Inevitably, all business owners will face the difficult question of when and how to begin properly planning for the long-term future of their business and the preservation of wealth that has been accumulated by the business over the years.
Having a sufficient succession plan in place will not only allow for the continued growth and development of the business, but can also have advantageous implications from a tax perspective, and (when passing down to another generation) can help to harmonise the family business going forward. With no two businesses being the same, and as such, no two succession plans being the same, the need for careful and considerate planning from an early stage is paramount.
Here we look at four common methods that can be utilised when thinking about succession planning:
- Transfer to family members;
- Trade sale;
- Management Buyout; and
- Employee Ownership Trust.
Transfer to family members
The passing of a business from one generation to another is by no means a novel creation. This kind of natural succession of a business has taken place in some of the most successful companies to date. There are still of course, many things to be considered when opting to pass the business on to a family member (or members), such as; (i) which family members are going to be involved; (ii) if more than one, what the spread of responsibilities is to be; (iii) whether there will there be any external (i.e. non-family members) involvement in the running of the business; and (iv) whether the existing owner will keep an active role in the business going forward.
An important point is also whether consideration will be paid by the next generation for the business. Where the proposed new owner family members are already shareholders in the company, it may be an option for the company to "buy-back" its own shares from the departing shareholders, so the retiring generation can fund their exit from the company's available cash.
Lastly, in the event that family members are already involved in the management of the business, the question as to whether the family would consider "buying out" the existing shareholder in a "family management buyout" should be asked (see note below on management buyouts generally).
What about situations whereby there are no family members to pass the company to? For an attractive, valuable business, the most common route is a trade sale most likely to a competitor. In the manufacturing sector, it is also not uncommon to sell the company to one of its customers as the company may be its main supplier of an important product or component and the customer doesn't want one of its competitors to buy the company and thereby disrupt its supply chain.
The sale will commonly be structured as a share sale whereby the buyer will agree to buy all the shares in the company which means that automatically all assets and liabilities (including tax liabilities) will remain within the company as owned by the seller.
A buyer will naturally wish to protect itself in such circumstances by carrying out an extensive investigation into the business it is buying (called due diligence) and look for comforts in the share purchase agreement, primarily being warranties and indemnities. The downside therefore is that there may be a lengthy process to go through the due diligence process and negotiate the share purchase agreement.
Management Buyout (MBO)
As the name suggests, an MBO describes the process whereby managers working within a company acquire ownership of the company. More often than not, the sellers will leave the company altogether once the new owners are in place – though this is not always the case.
As a means of succession planning, a sale via MBO may commonly be a preferred option to those selling. This can be the result of a number of factors, but generally an MBO is seller friendly in that; (i) there may be a limited pool of potential buyers at the time of sale; (ii) the seller may have peace of mind, knowing that the company will be looked after going forward; (iii) the seller may have reservations about approaching potential competitors when testing the market for selling, and may be hesitant at the idea of disclosing sensitive information; and (iv) as the managers will have knowledge of the business already, there will be less (or even very little) due diligence carried out and less onerous warranties and indemnities requested.
The general structure of a MBO will tend to vary with the complexity of the overall transaction, however the most common (and basic) structure used, is for the incorporation of a new company ("Newco") owned by the managers that will be used to acquire shares in the existing company. Newco will be funded by a mixture of equity (i.e. contributions by the managers for shares into Newco) and debt funding by external lenders. In a manufacturing business where there are possibly assets to give security over, there is more chance of securing lending from an external lender - it also goes without saying, the greater the equity contribution, the more attractive it is to an external lender.
Employee ownership is now becoming a more popular alternative for succession planning. There are different ways to structure employee ownership but all methods will result in a majority control of the company by the company's employees. The three structures are broadly:
1. The direct model
Here the owners will sell the shares to the employees in a share purchase agreement but payment is likely to be deferred over a period of time. There may be the possibility of external debt funding being provided to service part of the price if the business has assets to offer as security.
The employees will be the shareholders of the company and therefore the direct owners. The employees will enter into a shareholders agreement and adopt articles of association for the company. This would deal with the appointment of directors and it is expected that the articles would narrate for the appointment of employee directors to give a voice to the employees. The shareholders agreement and articles will also contain provisions providing for an employee to relinquish their shares on them ceasing to be an employee.
The employees will also benefit from dividends on their shares if the company has the cash to declare a dividend and in any future sale of the company, the employees will also benefit from the, hopefully, uplift in capital value.
2. The indirect model
Here an Employee Ownership Trust will be set up to buy the shares from the owners in a share purchase agreement. Again, as with the direct model, payment is likely to be deferred over a period of time and there may be the possibility of external debt funding.
The main difference though is that the trust owns the shares and instead the employees will be the beneficiaries of the trust. In such circumstances, ownership may not feel as real for the employees as compared to the direct model.
The trust will have a trust deed governing it with trustees appointed to protect the interests of the employees. However the trust does not run the business of the company - this function remains with the directors and a set of articles of association for the company will be adopted at the time of adopting employee ownership.
Such a structure though is attractive to a seller even though payment is likely to be deferred. This is because, subject to certain key qualifying conditions being met, the seller would be eligible for 0% capital gains tax.
3. Hybrid model
As the name suggests, this is a mixture of the direct model and indirect model with employees owning shares directly and an employee ownership trust also owning shares.
Get in touch
If you own a manufacturing business and are considering how best to deal with succession planning, please get in touch with a member of our team.