preparing for and selling a family company - Parmentier Arthur Independent Advisors with offices in London and Cambridgeshire UK

A. Preparing the Company for sale

Quality of Maintainable Earnings

• Major issue is CONSISTENCY
• Large, non-recurring gains discounted
• Wildly fluctuating earnings will deter purchaser
• Goal = consistent earnings of high quality
• Quality represented by:
• consistent sales growth
• control of manufacturing or supply costs
• constant or improving gross profit margins
• control of overhead expenses
• effective management of debt
• Cost control as valid as increased sales
• £1 saved in costs is equivalent to £5-£6 in additional sales
• Private companies' profits usually adjusted for:
• owner's remuneration
• conservative accounting policies - sometimes
• cost of financing non-income producing assets
• The aim of planning should be to present a clean profile on sale

Working Capital Management

• Often low in management priorities
• Auditors/accountants well placed to advise on improvements
• Debt collection
• Stock control
• Terms of supply
• Can have large, positive effect on cash flows

Adequacy of Cash Flows

• Investor will require adequate cash return on investment plus reasonable pay back period
• History of appropriate level of cash flow available for discretionary spending
• Dividends and other quasi-distributions added back in sale situation

Competitive Comparisons

• Competitive comparisons will include:
• profit margins
• sales growth
• expenses to sales ratios
• age and condition of manufacturing plant
• wage rates and production efficiency

Capital Investment and Future Planning

• Purchaser may well review major capital investments for:
• proper consideration and analysis thereof 
• actual benefits obtained v. planned benefits
• comparison with industry norms
• Worth assessing timing and absolute necessity of capital purchases in view of potential company sale
• For larger companies, preparation and regular update of a strategic business plan good practice
• Basis for purchaser to assess future cash flows

Management Succession

• Difficult in small companies
• If no obvious successor, existing management will need to stay
• For the larger company identify the key functions (sales, marketing, research and development) and plan for succession if not in place already

Hidden Liabilities

• Pension and tax liabilities not disclosed most common areas of concern
• Defined benefit pension plans vs. defined contribution
• Contingent liabilities
• product warranties/guarantees
• outstanding litigation
• environmental
• promotional (e.g. redeemable coupons)
• service contracts
• The cleaner the company, the easier the sale

B. Valuation of Company & Asset Retention Issues

Benefits of Independent Valuation

• Provides a focus for those operational aspects which need to be addressed to enhance saleability
• Will involve the identification of under-utilised assets, or elements of the business which may be separately saleable
• Anticipates the selling process - the investigation of the company, the preparation of selling documentation, and the identification of purchasers
• Provides the necessary information for quantifying contingent tax liabilities - the gross from which will be obtained the net
• Highlights the strengths and weaknesses of the company's sources of information, about itself, its financial history, its market place
• Introduces objective, reasonable bench mark uncoloured by emotional attachment

Investigation of the Company

• Breakdown of products and services produced
• Identify high and low margin products
• Assess competitive position of each product
• Identify cyclical factors in the market for each product, and maturity of product
• Assess factors determining market share including costs of entry to competitors, pricing strategy, technical advantage, geography
• If appropriate carry out comparative analysis of product and sales strategy of competitors.

Income and earnings profile

• Analysis of historical cost base and pricing strategy -guide to the future?
• Forward plan prospective production costs overhead and pricing strategy in the hands of identified purchasers
• Distinguish quasi-profit distributions - directors' bonuses, excess remuneration, pension contributions, benefits in kind, non-arm's length rents or management charges, non arm's length transactions with associated businesses
• Distinguish likely recurring income and costs from non-recurring items:
• Profit/loss on disposal of fixed assets
• Non-capitalised expenditure on fixed asset base
• Provision for one-off bad debts, litigation, compensation
• Non-recurring adjustments for exchange rates
• Consider earnings on a pre-finance basis, options for different finance structures and sensitivity at different levels of gearing
• Analyse any unnecessary adjustments for future taxation treatment.

Asset base

• Review utilisation of assets especially property
• Establish likely utilisation of assets in the hands of prospective purchasers
• Review accounting treatment against commercial reality as regards stock, work-in-progress, debtors
• Review depreciation policy against market value, as regards plant, vehicles, tooling etc
• Assess values not disclosed in balance sheet - premiums on long leases, intellectual property assets, separable value of trade, goodwill
• Re-evaluation of freeholds and long leaseholds

Risk and growth

• Exposure to cyclical economic change - should point to sale date
• Size of company relative to competition
• Substitutability of products by alternatives
• Degree of discretion in expenditure on products by customer base
• Strength of liquidity and cash flow for future expansion
• Degree of saturation of potential customer base
• Patterns of ownership within industry and prospective changes
• Technical and intellectual property advantages
• Dependence upon proprietors or key personnel
• Size and spread of customer base
• Number and size of suppliers

