The key issues to address when selling your company include:
- ensuring that you pay as little tax as possible e.g. by making sure the sale qualifies for the new entrepreneurs’ relief so you only pay 10% capital gains tax;
- judging the trends in your market with a view to selling before any downturn and preferably when sales/revenues are showing an upwards trend;
- negotiating the best possible deal in terms of price and ensuring that any deferred consideration payments are not at risk e.g. obtaining a bank guarantee for deferred consideration;
- if you do agree to a gap between exchange and completion and/or deferred consideration, that your freedom to operate your business is not unduly impaired and that the costs and controls that the purchaser can impose are minimised and factored into any deferred consideration payment;
- making sure that the deal is confidential until agreed to avoid prejudicing relationships with employees, suppliers and customers;
- undertaking a legal audit of your terms and conditions, employment contracts, property ownership, intellectual property etc. You need to be prepared to address all the purchaser’s due diligence enquiries e.g. is your data protection registration up to date, have you agreed recent tax computations with HM Revenue & Customs (‘HMRC’), have you dealt with all enquiries raised in any recent VAT, PAYE or other HMRC inspections and are your domain name and trade mark registrations current?
- focusing on your credit control to reduce bad debt to the minimum level possible and speeding up collections generally.
What tactics can you expect the purchaser to employ?
- Brinkmanship is common particularly from private equity houses. Purchasers will often seek to negotiate down the price at the last minute on the basis of issues they have discovered in the course of due diligence. Examples include:
- different interpretation of revenue recognition;
- identification of disallowable personal expenses;
- the purchaser may seek a retention or escrow arrangement for issues of concern such as tax claims, ongoing litigation, debt collection;
- the purchaser may seek to defer the payment of consideration by reference to an earn-out and require the vendor to continue to work in the business for a period of time;
- the purchaser may seek to validate the completion position by the production of completion accounts and include a mechanism for price adjustment following completion.
Preliminary issues to address
Valuation and identification of purchaser
Many vendors know who the likely purchaser of their business will be and have an idea of the value of their business. You may, however, wish to consider appointing a corporate finance adviser to assist you in determining an appropriate valuation and identifying purchasers. A corporate finance adviser is likely to charge a percentage of the sale proceeds for carrying out this role.
*Before commencing discussions you need to have a clear idea of the terms on which you are looking to sell your business. You should at the very least have an idea of:
- the price range within which you are prepared to sell and your target price;
- the timescale for any sale which might be soon after your next audit;
- the terms of sale e.g. cash or shares/loan notes and whether or not any deferred element is acceptable; and
- whether you need freedom to carry on any other business post sale.
Ideally you should talk to your lawyers and accountants before commencing discussions. It may be that you should defer completion until the next tax year for personal tax reasons – moving the deal by a couple of days can defer a tax bill by 12 months or even reduce the tax bill. There may also be some regulatory or other requirements which require early consideration such as clearance from the Pensions Regulator if the company has a defined benefit pension scheme which is in deficit.
Heads of terms/letter of intent
There is a balance to be struck between agreeing the key headline terms to enable work to progress and avoiding too much detail which results in the transaction effectively being negotiated twice.
Heads of terms set out the key transaction terms. In addition to the issues flagged in paragraph 3.2, you should expect to deal with:
- exclusivity – if the purchaser does not want you to negotiate with any other potential purchaser for a period;
- break fee – if either side should be entitled to a break fee if negotiations are called off;
- governing law;
- regulatory issues e.g. FSA consent to change of control of an FSA regulated business or clearance from the Pensions Regulator; and
- restrictive covenants on the sellers post completion.
Heads of terms are not normally legally binding save as regards the confidentiality, exclusivity and break fee provisions. In practice, however, it is very hard subsequently to negotiate against terms and concepts agreed in the heads of terms.
Sometimes the confidentiality, exclusivity and break fee provisions are contained in a separate agreement.
