Planning for succession: assessing an exit from a business you created
Life is about making choices and business-succession planning is little different. But are the right choices being made, if at all, despite the myriad options available?
Most businesses in the UK are owner managed, and planning for succession – the owner’s exit from the business – is self-evidently a serious undertaking. Due consideration must be given not only to the options open to the business but also to what exit strategy to pursue for the owner.
Whether it’s a case of passing on a business to other members of the family, or selling the business outright, the list of choices available is a sizeable one. Typically, this could include a company buy back, sale to another shareholder, a trade sale, flotation or even an employee buyout, as well as the aforementioned ownership transfer within the family.
While these options will probably guide the business owner towards a particular exit strategy, a number of questions will need to be asked first:
- How is the success of the business defined?
- What does this mean for the owner, going forward?
- What will the impact on family members be, and is it even relevant?
If the owner of a family business is ambivalent about passing on the business to the next generation – or simply not minded to do so, for whatever reason – then realising the value of the business will assume centre stage. A trade sale is one obvious option.
Yet even here questions will need to be asked. For example, is the business still developing (it may already be at the mature or declining stage)? Is it heavily reliant on a small number of large customers?
Ducking the issue
Many business owners are still failing to grasp the succession nettle. In its report Long-term goals meet short-term drive: Global family business survey 2019, Deloitte’s Family Business Center polled 791 executives of family-owned businesses across 58 countries. The key question was this: how do family businesses balance their long-term orientation with short-term demands?
Breaking down the numbers, 43% of companies that responded had annual revenues of less than £39m, 37% from £39m to £196m, 16% from £196m to £792m and 5% more than £792m.
Only 15% were less than 20 years old; 38% were established 20 to 49 years ago; 35% 50 to 100 years ago; and 13% more than 100 years ago.
A time bomb is ticking, given an ageing population in the UK and an estimated 4.8 million family businesses, which make up approximately 88% of all businesses in the UK (rising to almost 94% in Wales)
The report noted that while more than half of those polled believed their organisations are fit for the future in terms of ownership, governance and strategy, just 41% felt a similar confidence regarding their plans for succession.
It added: “Family business leaders traditionally focus their strategy on a two-to-five-year time horizon, and often take a reactive approach to events as they happen.”
It further noted: “Good governance can be a critical value driver for family businesses, but effective governance structures should be tailored to the company and opened up to non-family members.”
In short, family members may lack alignment in their goals for the business, “including goals beyond financial success”.
Against this backdrop, figures from the Institute for Family Business show only 30% of family businesses in the UK lasting into the second generation, 12% into the third and just 4% into the fourth and beyond.
A time bomb is ticking, given an ageing population in the UK and an estimated 4.8 million family businesses, which make up approximately 88% of all businesses in the UK (rising to almost 94% in Wales). Moreover, while the majority of these are small businesses, more than 17,000 are medium and large enterprises.
Business succession is also a major issue in Scotland, where SMEs account for 99.3% of all private sector enterprises, and 63% of SMEs are family businesses, according to Sustainability: the challenge facing Scotland’s SMEs and family businesses (Scotland’s Futures Forum 2014).
Would you buy your business?
Business owners only get one chance to extract the capital value from their business. Andrew Hall, Director, Wealth Management, Barclays Scotland, argues that one way of valuing an enterprise is for the owner to put himself/herself in the shoes of a would-be purchaser.
“Ask yourself the buy-versus-build question: is your product too hard for a competitor to build itself, making the acquisition of your company a better option?” says Andrew.
“Credible buyers will look to uncover any holes in your business as part of their due diligence process, so forewarned is forearmed. Seemingly small issues over accounts, record keeping, contracts or business structure can derail a good deal, or see an offer reduced,” he adds.
Increasingly, owners are resorting to earn-outs, where part of the price is dependent on the performance of the business for a period following the acquisition. As far back as 2017, up to 40% of M&A deals globally used some form of earn-out structure, according to Grant Thornton’s International Sale and Purchase Agreement survey.
An earn-out ticks the necessary boxes for purchasers who either cannot pay the full price at completion; or are not prepared to take the financial risk alone, instead making a deferred payment.
Typically, a purchase will be structured as a designated payment at completion, followed by one or more further payments based on the performance of the company over subsequent periods using metrics such as turnover or gross profits, for example.