Strategic value

• Principle of value in hands of purchaser
• Special purchaser has reasons for paying higher price
• Potential for 'auctions' between special purchasers
• Impact of merger on industry pricing
• Impact of merger on lines of supply
• Marketing and production synergies and fruits of potential rationalisation
• Overhead savings
• Strength of negotiating position and possible alternatives for the purchaser

Valuation methodologies

• Whole company going concern, subsuming underlying asset values
• Breakdown valuation, identifying separate asset values including intangible value
• Exit price earnings or earnings before interest, depreciation, tax and amortization 'EBITDA' ratio applied to maintainable earnings -may be recent historic, average historic, prospective in current year

Earnings and multiples

• Earnings must reflect commercial reality post-acquisition, not necessarily accounting practice
• Comparison with previous deals for multiples - data may be distorted by non-published aspects, including vendors motivation to sell, internal politics, cash and liquidity position, competitive relationship of vendor and purchaser, competence of advisers
• Quoted price earnings ratios - factor for quoted purchasers, especially offering paper
• Premium for control in quoted hostile takeovers
• Discount for unquoted status - may or may not be factor, depends on size and number of players in market, and alternative of green field or start-up option for potential purchaser/competitor

Discounted cash flow

• Derives from economic theory of value
• Enables valuation judgments to be aligned with financial management and investment planning strategies
• Traditionally closer to business school and management accounting thinking than to investment market approaches but the dot com boom and venture capital industry have driven this approach to the mainstream
• Generally likely to figure in the calculations of purchasers and financiers
• Weakness is dependence upon crystal ball gazing as to sales achievement, future earnings, costs, interest rates and technology

C. Maximising Base Cost & Pre-Sale Planning

Capital Gains Tax

• Liability of each U.K. resident shareholder on disposal of company shares
• Tax at marginal rate for Income Tax (or Corporation Tax in case of corporate shareholder)
• Amount of gain determined by reference to the acquisition cost and the amount of the sale proceeds
• Liability may be reduced or deferred by exploiting the available reliefs
• It is of fundamental importance to ensure an early and optimum business assets taper relief profile for all shareholders

Acquisition cost

• Each shareholder has to be considered separately
• May be original subscription price, market value at 31st March 1982, value at 6th April 1965, market value on transfer to present shareholder
• Shares acquired on death - 'chargeable' value of the shares in the estate
• Determines frozen indexation relief to 1998
• March 1982 values - husband and wife's shares separate, but scope for pre-sale mitigation (Revenue Statement of Practice 5/89, Extra-statutory concession D44)

Holdover reliefs

• IHT planning benefits of early transfers at frozen value and loss of Business Property Relief on sale
• Facilitate pre-sale transfers of shares to recipients with more advantageous tax profiles but review the effect of the loss of taper relief
• Transferee shareholder treated as having acquired shares at the acquisition cost of the transferor
• Accordingly, transferor transmits taxable gain to the transferee
• S.165 TCGA 92 relief - inter alia, shares in unquoted trading company
• Restriction on S.165 relief in respect of non-trading assets
• S.260 relief - alternative where element of non-trading (i.e. investment)
• S.260 - has to be immediately chargeable transfer for IHT, most commonly used with "nil rate band" discretionary trust type scheme.

Pension Fund Investment

• Low current yields have resulted in most 'proprietor' orientated pension schemes being under funded
• Self-Administered Pension Schemes can invest in Employer Company, subject to certain limitations
• SSAS are gross funds so clear tax attraction in such self investment

Examples

Asset Extraction - The Tax cost

SSAS Investment

SSAS Share Proceeds

Timing  on Cash Extraction

Pre-Sale Aggregation of Shareholdings

Solution : One Spouse Gives 35% Holding To Other One

Overview

The Buyer's Viewpoint

The buyer will often prefer to buy the business rather than the company.

There are a number of reasons for this.

