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How to do a management buy-out!

Shared from Tax Insider: How to do a management buy-out!
By Alan Pink, June 2020

Alan Pink looks at typical structure for a management buy-out and some issues that can arise. 

A management buy-out (MBO) can often be the ideal way for a business owner to realise the value that they have built up in his company over the years. The fact of the matter is that it is often the senior management, rather than an outside purchaser, who are best placed to take over the reins when the main men/women decides to retire, or give up their interest in the business for other reasons.  

This article assumes that the business is run in limited company form, because this is how the majority of such businesses are set up in practice, and also the set up that can give rise to the most problems.  

The structure of the MBO 

Assuming that the decision has been made to sell the company to its current non-shareholding senior management, the question of how the MBO should be structured will tend to be driven by the question of how the managers are going to finance the purchase.  

Some Business Tax Insider readers may be old enough to remember the time when it was common for managers in this situation to be able to raise the finance from a bank. This tactless reference to the age of the readers, though, does point to what seems to be a significant change that has taken place over the last twenty years or so. Banks no longer seem to be interested (with obvious exceptions) in financing the acquisition of comparatively small owner/managed businesses.  

Whilst this is the optimum arrangement from the vendor’s point of view (almost always) because it means they’re getting the whole value to their business paid to them up front, the practicalities determine that the purchase normally needs to be financed in some other way.  

Company purchase of own shares 

One possible MBO structure is to use the favourable tax provisions applying to a company purchase of its own shares. Providing various criteria are met, the outgoing shareholder can be bought out, not by the managers, but by the company itself.  

The tax provisions are there to bring such a purchase within the capital gains tax (CGT) code, rather than treating what the company pays for its shares as a dividend, provided certain criteria are met. The main criterion is that the purchase must be for the benefit of the company’s trade, and this will normally be met in an MBO situation.  

However, for one reason and another, company purchase of own shares is often ruled out at the outset as a method of structuring the MBO. Sometimes the outgoing shareholders will not all have owned the shares for the necessary five-year period in order for the capital gains treatment to apply (which is another of the criteria). More often though, probably, this route is ruled out by the dreaded employment related securities (ERS) rules. These are a problem when the would-be managers/owners do not have shares in the company prior to the MBO. It is obviously not possible for the company to buy back all its shares, leaving no shares in issue.  

Therefore, it is necessary, where the would-be owners have no shares in the company at the moment, for them to be issued with shares; and any issue of shares to an employee or director has the effect of training the massive ERS artillery against the individuals and company concerned.  

In short, the new shareholders, in this situation, need either to be able to show that they are paying market value for their shares, or need to put up with having a substantial income tax charge (together with National Insurance contributions (NICs) on the company), levied in respect of the transaction.  

In summary; in a large proportion of cases the purchase of own shares route will not work because the managers cannot afford the cost and/or the tax consequences of acquiring shares in the existing company.  

The holding company route 

This leaves what might be termed the ‘holding company’ route. Under this arrangement, the managers set up their own new company which is to act as the vehicle for the purchase. Typically, a small amount of share capital is issued, in whatever proportions the managers have agreed they will acquire the target company.  

This company then acquires the target from the outgoing shareholders and, normally, the consideration for this purchase is raised not by borrowing from a bank, but effectively by borrowing from the vendors. A liability is set up for a large proportion, or even all, of the agreed sale price and the holding company hopes to be able to pay this off, over a period normally of some years, out of the profits that the target company is making.  

From the point of view of the purchasers, this is tax-efficient because the profits can be paid up to the holding company by way of intragroup dividend, which is free of corporation tax in normal circumstances. So this is all very good for the purchasing managers, of course. Where the issues arise is with the situation of the vendor(s).  

Problems for the vendor 

In its simplest form, the holding company purchases the shares in the target company and agrees to pay the outgoing vendor an amount which it hopes to be able to lay its hands on at some time in the future.  

The big problem with this simple scenario for the vendor, of course, is that the vendor still needs to pay the CGT on the sale, on 31 January following the tax year in which the contract was signed, regardless of whether he has had any actual cash by that point, or sufficient cash to pay the tax.  

To get around this, the purchase will often be structured such that the new holding company issues paper in the form of ‘securities’ in exchange for the shares it is acquiring in the target. Subject to these being properly regarded as ‘securities’, i.e. having the general attribute of transferability and subject also to HMRC granting the appropriate clearance (a practical necessity in these transactions) the gain which the vendor is treated as making is held over against the value of the securities issued; that is, the tax doesn’t arise until the company makes good its promise to pay. 

Entrepreneurs’ relief 

But this format of the purchase, of issuing loan paper in return for the shares in the target company, can give rise to its own difficulties, which arise in the area of entrepreneurs’ relief (soon to be renamed ‘business asset disposal relief’).  

There are some complex technicalities here, but essentially the difficulty that can arise is that the gain arising on the redemption of the loan notes doesn’t qualify for entrepreneurs’ relief, because the outgoing shareholder or shareholders no longer meet the criteria – including, in particular, the requirement for the outgoing shareholder to have had 5% of the voting rights in the company up to the point at which the loan notes are redeemed and the disposal is thereby treated as being made.  

In order to achieve entrepreneurs’ relief, it is therefore necessary to complicate the structure of the acquisition more than a little, in order to attempt to retain the vendor’s entitlement to entrepreneurs’ relief until such time as the loan notes are redeemed, and the gains are thereby treated as being crystallised for tax purposes.  

Following the reduction in the lifetime limit for entrepreneurs’ relief in the March 2020 Budget to £1 million per person, it will often be the case that vendors will no longer be so interested in jumping through hoops to secure entrepreneurs’ relief in this situation. Whereas, before the Budget 2020 changes, entrepreneurs’ relief could be worth up to £1 million in tax savings, the maximum saving is now £100,000 (being the difference between the 10% rate that applies where entrepreneurs’ relief is given, and the 20% rate that normally applies to the sale of shares in a company where there is no entrepreneurs’ relief).  

Practical issues 

Finally, vendors will often be concerned, of course, with the ongoing health of the business when they are no longer involved themselves in running it. In the typical structure where they are to be paid out of future profits, this is obviously a crucial issue.  

Methods of protecting the vendor’s position in this situation include formal debenture terms over the loan note paper – enabling the vendors to take back control of the company if the agreed repayment schedule isn’t met – and a lien on the shares in the target company, enabling the vendors to take these back if they are not duly paid for.  

 

Alan Pink looks at typical structure for a management buy-out and some issues that can arise. 

A management buy-out (MBO) can often be the ideal way for a business owner to realise the value that they have built up in his company over the years. The fact of the matter is that it is often the senior management, rather than an outside purchaser, who are best placed to take over the reins when the main men/women decides to retire, or give up their interest in the business for other reasons.  

This article assumes that the business is run in limited company form, because this is how the majority of such businesses are set up in practice, and also the set up that can give rise to the most problems.  

The structure of the MBO 

Assuming that the decision has been made to sell the company to its current non-shareholding senior management, the question of how the MBO should be

... Shared from Tax Insider: How to do a management buy-out!
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