Succession Planning for Business Owners Part 1 – Some Exit Options

A large proportion of business owners running small to medium sized enterprises (SMEs) do not make succession plans.  Succession planning is considering ways for the business owner/main shareholder to retire and where their shares should go, i.e. family members, existing employees/management team, sale to a third party, etc. 

It is important to make long term plans well in advance of retirement or exit of the main shareholders.  In addition to the practical and commercial issues this involves, there are both tax and legal considerations.  Advice from professional advisors is crucial and should be sought as early as possible.

This blog looks at some of the legal options for succession planning and, in particular, a company buy-back of shares, a management buy-out (MBO) and an employee ownership trust (EOT).  Sales to a third party purchaser are covered separately and outside the scope of this blog.

1. Company buy-back of shares

A company buyback of its own shares (Buyback) can be advantageous to facilitate the retirement of the main owner of the company, particularly where a direct purchase of shares may be impractical due to a lack of funds.  A Buyback allows the company to fund the purchase.  However, the rules of the Companies Act 2006 must be followed. The company must have sufficient distributable reserves to fund the purchase and immediate payment is required, so no deferred payment terms.

Tax advice should be sought at the outset for both the company and the selling shareholder.  Briefly, considerations for tax clearances are as follows:

• the company must be an unquoted trading company and the purpose of the Buyback must be for the benefit of the company’s trade 
• the selling shareholder must be a UK resident, held the shares for at least 5 years, must sell all or substantially reduce their shareholding and they cannot be ‘connected’ immediately after the Buyback, i.e. they cannot hold more than 30% of the issues shares, loan capital or voting rights

HMRC advance clearance should be sought at the outset and there are post transaction reporting obligations, which you tax advisor will assist with.  Stamp duty is payable on the purchase at 0.5%

Please also see our previous blog, Company Buyback of Shares

• Management Buy-Out (MBO)v

Under an MBO, a newco will be incorporated to acquire the business from the selling shareholder.  The newco will be made up of the management team who wish to take over the business.  The existing shareholder(s) may also take part in the MBO to retain a stake in the company (vendor-induced management buy-out, VIMBO).  This can be a flexible option as it allows for new and existing shareholders, it is easier to obtain CGT treatment and there is no need for reserves or immediate cash.  Funding may come from cash reserves of the company, MBO team money, third party funding such as private equity investments and/or deferred consideration.  Often it will be a combination of these.

If considering an MBO, it is important to identify key individuals and communicate with them about the possibility of them taking over at some stage.  There will be tax consequences for all the parties and it is important that advice and clearances are sought at an early stage.

MLP will be publishing a series of blogs on MBOs in the coming months. 

• Employee Ownership Trust (EOT)

Under an EOT, the controlling interest of the company is held in trust for the benefit of all the employees.  All employees have a stake in the business, so it is thought to drive positive behaviours in employees and help a business thrive.  Many refer to this option as the ‘John Lewis model’.

An EOT can be a practical solution if a third party purchaser cannot be found or an MBO is not a viable option.  It is a tax free option for the disposing shareholder as it is treated as a no gain/no loss disposal.  The Trust can make an income tax free bonus to all employees on an annual basis.

To get the CGT exemption, the company must be a trading company and the EOT for all eligible employees.  There is a ‘controlling interest’ requirement so more than 50% of the shares and voting rights must be held by the Trust.  Smaller businesses may not meet the criteria as the ratio of participators benefitting from the exemption on sale to the number of employees participating must not exceed 40%

Practical considerations will include: How will the consideration be funded? Who is leading/driving the business? How flexible is it to sell in the future? Can managers be better incentivised with minority shareholdings, EMI schemes or similar?

Please refer to our Guide to Employee Ownership, which is available upon request.