• Firstly, the company may be unattractive because of its history, or because it may have assets/liabilities, etc. unrelated to the business being bought. There may, for instance, be potential legal claims against the company, and the buyer can usually avoid these by buying the business rather than the company
• Secondly, by buying the business the overall consideration can be reduced and it may be possible to save Stamp Duty. For example, cash and debtors can be left with the vendor, and goodwill can now be acquired free of duty. Conversely, if the company were bought (with all these assets included) duty would be payable on the value of the shares which would, of course, reflect the value of the underlying assets
• The acquiring company (or a member of its group) may be able to "roll over" capital gains arising on disposals of other business assets into the cost of the acquired assets, thus deferring tax on gains
• Acquired stock is a deductible expense and capital allowances may be claimed on purchased plant
• If there is a substantial goodwill element in the purchase, tax relief will be claimable in relation to amortisation of the cost of the goodwill, if the business is acquired, but not if the company is acquired
• Finally, professional costs on the acquisition of a business may be significantly lower as the legal structure is (usually) simpler and due diligence is reduced
• There are four main disadvantages to acquiring a business (as opposed to shares in a company) from the buyer's viewpoint:
• The transfer/assignment of assets and contracts may be complex or too wide ranging
• A subsequent disposal of the business will not qualify for the substantial shareholding exemption
• Carry forward tax losses in the vendor company may be lost
• The vendor may want a higher price to compensate for the disadvantages compared with selling the company

The Vendor's Viewpoint

The vendor will usually prefer to sell the company rather than the business, for the following reasons:

• He may be able to claim the substantial shareholding exemption under Schedule 7AC TCGA 1992 on the gain on sale (provided, of course, that the criteria are met)
• He can avoid tax on balancing charges on disposal of plant and machinery, industrial buildings, etc.
• The sale of the business may lead to a chargeable gain in the company and a further gain on winding up the company
• Selling the company means that the vendor is not left with any liabilities in connection with the business, e.g. negligence claims, claims under employment law, etc. (In practice, the vendor may be obliged to give warranties and indemnities in this connection.)

Any review of the tax planning possibilities should include the possible availability of one or more of the following: the new substantial shareholding exemption, tax relief for goodwill, reconstruction reliefs and taper relief.

E. Negotiations and Legal Structure

The best purchasers are likely to come from competitors or international buyers building a position in the UK.

When an investment bank sells a significant company, it will usually conduct a controlled private auction with a selected group of possible purchasers. This approach may be counter productive for the sale of a smaller company where private, and possibly, exclusive, negotiations can lead to the optimum outcome.

In both cases, it is essential for a comprehensive confidentiality agreement to be signed before any substantive information is disclosed.

• Even with such an agreement in place, it may be desirable to defer access to sensitive information, such as client lists or key management/marketing personnel, until it is clear that the purchaser is serious or even when contracts have been exchanged
• As a general proposition, the possibility of sale should not be disclosed to employees as it will create uncertainty, harm morale and detract from operational capability. However, a contingency plan should be made to cover any leaks
• A purchaser, after considering basic information, will wish to visit the company's main facilities in the case of a manufacturing/distribution business
• This is best done when the plant is not working but if this cannot be achieved then suitable 'cover' for the visitors should be arranged
• The vendor client is usually eager to receive an offer as soon as possible. In practice, it is preferable to ensure that the vendor's personal propensities as to continued service/consultancy and the purchaser's wishes generally are compatible and that the outline financial structure of the deal are mutually acceptable before the price negotiations commence
• This structure should assimilate the vendor's tax planning requirements which the purchaser must agree to in principle
• Whilst, in theory, the issued share capital of a company can be bought 'as is' (the position in hostile take-over bids of quoted companies), the structure of the deal is commonly based on the book asset value of a company
• An agreement is reached on an agreed goodwill figure to be added to the book NAV; either arrived at by a special audit, or the normal accounting date audit which saves cost
• A good business usually sells itself - the negotiator's job is to sell the warts
• Before legal expenses are incurred ensure that the purchaser's offer has been sanctioned at Board level
• Be realistic about the time necessary to consider, evaluate and document the target's assets and liabilities The corporate finance adviser can help here by building up a copy 'bible' of key documents for the initial briefing of solicitors
• The corporate finance adviser will usually document his negotiations by a subject to contract 'heads of agreement' which should be circulated and agreed by the principals and their authorised advisers
• Sometimes an exchange of contracts is agreed with a planned completion, when the consideration is paid and formal title to the ISC passes, in, say, two months, when an audit has been completed
• Despite the logic of this, it does create a 'no mans' land so far as day to day management is concerned so there is a benefit in simultaneous exchange and completion with financial adjustments on the conclusion of the audit
• It is preferable to find experienced corporate lawyers - on both sides - to 'fine tune' the negotiations to mutually acceptable documentation
• In the case of a sale of shares, some of the vendors and certainly the shareholder directors will give warranties. These can be described as a formal representation of truth, e.g. that the Corporation Tax provision in the accounts is accurate. This precludes the need for the purchaser to prove in litigation that he was misled
• In addition, the purchaser will seek to extract indemnities which provide for direct recompense in relation to differences that emerge from the formal warranties that have been provided
• An aggressive purchaser's solicitor and/or corporate finance representative will seek several hundred warranties: the debate on which can become very expensive. In most transactions 20/50 warranties will provide ample protection
• These negotiations which usually take one to three months to conclude should be conducted to a pre agreed timetable which, ideally, provides contingency time to catch up
• Professional expense will be saved and communication difficulties minimised if both sides appoint a 'leader' or main representative who decides on the extent, mode, timing and responsibility for all disclosures and negotiations in relation thereto

