Peter Rayney shares some valuable pointers about succession planning based on a recent client experience.
Vincent was at home recovering from a very nasty bout of pneumonia. He had been hospitalised for over three weeks and had to spend his 64th birthday in a hospital bed. However, it was the first time that he had time to really think about his life and the future of ‘his’ property construction consultancy business, which he ran through his 100% owned company, Starry Night Consultants Ltd (SNCL). He was pleased to learn that the company’s senior management team had really stepped up to the plate during his illness. And they had managed without him for over two months now.
Vincent’s accountant, Don, had visited him a few days ago and they got around to discussing the dreaded subject of succession planning. If he had learned anything from his illness, it was that he was not immortal. What would have happened if he had died? He had never involved his wife in the business and therefore she knew nothing about it – she would have been helpless! Moreover, his two daughters, Fatima and Mourne, had no interest in following him into the business. They now had their own established professional careers!
Getting to grips with succession planning
Despite his tête-a-tête with Don, Vincent was still struggling to come to terms with everything. He earned around £180,000 each year from the business together with a number of benefits. It was a lot to give up and he was not quite ready to ‘call it a day’ yet. But he could not ignore this issue anymore. He remembered that Don had become very animated when he stressed that Vincent should have a proper succession plan in place and he must involve his senior managers in his thinking.
Vincent had quickly ruled out passing the business down to his daughters – this was simply not feasible. Consequently, Don outlined a number of practical options for further consideration by Vincent.
Trade sale of the business
Given that Vincent had no natural family succession path, Don said that he might first consider selling SNCL to a ‘trade buyer’. To obtain the best possible sale deal, this would require considerable time, planning and organisation to get the business ready. The company had performed extremely well in recent years and a sale price of around £5m was realistic.
However, Vincent considered that the most likely acquirer would be a much larger property consultancy seeking to consolidate. He felt tremendous loyalty to his staff and thought that a ‘trade’ sale was likely to spoil the ‘family’ culture he had built up within the business. Besides, he was pretty comfortable financially and he did not really need the stress of a sale at his time of life.
Sale to the senior management team
In recent years, Vincent had often considered passing the business to his senior management team for a reasonable price. One way of arranging this tax-efficiently was through a traditional management buy-out (MBO) transaction. This would involve the senior management team setting up a new company (Newco), which would acquire 100% of the share capital of SNCL from Vincent.
Don had explained that, if no outside funding was involved, Vincent would effectively have to ‘finance’ the deal. Thus, Newco would probably buy all his SNCL shares for some immediate cash and deferred cash consideration (which might be evidenced by Newco issuing a loan note).
Under this structure, Vincent should be able to benefit from the special 10% business asset disposal relief (BADR) rate of capital gains tax (CGT) on up to a maximum amount of £1m of gain. Any gain in excess of the £1m would currently be taxed at the normal 20% CGT rate.
It might also be possible for Vincent to retain some equity in the business going forward by taking some of his sale consideration in the form of a fresh issue of shares in Newco (using the CGT share exchange provisions). This would reduce the cash outlay for Newco. However, the amount of equity offered would have to be restricted to no more than (say) 20%/25% of Newco to avoid Vincent being challenged by HMRC (under the ‘transaction in securities’ (TiS) rules). This would be disastrous since, if HMRC were successful in applying the TiS legislation, all or part of the sale consideration would be taxed as quasi-dividend income (probably at 39.35%).
Don had provided a rough MBO structure diagram, as shown below.
Newco would incur a stamp duty cost of some £20,000 (0.5% x £4m) on the full purchase consideration for its purchase of the SNCL shares.
The MBO would largely be financed from current and future trading cash flows. Vincent would therefore need to be comfortable that the company would be able to service the capital and interest repayments on his deferred consideration.
This structure would also be tax-efficient for the MBO team since the deferred consideration payments would be made out of company monies (taxed at relatively low corporation tax rates). On the other hand, if the MBO team had to borrow the money personally to buy SNCL, they would suffer high income tax rates on the money extracted from Newco/SNCL to repay their personal borrowings. Don had also advised Vincent the MBO team should invest some personal funds into the buy-out transaction.
Vincent accepted that, in an MBO scenario, his sale price is likely to be restricted by SNCL’s ability to generate sufficient cash flows to pay him. The price will therefore be lower than the price that might be achievable on a trade sale. Many corporate finance specialists consider if the business cannot generate sufficient cash flow to repay the ‘seller’ loan or deferred consideration within five or six years, then the purchase price is probably too high!
Alternatively, with suitable advance planning, the MBO could be effected by means of a company purchase of own shares (POS). This would invariably involve first issuing some shares to members of the senior management team (which would have ‘employment-related securities’ issues). Once Vincent’s shares had been purchased by the company, the MBO team would control the company.
Given the various legal and tax constraints (to obtain ‘capital’ treatment), the POS would need to be structured using the so-called ‘multiple completion’ method (company law prohibits the use of deferred consideration for a POS, but this obstacle can often be overcome by arranging to complete the sale of the shares over a number of years).
Sale to an employee ownership trust
Don also mentioned that a substantial number of owner-managers are now selling ‘their’ companies to employee ownership trusts (EOTs). It is generally easier to sell to an EOT without the time-consuming negotiations and distractions that normally arise in a trade sale. The current difficult M&A market (high interest rates, low economic growth) also increases the attraction of a sale to an EOT.
Furthermore, because the government wishes to encourage employee ownership of trading companies, sellers are given a very attractive CGT incentive. Thus, there is no CGT charge on the sale of their shares to an EOT, provided certain detailed conditions are satisfied. This full CGT exemption is only available if the sellers sell at least a controlling (i.e., more than 50%) equity interest to the EOT ‘up-front’. The trustees of the EOT must evidence that they are paying a ‘fair market value’ price for the company.
EOTs must be established for the benefit of all employees. Empirical studies have shown that EOTs improve employee engagement and motivation, which help drive future growth and profitability in the business. Nevertheless, Don told Vincent that he should only consider an EOT if he intended to establish an egalitarian or co-operative employee ownership model – rather than just ‘chasing’ the valuable CGT exemption!
The way forward
While Vincent would definitely have preferred not to have contracted pneumonia, he was now feeling grateful for the ‘wake-up’ call relating to his succession planning strategy. He had left it a little late, but he now had the beginning of a workable plan.
In recent years, some of his senior managers had indicated an interest in taking over the business and he planned to explore this option with them first. This route is likely to be more flexible than the others and it is likely that they would allow him to remain as a part-time consultant in the business as he gradually ‘wound down’ towards retirement – his wife would like that too, he mused!
Practical tip
Life is unpredictable – so it is best to ensure that any succession planning strategy remains sufficiently flexible to deal with changes in future circumstances and tax rules. Succession plans should always be documented and clearly communicated to the owner-managers, fellow directors or senior management team.