These will be determined by the type of companies involved and their industry sector. Examples include:
- *Re-registration as a private limited company
*If the company to be sold is a public company (but not listed), the purchaser may not want to prepare a takeover offer document but instead may want to proceed as if the target company was a private company (i.e. with a share sale agreement or shorter form private offer circular). A waiver from the takeover code can be obtained where a company has 10 or fewer shareholders and they all sign a waiver.
Alternatively, the company can call a general meeting for shareholders to approve the company’s re-registration as a private company. In either case, the Takeover Panel Executive needs to be consulted. The re-registration circular will, in any event, have to contain a raft of information required by the Executive. Re-registration is only effective when Companies House have issued a re-registration certificate. For more information see www.thetakeoverpanel.org.uk/.
- Competition issues
The purchaser and the vendor should consult well in advance as to whether the acquisition is of a sufficient size to need UK or EU merger clearance.
- FSA approval
The purchaser of an FSA regulated entity will need to seek prior clearance from the FSA for the change in the control and submit a change of controller application to the FSA.
*The purchaser will need to speak to the company’s pension trustees if the company to be sold has a defined benefit pension scheme which is in deficit. The purchaser may also need to instruct actuaries and seek prior clearance from the pensions regulator.
*Depending on how the deal is to be structured, a prior tax clearance from HMRC may be advisable. If the consideration is to be paid in shares or loan notes, the capital gains tax liability on the sale can usually be deferred provided that the acquiring company ends up with more than 25% of the target company’s ordinary shares. A clearance application for this rollover treatment should be submitted. Failure to obtain a clearance can lead to the vendor paying income tax at rates of up to 32.5%, rather than capital gains tax of 10 or 18%.
A big concern for most vendors is to minimise the tax arising on the disposal of their shares. Entrepreneurs’ relief (which replaces business asset taper relief from 6 April 2008) can reduce a vendor’s capital gains tax to an effective rate of 10%. However, the relief is much more limited than business asset taper relief.
Only the first Â£1 million of qualifying gains will benefit from entrepreneurs’ relief.
Any gain in excess of this lifetime allowance will be charged at the standard 18% rate.
For a disposal of shares to qualify for the relief:
- the shares must be in a trading company or the holding company of a trading group;
- the individual making the disposal must be an officer or employee of the company or one of the companies in the trading group; and
- the individual must hold at least 5% of the ordinary share capital of the company and at least 5% of the voting rights in that company.
These three requirements must all be satisfied throughout the 12 months ending with the date of the disposal.
A key point will be to ensure that any non-trading activities do not have a ‘substantial’ effect on the company’s activities, causing it to cease to be a trading company or the holding company of a trading group. It is thought that HMRC will apply similar tests to those formerly used for business asset taper relief, where ‘substantial’ was interpreted as meaning at least 20%. Factors HMRC may consider include:
- the turnover attributable to non-trading activities;
- the value of non-trade assets such as investments;
- expenses attributable to non-trading activities; and
- time spent by management and employees as regards non-trading activities.
Vendors therefore need to review the following issues to safeguard their entrepreneurs’ relief:
*These should ideally be held in a separate entity or by the vendor personally.
- *Cash balances
*Surplus cash should be distributed to shareholders as soon as practicable after it arises. A vendor will need to convince the HMRC that any cash left in the business is required for working capital or the future requirements of the trade.
- Loans to directors/shareholders and non-group companies
These should be repaid and the resulting cash distributed to shareholders.
The purchaser will want to conduct legal and financial due diligence and will appoint lawyers and accountants to do this. Other professionals may also be engaged depending on the nature of your business and the assets involved, e.g. actuaries, surveyors, specialist consultants etc.
Due diligence is a gruelling procedure to go through and you need to expect every aspect of your business to be picked over with a fine-tooth comb. For this reason, carrying out a dummy due diligence review of your business before the purchaser’s advisers commence their due diligence is always a productive exercise, enabling you to identify and resolve issues in advance.
The purchaser’s lawyers will usually draft the share purchase agreement and tax deed and the vendor’s lawyers will prepare the disclosure letter.