F. Non Cash Consideration

• Bearing in mind that a vendor of a private company is often seeking to swap the risk of day to day trading for security in retirement, advisers should be circumspect about non cash consideration
• In particular, exchanging a majority equity interest for a non marketable security in the purchaser's unquoted vehicle is fraught with diverse risks. The buyer's hidden agenda here is to finance the purchase from the target's own cash flow. However the targets assets after the sale will often be collaterally charged to a lender leaving the original vendor completely unsecured
• Where a client sells shares in his company to another company and the consideration received is an issue of shares or debentures in the purchaser, CGT may be deferred. In the case of a share for share exchange, there will usually be deemed to be no disposal of the original shares, the base cost of the old shares becomes the base cost of the new shares and the deferred gain will not become taxable until the new shares are disposed of: Section 135 TCGA 1992
• The exchange must be effected for bona fide commercial reasons and must not form part of a scheme or arrangement for the avoidance of liability to CGT or corporation tax. It is common to apply in advance to the HMRC for statutory clearance (under Section 138 TCGA 1992) that they accept that the transaction is a bona fide commercial transaction untainted by a main purpose of tax avoidance
• Rollover relief is also available where the buyer issues debentures. This is important because it is common for a company to be sold for cash with a loan note alternative
• The Finance Act 2002 confirms a Revenue statement made in a Press Release of 15 November 2001, to the effect that all debentures (even unmarketable loan notes issued by private companies) will be deemed to be securities for taper relief purposes. The new provisions apply to disposals after 5 April 2001 but will be fully retrospective for taper relief purposes
• The gains tax and taper relief rules applying to individuals depend on whether the loan notes for which the shares are exchanged are qualifying corporate bonds (QCBs) or not
• If they are QCBs the gain crystallises on the exchange but is held in suspense until the QCB is realised. CGT is then payable on the gain, even if the note is sold or redeemed at a loss or is written off. Taper relief will apply at the rate at the date of the original exchange
• If they are not QCBs and roll-over applies by virtue of s.135 there is no disposal of the original shares and the new holding is treated as the same asset and acquired when the original shares were acquired. If the non QCB loan note later becomes valueless, the gain deferred is reduced or eliminated
• If the non QCB is issued by an unquoted trading company it will be a business asset and so the relief will continue to apply at the business asset rate. If it is issued by a quoted company it will only be a business asset if the holder has at least 5% of the voting rights and is an employee. If this is not so when the loan note matures there will be the usual apportionment between business and non-business periods
• In the case of a corporate vendor, almost any asset representing a loan relationship of a company is a QCB. This will mean that no indexation allowance will accrue after the date of exchange. But if the loan notes ultimately become a bad debt, the corporate holder will generally be able to obtain relief against trading profits under the corporate debt legislation

Earn Outs

• It is quite common for shares in a company to be sold for a cash sum plus a further amount of consideration which is calculated on the basis of the target company's future performance. In these circumstances, the effect of the House of Lord's decision in Marren v Ingles is that the shares will have been disposed of for consideration comprising the cash plus a new chargeable asset. That new asset would be the right to receive further sums in the future in certain circumstances. This right will not inherently be a business asset for taper relief purposes
• As the right to deferred consideration is a separate asset, any relief which was given on the sale of the shares will not be available on the disposal of the right itself (i.e. a cash earn out will not qualify for business asset taper relief). The tactical view may be to place a high value on the chose in action when the shares are sold to maximise the fast-track business asset taper relief at the date of disposal. Clearly the ideal would be to sell a Company shortly after 5 April and restrict the earn out to 1/2 years

Earn-Out Rights Satisfied in Shares or Loan Notes

• However, it is possible to structure an earn-out agreement so that an identifiable part of the consideration is satisfied in shares or loan notes, with the remainder being in cash. S138A TCGA 1992 will then apply to the shares/loan notes component and an up-front tax charge only arises on the cash element

These notes formed the basis of a presentation by Robin Arthur to the Newcastle and District Branch of the Chartered Institute of Taxation on 28/11/02 as subsequently updated. They are not intended to be exhaustive and should not be regarded as such. Neither do these notes offer specific advice. They are merely an outline of the subject matter.

No liability will be accepted in respect of actions taken or refrained from as a result of information given herein or given by the author during the presentation. Specific professional advice should always be obtained.

Copyright Parmentier Arthur Group Plc: may not be reproduced without permission.