Business succession: exploring your succession solutions

Louise Fisher and Simon Everingham

In part 1 of our article, Business succession: meeting your succession objectives, we identified five succession objectives that, in our experience, are often of fundamental importance to business owners looking to exit their businesses.

When some or all of these five succession objectives are important to business owners, we suggest they consider the following three succession options:

Succession Option 1: Management Buyout

Succession Option 2: Employee Ownership

Succession Option 3: Family Succession

Why these options?

Continuity and sustainability of the business are typically central to each of these three succession options. In each case the business legacy is continued by the people who know the business best: its employees or, in the case of family succession, the founding family and the employees. They understand the business and its culture and values. The exiting owners and management are in control of valuation, cash flow and structuring repayments in a way that balances: (1) ensuring the exiting owners have enough cash to be financially secure in the next stage of their life with (2) the business’ ability to make the payments while remaining viable over the repayment period.

What follows is a summary of each these succession options, including the headline tax consequences.

Option 1: Management buyout

A management buyout (MBO) involves the management team of a company buying the company they manage from its current owners. Usually this will involve the management team setting up a new company to buy all of the shares in the target company from the exiting owners. As the new owners and leaders of the business, the management team can use their combined expertise to grow the business and drive it forward.

The precondition here is the existence of a management team that is willing and financially able to buy the shares. If the correct management team is in place to take over running the business, the viability of business and continuity for its employees is secured. In this structure the MBO team will bear the financial burden of the transaction. They will need to have capital to invest in the business to buy out the current owners and they will have to give guarantees to lenders and the exiting owners that any deferred consideration (debt) will be paid over an agreed time period.

A longer-term issue is that the MBO team will face its own succession challenge in the future. Can the business sustain another management buyout when the new manager-owners are ready to retire?

Tax consequences for the exiting owners

The proceeds of a sale of shares through an MBO would be subject to capital gains tax (CGT) and the current rate of CGT is 20%. At the time of writing, Business Asset Disposal Relief on lifetime gains of up to £1,00,000 is usually available on the sale of shares in trading businesses, reducing the tax payable on the first £1,000,000 to 10%. The full rate of CGT (currently 20%) is payable thereafter.

Option 2: Employee ownership

Employee ownership is where all the employees of a given business have a significant and meaningful stake in that business. This usually means that at least the majority of the ownership is transferred to the employees. The employee ownership model is established around a number of clear principles and choice of structures that have the flexibility to suit the circumstances of most businesses.

Direct ownership

In the direct ownership model, employees become individual shareholders in their companies. Shares are usually acquired using a share scheme. There are several different schemes that offer tax advantages. As direct shareholders, employees can influence the direction of the company and can benefit financially through dividends as the company grows. However, employees would need to be in a position to use their own cash to purchase the shares. Most companies would oblige shareholders to sell their shares when they leave the business.

Indirect ownership

Indirect ownership is where some or all of the shares are held collectively for the benefit of all the company’s employees, usually using an employee ownership trust (EOT). The EOT model gives employees many of the benefits of ownership without them being obliged to buy shares directly with their own money.

An EOT provides a stable ownership base for the continuation of the business as an independent entity. The introduction of an EOT also supports good governance of the business as ownership and leadership of the business are separated, often for the first time. Usually, there is some employee representation on the EOT, which can add an extra layer of accountability for the leadership of the business. The vision and values of the business and the exiting owners’ wishes for the preservation and extension of the business’ culture – what makes it unique – are often expressed in the documentation establishing the EOT.

Hybrid model

Many business owners choose a hybrid or blended model of employee ownership as their succession solution. In this model, the majority of the shares in the company will usually be held by an EOT, and some of the remaining shares or options over shares will be made available to employees as a way to incentivise key employees in the business. Employee shareholders may have voting rights within the governance of the business and can have financial benefits such as income from dividends and capital gains if they sell their shares at a profit. The EOT provides stability and continuity of ownership for the future, and can also provide a ‘share warehouse’ to enable minority shareholders to realise the value of their shares when they leave without the need for an external sale.

The hybrid model can also enable the exiting owners to retain a minority legacy or family shareholding. This allows the exiting owners and/ or their families to continue to participate in decision making and remain custodians of the business. Employees are given the opportunity to participate in and benefit from the success of the business, but the legacy shareholders have a say over the things that really matter to them.

Tax consequences for the exiting owners

The tax rules currently provide that if an EOT buys at least the majority of the shares in a company, the sale proceeds should be exempt from CGT, provided that the transition to employee ownership is structured correctly. There is currently no limit on the value of this exemption. In addition, employees can benefit from an income tax free bonus of up to £3,600 each year.

Option 3: Family succession

Family succession options involve the ownership and often leadership of a business transferring to the next generation of family members. Where there are relatives willing and able to take on all or some of the responsibilities of the exiting owners, the following three models are often considered.

Maintaining the status quo

A senior generation business owner and leader has nurtured and mentored a successor to ‘step into mum or dad’s shoes’ when they retire. Ownership and leadership of the business is transferred to the successor and business and governance practices are recycled from the previous generation. The status quo is maintained.

Next generation owners and managers

This model envisages a number of next generation family members having the appetite and talent to take over ownership and management of the business. The work required is around harnessing talent and designing a system of governance that will allow the business to thrive with new group of family owners at the helm.

Active next generation shareholders

When next generation family members do not wish to be owner-managers of the family business, systems of governance can be designed that allow the family to continue as active shareholders with a non-family board running the business on the family shareholders’ behalf.

Tax consequences for the exiting owners

The tax consequences of family succession options vary depending on the structure used to facilitate the ownership transition. The transition may be facilitated by a family buyout which uses a structure similar to a management buyout, but in this case next generation family members would create a new company to buy the shares from the exiting family members.  In this model the sale proceeds would be subject to CGT. If the exiting owners’ shares qualify for Business Assets Disposal Relief, 10% CGT is payable on lifetime gains of up to £1,000,000. The full rate of CGT, currently 20%, is payable on everything over £1,000,000.

If shares are gifted to the next generation by the exiting family members, there are potential inheritance tax consequences for the transferor and the shares are a chargeable gain in the hands of the transferee. However, if the shares qualify for Gift Holdover Relief, CGT will not be payable by the next generation family members until the shares are sold. We would advise that you seek specialist tax advice before you begin to implement any family succession plan.

Finding the right succession option

Every business and its owners are different. The succession solutions chosen by business owners should reflect this. If some of the five succession objectives are important to business owners, we suggest they explore some or all of the three succession options. At Baxendale we can help business owners design and implement succession solutions that are right for them and their businesses.

If you would like to know more, visit the Baxendale Succession Options Portal or get in touch with Louise Fisher or Simon Everingham of the Baxendale team.