Busting jargon with Roger Esler #1
Cash out, equity release, partial buy-out, VIMBO & FAMBO
Two important considerations for business owners as they navigate through the Covid-19 pandemic to greater stability and more normal trading are firstly, is too much of their wealth tied to a single private business and secondly, are Capital Gains Tax (“CGT”) rates about to increase, perhaps also with the abolishment of what’s left of Entrepreneurs Relief?
Selling a business to a larger trade buyer is a straightforward concept, albeit complex and time consuming to execute properly. But that is not always the right answer for a business owner not ready to fully retire, with loyalty to his/her management team or with family members’ jobs to secure.
The most common form of releasing value to shareholders is paying dividends, though these are taxed at rates towards income tax rates, much higher than current CGT rates and are also limited by distributable accumulated profits in the business.
What about a share buy-back? Whilst in legal terms a capital transaction, there are HMRC anti-avoidance provisions if the broader commercial purpose and shift in ownership dynamics are not evident. A share buy-back might simply be construed by HMRC as a disguised dividend if it not materially reducing, or buying out in full, a particular shareholder.
Sell some shares to a third party? Ok, but who? A management team might not have the funds, a strategic trade party (eg a supplier) might not be willing or could create conflicts of interest and commonly an institutional funder such as a private equity investor will require wider reshaping of the capital structure.
So “cash outs” and “equity releases” require much more careful consideration to be fully tax efficient and fulfil shareholders’ objectives for equity value release as well as wider management incentivisation and succession. They are isolated transaction events and not routine payments like dividends. They should also be precleared with HMRC to ensure the principal fund flows are treated as capital and not as income.
A common form of equity release is referred to as a Vendor Initiated Management Buy-out or “VIMBO”. If involving a next generation of the owner’s family then FAMBO. It particularly suits businesses that are net cash positive and/or have accessible debt capacity and, importantly, where there is a wider management team to incentivise and transition ownership to. It does not preclude a future sale of the business and need not include external shareholders.
Equity value is released by unlocking any surplus cash and accessing debt capacity in the business tax efficiently. Existing shareholders roll over the balance of their equity value in the business into a new capital structure in the form of interest-bearing redeemable loan notes and a sizeable minority equity position. A robust shareholders’ agreement protects their interests through consent rights over all significant decisions.
The management team holds the rest of the shares which only accrue value from post-deal growth, since they rank behind the debt facilities and redeemable loan notes. Whilst some modest subscription “hurt” monies from management are generally required, these are proportionate to individuals’ circumstances and there is no tax consequence of being awarded such shares. This can be powerful incentivisation to a management team to grow the business and also ties in and retains key members of the team for the longer term, often better positioning the business for a future more definitive exit event.
The twin characteristics of commercial purpose and shift in equity ownership should satisfy HMRC that the transaction is capital in nature, and that it does not trigger the anti-avoidance provisions.
It is true that the banks are exhibiting more caution in the current environment to funding such partial buy-out structures. However, there are many alternative lending institutions in the market currently including asset-based lenders and SME debt funds, so there is a broad armoury of funding solutions. Further, the redeemable loan notes can be refinanced tax efficiently at different stages going forward, where resources permit.
Very often equity release transactions are combined with raising growth capital, the latter being a prominent theme in a recovering market where opportunities such as acquisitions or investment are evident but need financed. Like the debt market, the equity finance market is also broad with growth capital and venture capital providers very accustomed to being minority investors, and private equity investors also being now more receptive to such transitionary deals.
In the heightened risk environment in which we find ourselves, equity release transactions will be scrutinised more closely by funders and demonstrable management succession and incentivisation will be important to counter an owner’s desire to diversify wealth. Conservative debt structures, albeit from a broadening population of lenders, and growth equity investors, will also be more evident.
Such “interim” transactions can fulfil multiple objectives for business owners and can support a business through growth and management succession – perhaps to a more definitive exit event such as a full management buy-out or trade sale when the time is right.
Needless to say, getting these deals to work for all parties requires experienced advice: imaginative deal structuring, achieving consensus on valuation, business planning, financial modelling, securing optimal funding terms, establishing the new shareholder agreement and, of course, getting HMRC clearance.
Roger Esler – Partner Dow Schofield Watts Corporate Finance, North East Office
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