Share purchase agreement
This agreement sets out the terms of sale. The main negotiation areas are:
The time limit for claims under the general commercial warranties and tax warranties and the limitations on the level of claims are normally heavily negotiated. As a minimum, the purchaser will be looking to be able to claim under the warranties for a three month period after the publication of the company’s next audited accounts and will normally start off asking for a three year limit. It is usual to agree a seven year limit for tax warranties as this is the period in which the HMRC can re-open tax computations.
The purchaser will normally insist on an overall limit on claims of no less than the purchase price. The purchaser may agree that small claims of less than 5-10% of the purchase price in aggregate are ignored.
- Scope of warranties
The purchaser will draft the warranties as widely as possible. A vendor will want to qualify them by the vendor’s knowledge and belief where possible and also narrow their scope. It is particularly important to ensure that accounts warranties are not given which result in the accounts being warranted to a standard above which they are required to be produced by law. It is also important not to warrant the accuracy of unaudited management accounts.
- *Gap between exchange and completion
*If there is to be a gap between exchange and completion, for instance because the approval of the purchaser’s shareholders is required, it is important to ensure that the protections/vetos required by the purchaser do not prevent the vendor from carrying on the business as normal.
*If there is to be deferred consideration paid pursuant to an earn out, it is crucial that this is carefully reviewed and example calculations undertaken. Please see paragraph 9 for a detailed discussion of earn-outs and their tax implications. Key issues include ensuring that the purchaser cannot dilute the earn-out with excessive management charges, additional costs or through failure to support the business post completion.
- *Restrictive covenant
*The purchaser is likely to demand restrictive covenants from the vendor in terms of non-compete, non-solicitation and non-poaching provisions. These are usually unenforceable unless they reasonably protect a valid business interest of the purchaser. The purchaser may also seek to make the covenants operate by reference to the date when the vendor ceases to be employed by the company (if they are staying on after completion) and this should be resisted.
*The tax deed (also known as a tax covenant or tax indemnity) is designed to ensure that any tax which is not provided for in the accounts and arises outside the ordinary course of business between the date of the accounts and completion is borne by the vendor.
The disclosure letter
The disclosure letter is a letter from the vendor to the purchaser disclosing issues which qualify the warranties e.g. the existence of litigation, employment claims, terms and conditions which are not up to date etc. By this process, the matters disclosed cannot form the basis of a warranty claim.
Managing the transactions
The sale process and particularly the due diligence exercise will be extremely time consuming. You therefore need to plan how you are going to continue to run your business during the process and what assistance you need.
As regards due diligence, if you can collate information at an early stage, your lawyers and accountants should be able to manage much of the process. You will, however, end up having to deal with a large number of enquiries yourself where answers are not clear from the company’s records. It is important to document carefully what information you give to the purchaser, to avoid arguments later on.
As regards negotiation, this will become more time intensive as negotiations progress and it is likely that some lengthy all parties meetings will be required to agree final points of difference.
Share/loan note consideration
A listed purchaser may well wish to offer shares as consideration rather than cash. Vendors may also want to take loan notes instead of cash to postpone the disposal or the payment of CGT. A vendor taking shares or loan notes should be aware of the following issues:
*It is easy to assume that because the shares you are receiving are listed, their value is secure. However, the share price of many listed companies, particularly AIM companies, are volatile, and a vendor should not assume he will be able to sell his shares at or above the market value at which they were issued.
If the value of the listed company shares is significant, a vendor would be wise to perform some due diligence on the purchaser. It may be possible to arrange for a ‘vendor placing’ of the shares on completion to realise cash. In any event, a vendor should avoid being locked in and prevented from selling their shares for a lengthy period.
*Loan note consideration
*A key point to appreciate is that a holder of a loan note is an unsecured creditor of the issuing company unless some form of guarantee is given. A common route is to obtain a guarantee from the parent company or seek a bank guarantee. A vendor may also wish to prevent the issuer from creating any further indebtedness ranking in priority to the loan notes.
*Taxation of share and loan note consideration
*As was mentioned in paragraph 3.5 above, it is possible for vendors to roll over their gains on their shares into any purchaser shares or loan notes they receive by way of consideration. The problem for the vendor, however, is that unless he continues to hold a qualifying holding of shares after the exchange, there will be no entrepreneurs’ relief available on the eventual disposal of the shares/loan notes.
