Philip Marsden, Managing Director at Vantis Corporate Finance, presents the fourth in our series of articles on SMEs, in which he writes on executing a sale.
This is the fourth in a series of articles covering the life of an SME (small or medium-sized enterprise) and deals with the issues faced by proprietors in executing a sale of their business. We will touch on the key tax issues but will mainly focus on the commercial considerations.
Setting the Scene
Regardless of the current economic conditions, owners of businesses have to recognise that at some stage they are likely to sell. Even the owner-manager who is happy drawing the annual profits will eventually reach the point of exit. This gives rise to two key questions which they must factor into their decision-making -- namely, when to sell and who to sell to?
When to Sell?
A number of factors will have to be considered, some commercial and some personal. Common commercial considerations are market conditions, operational issues and exit strategy.
Market considerations
These include a review of market trends. Is the relevant market growing or stagnating? A growing market attracts new entrants, broadening the pool of potential buyers. In a stagnant market, buyers are likely to be limited to competing trade buyers and the current management team.
In order to maximise the value, the right time to sell might be now. Alternatively, prospective developments within the market could result in the sale value of the business increasing significantly, along with trading performance, if the sale is deferred.
Another key factor is the level of mergers and acquisitions (M&A) within the sector. M&A volume fluctuates, and the key is to try to hit an upturn in activity.
Other external factors, good or bad, may have an impact on value -- for example, changes in Government policy or EU legislation which will, in due course, affect the business.
Operational issues
Those most frequently encountered include the following.
- Management team -- it is essential to have an appropriate and proven team in place, one
which is committed to remaining with the business. A number of transactions have fallen by the wayside, or sale value has been affected, when key managers have decided to leave the business. This issue is compounded where key customer and supplier relationships rest with senior managers. An impartial assessment by the vendor should ensure that any issues relating to the management team are addressed and factored into the decision of when to sell the business. Otherwise purchasers of the business may want to defer part of the purchase consideration in
the form of an 'earn-out' against achievement of profit targets.
- Returns on recent capital investment -- if a significant sum has been invested in plant and machinery, the ultimate returns to the business will need to be clearly demonstrated in the sale consideration. Prospective purchasers are reluctant to pay for 'perceived benefits'. Delaying a sale allows the benefits of the capital investment to be reflected in the profit and loss account.
- Trade agreements -- if the business trades with key customers under 'term agreements' (typically up to three years in duration), clearly the business will be more attractive if the key contracts have the majority of the term to run before renewal. Otherwise, delaying the sale until the contract(s) have been renewed could be a consideration.
- Other issues impacting on value or the timing of sale include pension liabilities under defined benefit schemes (and given current movements on share prices it is likely that such schemes will have a worsening pension deficit which must be planned for and agreed with the Pensions Regulator) and the level of working capital required by the business to support ongoing trading activities. The expected level of working capital must be agreed with the purchaser if the vendors wish to extract any cash that is surplus to the needs of the business, so an understanding of working capital requirements and the impact of any bank debt on the sale consideration is essential.
These are just a few examples of issues that we frequently come across. The message is to ensure that any 'skeletons in the cupboard', including bad debts or claims, are addressed prior to entering negotiations with prospective purchasers.
This also applies to tax debts and exposures. The prospective purchaser has a different view of aggressive tax planning and acceptable risk levels. The purchaser's due diligence team will no doubt suggest that risks associated with aggressive tax planning should remain with the vendor, possibly by way of a withholding from the purchase consideration.
Exit strategy planning
The key to a successful exit is to plan in advance. A thorough review of the company and its trading environment is essential so that all key issues, positive and negative, which can impact on the timing and eventual sale are identified and addressed prior to marketing the business for sale.
Whom to Sell to?
The second key question a vendor must address is: to whom should the business be sold? There are several possibilities.
Sale of the business to its senior management team
This is typically referred to as a management buy-out (MBO). There are many advantages to a vendor. The most obvious is confidentiality: there is no need to enter into discussions with external third parties. Many vendors are uneasy about discussing the potential sale of the business with trade buyers who may be direct competitors of the business. By taking this route the business will be maintained as a stand-alone entity and will not 'lose' its identity, which may be the case if it was acquired by a trade buyer.
The vendor may also regard the sale of the business to the management team as an act of repaying the management team's loyalty and support in developing the business.
