What it means
People who hold a large number of shares in one company often want cash and protection from a fall in price, but selling the shares would trigger tax and may send a signal to the market. A variable prepaid forward contract is a way to get liquidity and protection without an outright sale.
The shareholder enters an agreement with a bank, receives a payment today that is a high percentage of the current share value, and pledges the shares as security. At maturity, usually in a few years, the shareholder delivers a number of shares set by a formula that depends on the price on that date.
The formula sets a floor price and a cap price. If the share price ends at or below the floor, the shareholder delivers all the shares, and the bank bears the fall below the floor, while if the price lands between the floor and the cap, the shareholder delivers fewer shares and keeps the rest.
Above the cap, the shareholder gives up further gains because the number of shares delivered rises again. The structure is, in effect, a collar (a combination of a bought put option and a sold call option) combined with a loan.
The shareholder can also usually settle in cash instead of delivering shares. Tax treatment is the point of controversy.
Many arrangements are designed so that the shareholder is not treated as having sold the shares until delivery, and tax authorities look closely at whether the substance of the deal is a sale. The rules differ between countries and have changed over time, so specialist advice is essential.
For a company, such arrangements raise governance questions. Boards often require disclosure and approval when executives use them, since hedging can reduce the alignment between an executive's interests and the interests of other shareholders.
In practice
Real-world examples.
Example
A founder owns 2 million shares in a listed technology company and wants cash for a property purchase. She enters a variable prepaid forward with a bank and receives 80% of the value up front. She delivers shares in three years' time under the formula.
Example
A senior executive worries that the share price might fall before he can sell under company rules. He agrees a floor at today's price, which protects him from a fall. In return, he gives up gains above the cap.
Example
A bank evaluates a request from a client with a large concentrated holding. It checks the liquidity of the shares, sets the floor and cap, and decides how much cash to advance. It charges a financing cost that is built into the terms.
Formula
Calculation
Shares delivered at maturity, with N shares pledged, floor price F, cap price C and share price P at maturity:
If P is at or below F, shares delivered = N
If P is above F and at or below C, shares delivered = N x F / P
If P is above C, shares delivered = N x (P - C + F) / P
An executive pledges 100,000 shares worth $50 each, which is $5,000,000. The floor is $50 and the cap is $70, and she receives an upfront payment of $4,000,000, which is 80% of the value. At maturity the share price is $62.50, between the floor and the cap, so shares delivered = 100,000 x 50 / 62.50 = 80,000. The delivered shares are worth 80,000 x 62.50 = $5,000,000, and she keeps the other 20,000 shares, worth 20,000 x 62.50 = $1,250,000, plus the $4,000,000 she received earlier. If the price had been $80, above the cap, she would deliver 100,000 x (80 - 70 + 50) / 80 = 75,000 shares.Case study
Seen in the real world.
This illustrative story is about a fictional executive, Daniel, who held 500,000 shares of a fictional company, Brightfield Technologies, worth $40 each. Almost all of his wealth was tied to one share price, and the company's results were uncertain.
He entered a variable prepaid forward through a fictional bank, with a floor of $40 and a cap of $56, and took an upfront payment of $16,000,000, which is 80% of the $20,000,000 value. The company's share price fell to $30 by maturity, below the floor, so he delivered all 500,000 shares and kept the $16,000,000 as settlement.
Without the contract, Daniel's shares would have been worth $15,000,000. The structure gave him the cash he needed and protected him against the fall, but if the price had risen to $56 or more he would have given up the gains above the cap. The story is fictional, but it shows the trade-off in the design.
Watch out
Common mistakes.
- Treating the upfront payment as free money. It is a financing arrangement with a cost built in, and the shares remain pledged until maturity.
- Assuming there is no tax risk. Tax authorities may challenge the treatment, and the position depends on the exact terms and the local rules.
- Forgetting disclosure rules. Executives and directors may need company approval and public disclosure before entering such a contract.
Questions
People also ask.
Is a variable prepaid forward the same as a loan?
It works like a loan in cash flow terms, but legally it is a forward sale of a variable number of shares, which is why tax treatment is so important.
What does variable mean here?
The number of shares to be delivered varies with the share price at maturity, between the floor and the cap.
Can the holder keep the shares by settling in cash?
Often yes, many contracts allow cash settlement or share settlement, at the holder's choice, subject to the terms.
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