Planning for succession may not be rocket science but it does need to start early.
Out of the blocks
Start early and let go gracefully. anthony harrington on how to pace the sale of a business in a difficult climate.
Three years into a bear market is not the best time in the world for an owner-director to decide that he or she would like to retire next month.
Succession planning takes time, even when one's children are willing and able to take the helm. Where there are no children or family to pass the business on to, the state of the general economic outlook becomes a real factor, since the most natural and profitable exit route for an owner is a trade sale. Even a management buy-in (MBI) or buyout (MBI) is more difficult to get off the ground when times are harsh.
Andrew Millington, partner in charge of corporate finance for the Midlands at Mazars, reckons that despite the slowdown, deals are still being done.
Trade sales may be very thin on the ground but MBIs are possible, under the right circumstances. Where it is not obvious to the founder who the successor might be, since his immediate heirs are either not interested or not up to the job, the usual path in the past was the trade sale. But the large firm up the road is unlikely to be in acquisition mode with the economic outlook so unsettled. So that leaves the door open for MBI deals.
"These are the bulk of the deals being done at the moment. They tend to be smaller deals in the owner-managed segment of the market. The reason they are getting done when so few other deals are flying is that they provide a solution to a difficult problem - namely the succession problem," Millington comments.
In the last couple of weeks, his team helped to acquire a second generation family-owned business for a client. The business was up for sale because the younger man, coming in to his father's business, was unable to settle. "This is not really untypical. You often find that the next generation will have a stab at running things, then will want to move on and do other things," he comments.
One of the more important and long-lasting obstacles to deals being done is the continuing gap between buyers and sellers when it comes to price. Sellers still tend to want top dollar for their businesses, whereas the current fog of uncertainty on the economic front makes buyers wary.
Many are now unwilling to invest unless the deal is a clear bargain. Millington points out that it is possible, however, to use the tax regime to help to bridge the gap between the seller's expectations and what the buyer is willing to pay. "Effectively, business asset taper relief gives the dealmaker a lot of leeway," he says.
Much depends on the type of asset that is being sold, what the company is trading and how long it has held the asset, but if all goes well, then instead of the seller paying capital gains tax at the highest rate, the deal can be structured to bring this down to 10 per cent. This in turn can help to bring the seller much closer to the post-tax figure he or she was expecting from the deal, Millington notes.
Of course, businesses that are running extremely well in these harsh conditions will not experience any impending cash flow crises pushing them to sell below their favoured price. But then such businesses are a lot easier to sell anyway. It is the average business, doing an average return that is proving very hard to shift.
David White, a partner at Grant Thornton, agrees. "The market right now is extremely flat as far as trade sales are concerned. Moreover, with an MBO, if the founder is trying to sell on to the incumbent management team, or even to a member of the family, the financing options tend to be more limited for smaller owner-managed firms," he comments. On deals of under a million pounds it is difficult for venture capitalists to justify the due diligence and other costs.
Instead, his team looks at what White calls "more interesting ways of planning for succession", including specially structured share schemes that differentiate between control and income, with non-voting shares.
Where the exit is going to be via a buyout from the management team, the founder needs to start planning for this well in advance. "You really want to start de-gearing the company, and to be sure that you are grooming the management."
Tax planning is also critical here, White adds. Where family hold shares in the company, business property relief means that there is no inheritance tax to pay on the shares. However, if the shares are sold and the holder has a cash pot, anything over £3250,000 attracts 40 per cent tax.
Andrew Hubbard, tax director at the professional services firm Tenon, says that one of the more dispiriting phenomena it is experiencing is the spectacle of false starts. All too often, he says, such deals as do start to get some traction run part way down the road to completion, then fail because the buyer can't achieve the degree of certainty or comfort about the business's future prospects that they are looking for.
"If I were an owner-manager and wanted to sell the family business today, I would probably get as many expressions of interest as I would have got a few years ago, but turning that interest into a successful sale is just so much harder now," he says.
His advice to clients is that perhaps the most profitable road down which to channel their energies in the current climate is to focus on grooming the business for a sale in two or three years time. Selling a business is a lot easier if the owner takes care to rid the balance sheet of all the detritus, such as luxury villas and yachts or other oddities that private companies with some good years behind them tend to collect.
