The underlying economics determine what it is worth.