It is possible to elect for the roll over rules to be disapplied, so triggering a disposal for which entrepreneurs’ relief will be available. One disadvantage of this is that tax may then be due at a time when the vendor has no funds to pay it, because his sale proceeds are tied up as shares or loan notes.
Vendors who are eligible for entrepreneurs’ relief at the time of sale may prefer to negotiate payment in loan notes structured as qualifying corporate bonds (‘QCBs’) to lock in their entrepreneurs’ relief (assuming some deferral of payment is required for commercial reasons). Generally speaking, a loan note is a QCB unless it is convertible, carries the right to additional note or is capable of being redeemed in a foreign currency. With a QCB the vendor’s tax position is frozen at the date of exchange with the payment of the CGT being postponed on an interest free basis. The advantage of freezing the tax position is that there is then no risk of the entrepreneurs’ relief position being lost.
One major disadvantage with a QCB loan note is that no debt relief is available if the purchaser is unable to pay. However, when the loan note is redeemed for little or no value the original gain would still be taxed in full. The HMRC by concession does allow the note to be gifted to charity in these circumstances without triggering a gain. However, it is preferable to obtain a commercial bank guarantee for a QCB to ensure that the vendor obtains his money.
If entrepreneurs’ relief is not available on the sale, a vendor may instead prefer to take a non-QCB, which will defer the disposal for CGT purposes and for which debt relief is available if the purchaser cannot pay. Deferral can be useful for taking advantage of subsequent years’ CGT annual exemptions.
*Purchasers will often insist on earn-outs both to validate the price they are paying for a company and to ensure an orderly hand over of expertise to the people that will manage the business after the departure of the vendor.
The basis of the earn-out will depend on how the purchaser has valued the business.
Different industries have different valuation bases. Simplistic examples include:
- Fund Managers - Multiples of funds under management
- Professional firms - Multiples of fee income
- Restaurants - Value per cover
- Hotels - Value per room
- Movie theatres - Value per movie screen
- Oil, gas, timber and mining – Value of natural resource reserves based on recent prices paid solely for such reserves
- Mail order/database firms Price per address
A purchaser will normally use a combination of valuation methods when assessing a company’s value. Any valuation is always reviewed against the value of comparable companies in the same sector. One common yardstick is the P/E ratio = share price/Earnings per share
A high P/E ratio implies:
- expectations of rapid growth in earnings in the years ahead;
- high quality of earnings i.e. low volatility; and
- listed company status – a private company’s shares may be valued at around 50-60% of a similar listed company.
When ascertaining a P/E ratio the purchaser will look at:
- the dependency of the business on the technical skills of key individuals;
- general economic and financial outlook;
- the prospect for the industry in which the company operates;
- the size of the company;
- asset backing;
- liquidity (limited in a private company);
- the reliability of any profit forecasts and the company’s past profit record; and
- whether or not the company has a high break-up value.
Tax issues for earn-outs
- Taxation of cash based earn-outs*
A vendor is taxed on the cash consideration he receives on completion plus the value of the right to future consideration. The vendor is also taxed on each earn-out payment actually received less the value of the right to the relevant tranche of consideration.
If HMRC considers that the substance of the earn-out arrangement is to provide a reward for services as an employee/director as opposed to consideration for the sale of shares, they may seek to impose an employment income tax charge as outlined below.
- Taxation of share or loan note earn-outs*
A vendor can obtain a rollover or deferral provided that the earn-out can only be satisfied by shares and/or loan notes. It is important not to inadvertently fall foul of this by, for instance, allowing a listed purchaser to pay cash if the shares cannot be listed for some reason. It is possible to have an earn-out agreement which is structured so that an identifiable part is satisfied in shares/loan notes and the remainder in cash.