There are, however, potential downsides to selling a business to an MBO. The MBO team may not have the financial wherewithal to obtain the necessary funding to acquire the business at an acceptable value. More importantly, a trade buyer will probably derive synergistic benefits from merging the acquired business with its own, thereby justifying a price premium which the MBO team is unable to match.
An MBO is a once-in-a-lifetime transaction, and a potentially life-changing process. For most MBO teams it is highly complex and involves a 'roller-coaster of emotions' for all parties.
The key tax consideration is that HMRC, being naturally suspicious, will be on the lookout for 'mischief' in the form of turning 'income' into 'capital' -- given the difference in tax rates. ITA 2007, s 684 provides the armoury to do this, and the sale of an owner-managed business (which is usually a 'close company') could fall within one of the prescribed 'circumstances'. It is generally advisable for the vendor to seek advance clearances that the relevant anti-avoidance provisions will not be applied (under ITA 2007, s 701 and, if seeking capital gains 'rollover' treatment for any 'paper for paper' element of the consideration, under TCGA 1992, s 138).
The new entrepreneurs' relief (ER) contains more conditions than business asset taper relief in its final form and in some ways harks back to the old retirement relief. ER is sure to create conundrums -- for example, whether loan notes should be qualifying corporate bonds to bank ER which might not be available later if insufficient voting rights are retained, noting that there will be no tax relief if the buyer defaults.
Tax issues for the MBO team will involve the above clearances, if any of the team already hold, and are rolling over, an equity stake. Take care that the MBO team is not receiving shares at a lesser price than equity invested by financial investors (the discount being potentially taxable under the employment-related securities provisions within ITEPA 2003). Finally, it should be noted that elections under ITEPA 2003, s 431 (to ignore any 'restrictions' attached to the shares and fix 'capital' treatment going forward) need to be entered into within 14 days of the shares being issued.
Sale of the business to trade
A trade buyer can come from a variety of sources -- a direct trade competitor, an overseas-based company, or a company looking to enter a new market through acquisition.
There are numerous benefits over MBOs. Firstly the vendor will achieve a 100% sale of the company with, typically, little of the consideration being deferred. The buyer will know the market and probably the target company, resulting in its due diligence being targeted and limited in scope compared to the requirements of the MBO's funders. More importantly, a trade buyer may be able to justify a strategic premium!
When identifying potential trade purchasers, it is important for advisers to clearly understand which companies the shareholders would never sell to, and who has made an approach in the past. There may be sensitivity, for instance, about sharing 'trade secrets' with a direct competitor.
In planning a trade sale, the vendors must have an understanding of the various deal structures -- cash on completion with or without a mix of earn-out or deferred consideration. The comments above as to the mischief HMRC would typically be looking for, and the clearances available to prevent reclassification as income, remain relevant if 'rollover' treatment is sought.
If there is no management participation in the transaction, the vendor will want to ensure that management do not become disenchanted with the process and the eventual purchaser. One-off bonuses or other incentives upon completion are common. It is important to remember that there are tax implications and that any such commitments will be factored into the price by the purchaser.
Other transaction types
A sale of company assets versus a sale of shares is generally much less tax-efficient for the seller (because there are two tiers of tax -- corporation tax within the company, followed by tax on extracting funds from the company by way of dividend or liquidation of the company) and so is seldom seen. This is despite the fact that a UK corporate buyer (who can claim a tax deduction for amortisation of goodwill purchased directly) is diametrically opposed in terms of which structure is beneficial. However, a purchaser will probably prefer an asset deal over shares if there are significant liabilities within the company that the purchaser is not prepared to inherit.
In a public sale -- sale of shares by way of flotation or initial public offering on a stock market -- a public prospectus with a 'long-form accountant's report' replaces the usual sale document (Information Memorandum) and due diligence report addressed to specific funders. This will require more involvement in preparing, and more responsibility for, these documents. There will also be additional advisers and costs (including stockbroker's and financial sponsor's fees). Clearly, this is also at the other end of the spectrum from an MBO in terms of disclosing sensitive trade information.
Conclusions
The issue of sale or succession (covered in Issue 951, 6 October 2008) will be encountered by every business owner, without fail. Whilst the vendor will be guided through this process by appropriate advisers at the time (a corporate finance adviser on who to sell to and when, and so on, and a lawyer for the legal documents), you are more likely to be able to help prompt the vendor and initiate the process at the appropriate time, achieving a better end result for the vendor, if you have an understanding of the process. We hope this article will help in this regard.
This article was originally published in ‘The Tax Journal’ on 24 November 2008.