On the face of it, earn-outs offer advantages for buyers, given that they allow for the hedging of risk. From the vendor’s standpoint the reverse holds true, especially where much of their control is being relinquished
The most common metric used for earn-outs is EBITDA, given it is a familiar value for dealmakers, since the headline price or “enterprise value” is commonly calculated on an industry-specific multiple applied to EBITDA.
It would be stretching matters to argue this is the only metric of relevance for the would-be purchaser. Other obvious considerations include sales volumes, prices and revenues.
But as Keir Willox, Partner with Shepherd and Wedderburn, points out: “There are many reasons why an earn-out may be used, for example when the target company has either
no or very little operating history, but the business is expected to grow quite substantially and quickly, or if the buyer has limited access to funds.”
On the face of it, earn-outs offer advantages for buyers, given that they allow for the hedging of risk. From the vendor’s standpoint the reverse holds true, especially where much of their control is being relinquished.
One way round this is to insert provisions in the contract to address dispute procedures (such as the accounts) that may arise, as well as providing legally enforceable measures placed on the buyer as to how the business will be managed after completion.
Lesley Munro CA, Corporate Finance Director, Johnston Carmichael, says that for the vendor
an earn-out can be an opportunity to secure an increased valuation for the business that might not be on the table with an “all-in” up-front payment.
Paying the consequences
She adds: “A downside is that the vendor may be tied into working for the buyer for a period of time, delivering both an agreed set of objectives as well as a minimum profit. As an earn-out is based on future targets. It is not guaranteed and therefore may never actually be received. Depending on the structure agreed, there are opportunities for the vendor to lock in the tax treatment on the sale proceeds on the date of sale or defer it until the earn-out payment has been received.”
Sometimes a buyer will insist that some – or maybe all – of an earn-out payment is dependent on the sellers (or some of them if they are key employees) continuing with the target business
Lesley adds that the buyer can also tie in the vendor to help smooth the transition of the business to its new owner, maintaining relationships with key customers and suppliers as well as the workforce. This may result in a higher valuation being paid for the business over time, but a cap can be set to define the maximum price payable.
As Keir Willox explains: “Given some or all of the price will be deferred, this may improve the buyer’s cash flow as well as possibly removing the requirement for the buyer to seek third-party funding, which can be expensive.
“Sometimes a buyer will insist that some – or maybe all – of an earn-out payment is dependent on the sellers (or some of them if they are key employees) continuing with the target business.”
Keir adds that sellers will then be motivated post-completion to work hard to maximise the success of the business, which in turn ought to ensure they maximise their earn-out.
When not used properly, such as in the case of an improperly drafted SPA (share purchase agreement), the earn-out route can damage the business and create significant contentious post-deal disputes. It can also prove time consuming and costly.
Indeed, as Grant Thornton noted in its 2019 report Earn-outs: How to avoid pitfalls and protect value, earn-out clauses are one of the most disputed areas of SPAs, post-deal.
To improve clarity, however, it suggests there should be clear definitions for what should be included and excluded, preferably illustrated by way of a pro-forma earn-out schedule calculation.
There should be clear accounting policies dealing with judgemental areas open to interpretation and manipulation, as well as a clear reference point for measuring earn-out results consistently against prior results and the target, for example by reference to a historical set of audited accounts or diligence-management accounts.
Rather like 3D chess, simply selecting the right route or option to business succession will not necessarily always suffice, because options and scenarios within the selected option will be required too
Constructed carefully, earn-outs can incentivise management, who are often remaining with the business for a transitional period, to deliver further growth or profits to the benefit of both themselves and the buyer. This is especially applicable to consultancies where the value of people, rather than products, is the prime determinant of the business’s overall valuation.
Richard Beavan, Partner with law firm Boodle Hatfield, says another potential pitfall of earn-outs is that they can be inefficient for tax purposes, and may lead to part of the sale price being treated as income, rather than as a capital gain.
“Even if the earn-out is treated as capital gain, the seller risks losing his/her 10% entrepreneur's relief rate if he/she doesn't elect to pay capital gains tax on the full potential earn-out up front. If performance of the target during the earn-out doesn't measure up to forecast, the seller might have incurred an unnecessary tax charge,” says Richard.
Rather like 3D chess, simply selecting the right route or option to business succession will not necessarily always suffice, because options and scenarios within the selected option will be required too.
To be forewarned is to be forearmed. Professional advice should outline any obvious scenarios. But failure to take this into account by drafting an incomplete or badly written agreement could prove counterproductive and lead to misery later on.