- Income tax and NIC charge on earn-outs satisfied by loan notes/shares
*HMRC will generally only seek to charge earn-outs to income tax and NICs where the earn-out does not fully represent consideration for the sale of the target company’s shares. HMRC will be looking to see whether the earn-out partly constitutes a reward to the vendor for services during the earn-out period. In this case, the ‘earnings’ element would suffer an income tax and NIC charge.
HMRC take into account some of the following factors in determining whether an earn-out is further sale consideration rather than earnings:
- whether or not personal performance targets are incorporated in the earn-out;
- whether the earn-out reflects compensation for receiving less than the full remuneration for their continuing employment;
- whether the earn-out is conditional on future employment beyond a reasonable handover period; and
- whether the value received from the earn-out reflects the value of the shares.
*Commercial issues as regards earn-outs
*Whilst the earn-out should not be expressed to be conditional on the vendors’ continuing employment for tax reasons, the vendors will want comfort that they cannot be removed without cause before the expiry of the earn-out period.
The vendors will also want to ensure that:
- the purchaser does not do anything post completion to reduce or distort the earn-out;
- management charges, intra-group charges and interest payments on intra-group borrowings are limited;
- the purchaser commits to providing sufficient resources to the company to enable it to realise the maximum earn-out and to operating the company with a view to maximising profit;
- no other competing business is established within the purchaser’s group and no business is diverted to another company in the purchaser’s group;
- staff are not demotivated by adverse changes in their employment terms;
- they can demand that an independent accountant reviews the earn-out calculation;
- the accounting principles upon which the earn-out is calculated are agreed;
- the purchaser operates the business in the ordinary course and that it is not materially altered or wound down;
- business is conducted on arm’s length terms;
- goods and services purchased or employed by the company are only used by it;
- if there is a change in control of the purchaser, the payment of the earn-out is accelerated;
- they either have a veto over a sale of the target group or that earn-out payments are accelerated or that they have a right of first refusal; and
- they have veto rights over the winding up of the company, limiting capex etc.
The vendors will want to carve out from the profit figure used to determine the earn out any extraordinary items such as redundancy costs and relocation costs.
The purchasers may seek to argue that there are synergistic benefits from the merger and look to carve these out from the profit figure used to determine the earn out. Examples include cheaper borrowing and insurance.
Detailed negotiations will also take place regarding the applicable accounting standards for the earn out and the treatment of issues such as bad debt provision.
*Safeguarding the earn-out
*A vendor will be concerned to safeguard their earn-out entitlement. A vendor can seek to protect their position in a number of ways:
A vendor should seek to obtain a parent company guarantee where the purchaser is a subsidiary, particularly where the purchaser has a listed parent.
- Charge over the shares being sold*
A purchaser may offer a charge over the shares being bought. This, however, offers a limited degree of protection to the vendor particularly where the shares represent a minority interest.
- Bank guarantee*
This is likely to be expensive and therefore unattractive to the purchaser.
- Cash escrow
*A purchaser may be willing to put some of the cash to be paid into an escrow but this is unusual.
- Charge over the target’s assets*
This would constitute financial assistance and may require priority negotiations as regards any existing security.
Transfer of assets from the business prior to the sale and payment of fees
It is important that any assets in the company which are not to be sold with the company are transferred out at market value rather that at book value. Otherwise, the directors may be guilty of financial assistance in connection with the sale of the company which is a criminal offence. It is also important that legal fees and any other fees incurred in connection with the sale are borne by the vendor and not the target company.
The purchaser will want to appoint new directors and often a new company secretary, auditors and bankers. A vendor needs to tee up their bank for completion as new bank mandates will need to be put in place and confirmations given as to the balances in bank accounts on completion.
Board meetings of the purchaser and the company will need to be held, documents signed and monies transferred. Money transfers will be more complex where the purchaser is borrowing to finance the purchase. The purchaser’s bank may also require security over the company’s assets in which case the company’s auditors will need to be involved in a financial assistance whitewash. This is a process whereby the board confirms that the company will continue to be solvent for 12 months on the basis of an audited balance sheet and auditor’s report. Any director resigning on completion will not want to be involved in the whitewash process as it carries criminal sanctions if not correctly implemented.