"When you've earmarked the obvious oddities, look at your earnings. Study the management accounts. Does the cash flow really hold up and is it being sensibly allocated? These quieter years are a great time to get the company in to better shape," he comments.
Wearing his tax professional's hat, Hubbard points out that succession planning within the family also requires serious work. An excellent vehicle for ensuring that tax is kept to a minimum, he points out, is the discretionary trust. However, since a discretionary trust puts a chunk of shares beyond the control of the owner this, in a sense, crystallises the fact that the retirement process has begun. For this reason, accepting the need for a discretionary trust can be a high hurdle for some owner-managers to get over. As Hubbard says, the tax planner also has to be something of a psychologist when it comes to succession planning within the family.
"Time and again, what we see is that the owner hangs on too long.
In their early 50s they feel strong and confident and they still claim to have all their drive and enthusiasm," he says. Unfortunately, this thrustfulness often wanes with advancing years. By the time they are in their early 60s, the business may well have passed its best by quite some margin.
Once things start to run down hill, they can snowball rapidly. Instead of inheriting a thriving business, the next generation can often be faced with difficulties and challenges that they have neither the experience nor the appetite to struggle through.
Hubbard points out that one of the factors that makes it difficult for owner-directors to square up to the succession problem properly is that it seems, by its very nature, to be something without a pressing time deadline or urgent reality about it. "In terms of advice, if an owner is involved in an actual transaction, say where you are engaged in a trade sale or purchase, then they can see the pressures and challenges and they will take advice very happily. If you are just giving advice on what looks like a normal day, then there is much less incentive for them to take hard decisions," he says.
David Thomas, a partner with PriceWaterhouseCoopers, reckons that despite this, advisers have to insist on the importance of forethought and planning. "If you have both of these in place, the succession can be really smooth and one can achieve the 10 per cent tax rate offered by the government. Try to do things at the last moment, thinking you fall inside the 10 per cent provisions, and all too often you will find yourself paying 40 per cent," he comments.
Thomas points out that UK owner managers now have some of the best tax reliefs available in decades, but to be sure of getting the sums out that they had in mind, there is no substitute for planning two to three years ahead of an exit. "Most owner-managers work off a net in-the-pocket figure that they expect to get from the disposal of their business. They gross this up by 10 per cent to take account of tax and that gives them the number they want to walk away with. If they get hit for 40 per cent tax, instead of 10 per cent, that knocks a substantial hole in their anticipated figure, but by that stage it is too late," he warns.
The best time to do tax planning is when you have nothing of value or when you have just bought something, when moving it creates no capital gains tax (CGT) issues. "If you set up a new company in the right place at the right time, you will save yourself huge amounts of hassle. Another point, of course, is that if you have funders in the frame (as for example a lead manager in a management buy-in deal would have) it can be embarrassing to have to restructure matters because you have overlooked some tax implications.
"Your funders can easily start to wonder why you did not get the structure right in the first place. It doesn't look slick," Thomas notes.
The reason why time is required for a family sale is simple enough. The owner can't simply drop his/her shares into a family trust the day before the sale. For the full taper relief to apply, the shares have to be held by the trust for two years. Then, when the trustees sell the shares (for example, to the new company acquiring the owner's business), the trustees only pay tax at under 10 per cent on the proceeds.
The way business taper relief works, in short, is that on a gain of 100, the trustee would pay tax at 25 per cent of the full rate. It happens that 25 per cent of 40 per cent is 10 percent. However, for a discretionary trust, the full rate of tax is 34 per cent, so 25 per cent of this rounds to 8.5 percent.
The Inland Revenue rules, of course, also specify that the owner has to survive seven years after depositing the shares into the trust, which is another reason for owner-managers not to wait until they are approaching 65 before planning their exit strategy!
"The main point to make to owner-managers is that in reality, it is never quite as easy as these explanations make it sound. There are anti-avoidance rules to be dealt with. But what we are talking about here is simply tax-efficient planning, and has nothing to do with aggressive tax planning heading towards tax avoidance." (Lord Denning famously drew the distinction between tax-efficient planning, which every sensible person is entitled to do, and tax avoidance, which Denning and the law viewed as criminal.)
In short, the message to owners is simple. Efficient tax planning needs time and it needs a willingness to co-operate with advisers. If there is no exit in sight, then this is probably an excellent time to call the advisers in and get stuck in to a long period of grooming the business for a more profitable exit later.
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