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If you are an owner-managed business but want to maximise sale proceeds at completion (and avoid an earn-out structure) then you need to have bedded-in a new management team ahead of your exit to demonstrate to the buyer that they don’t require you to remain in the business to perform any managerial or sales functions to maintain profitability after completion.
But what sort of remuneration package will you need to offer to recruit and incentivise a management team ahead of your exit from the business?
One element of such a package, obviously, is to offer market-rate salaries, which may have a negative impact on the earnings before interest, taxes, depreciation and amortization (EBITDA) of the business if, as is the case with many businesses, the owner’s salary prior to a sale has been modest with a top-up coming in the form of dividends paid on shares.
A second element is to offer some form of equity incentivisation. This could be in the form of shares, options or phantom equity.
“Phantom equity” means little more than a bonus cash payment from the company or seller to the manager dependent on the level of sale proceeds achieved on an exit and is tax inefficient as it will be subject to Income Tax and National Insurance.
By contrast, if you issue shares to management, they can benefit from dividends prior to a sale and a capital gain upon sale. If structured correctly the issue of shares can be more tax efficient than phantom equity. But as you are issuing actual shares you need to consider including provisions in a shareholders agreement or the company’s articles of association to ensure the following: (i) that any voting rights attached to management shares are not sufficient to be able to disrupt your daily management of the company, (ii) that you can easily recover or forfeit the shares if a manager leaves or is terminated prior to an exit, with suitable valuation and vesting provisions for good, bad and intermediate leavers and (iii) that upon the exit itself you can also ensure that managers sell their shares alongside you, usually by inclusion of a ‘drag along’ right.
It is important to take tax advice so that the shares are not seen as emoluments and subject to PAYE and National Insurance (which can be difficult) and the manager receiving them will need to understand potential future Capital Gains Tax (CGT) (or Income Tax) liabilities.
Under current rules, CGT is payable on a sale of shares at 20% unless (amongst other conditions) they have been held for 24 months where they may be capable of qualifying for Business Asset Disposal Relief and a 10% tax rate on the first £1m of gain.
An alternative to issuing shares is to grant options under an Enterprise Management Incentives Scheme (EMI) which is available to companies which meet certain criteria including (non-exhaustively) – gross assets of £30m or less, fewer than 250 full time employees, employees working at least 25 hours a week and limited to £250,000 worth of shares can be granted to each individual.
The advantages of EMI options over the issuance of shares include the following: (i) that options can be written to be exercisable only on an exit and to lapse if a manager leaves prior to an exit without the need physically to transfer or forfeit the shares (ii) that there is no need for management to pay for their shares until a cashless exercise on exit when sale proceeds are available to fund that payment and (iii) that there should be no risks for the company associated with voting by managers or dealing with minority shareholders.
You will of course need to allow the incoming management team time ahead of a proposed exit not only to take over the day-to-day running of the business but also to demonstrate that under their management it is as equally and reliably profitable as it was under your own day-to-day control. How long this period is will depend on the nature of the business and the idiosyncrasies of the intended buyer but could be as long as 1-2 years to enable the buyer to see a track record of success under the new management team to reassure the buyer that the team are capable.
As always before planning an exit from a business, give yourself time to think about the outcome you want to achieve and build in the best strategy to help deliver that.