It’s a common dilemma: one shareholder wants to exit and to realise the full value of their shares to fund their retirement. The remaining shareholders do not have the funds to buy them out. Unless you have already catered for this eventuality in a shareholders agreement or in your articles, you may find yourself in a difficult situation when this day comes. However, a trade or private equity sale is not inevitable. Bonnie Jackson discusses the alternative options available for those staying on.
Deferred Consideration
The most obvious solution would be for the remaining shareholders to buy the shares from the leaver, with payment over a period of time. While this suits the remaining shareholders, it is unlikely to appeal to the leaver, who will have transferred legal title to the shares and will have to enforce the debt against several individuals if they don’t pay up.
Share Buyback
If the company has healthy distributable reserves (accumulated, realised profits minus accumulated, realised losses) then a share buyback could be an option. This way, the company it can purchase the shares back from the leaver and either hold them in treasury for redistribution, or cancel them. Payment for the shares must be made in cash (or cash equivalent) at the time the shares are bought back. But what if the company cannot afford it? There is nothing to stop a company from agreeing to buy back shares in tranches over a period of time, as funds allow. This may not suit the departing shareholder and in the meantime, during the buyback period, they would retain any rights to dividends and voting for the shares they still hold (unless you had the foresight to provide for this situation in your articles).
Alternatively, if certain conditions are met, it is possible to use capital reserves to fund a share buyback. As this option presents a greater risk to creditors, there are additional hoops to jump through to demonstrate solvency and directors may bear personal responsibility if the company becomes insolvent. However, this is a useful option if your company is well capitalised.
Management Buy Out
A more attractive proposition may be for the remaining shareholders (and potentially the senior management team) to secure outside borrowing, to enable them to buy the departing shareholder out – a Management Buy Out (MBO). This will usually involve incorporation of a holding company, which buys out all shareholders, issuing new shares to the remaining shareholders via a share for share exchange. This offers a ‘clean break’ for the departing shareholder, who in selling its shares, sacrifices any future control and dividend rights and receives upfront payment. The company is then left to repay the lender over time.
This ‘flavour’ of MBO does require a healthy cash flow, as debt will usually be secured over the assets or future cash flow of the company and occasionally the management team will be required to give personal guarantees.
An alternative if this prospect is unlikely, could be for the holding company to pay for the MBO by issuing loan notes to the departing shareholder in return for their shares. This is undoubtably a riskier proposition for the seller, for whom payment will be reliant on future cash flow of the company. This risk can be mitigated by securing the loan notes, for example with a debenture secured over company assets, providing the seller with recourse if the debt is not repaid. It should be noted that this security will usually rank behind existing security, leaving the departing shareholder last in the queue in an insolvency situation. However, the departing shareholder will have intricate knowledge of the company, its prospects and the capability of the management team and is in a great position to judge this risk. Loan notes often attract interest and offer tax benefits for the seller, though may prevent dividends being paid to remaining shareholders until repaid – which could be several years.
Employee Ownership Trust
Employee Ownership Trusts (EOTs) saw huge popularity after their introduction in 2014 thanks to their significant tax reliefs. However, since then, some have questioned whether they have lived up to expectations – not least because the headline tax benefits have been slashed in recent budgets. In this model, a trust is created which purchases some, or all of the shares from the existing shareholders, paying the purchase price in instalments over time, often several years. Fans of the EOT point to the cultural benefits for the company, which is owned by and for the benefit of its employees.
While this does offer a clean break for a departing shareholder, the reality is not often as promising as it might initially appear. To qualify for 50% capital gains tax relief, the trust must purchase a controlling stake in the company. This means that if the departing shareholder does not meet the criteria, the rest of the shareholders will be called on to ‘top up’ the shares that the trust purchases, sacrificing their own equity and control to facilitate the exit. The departing shareholder becomes a creditor and again, must rely on future profits to finance the purchase.
After the exit, governance becomes more complicated, since a trustee board must be established, kept informed and involved in major decisions (though day to day control remains with the directors). It’s for this reason that EOTs are often considered more suitable for companies where there is a passive employee base, as opposed to an MBO which caters for an actively engaged senior leadership team.
EOTs are still relatively novel and may not be as attractive to a potential future private equity or trade purchaser, who will be accustomed to traditional share ownership with clean, individually held equity structure. It may also hinder traditional deal mechanics, such as earn-outs or management incentives. For this reason, an EOT may be better viewed as a solution where all, not one, shareholder wants to sell and where there is no long-term plan to sell up.
In all cases, good tax advice is an essential pre-requisite, and your lawyer should work hand in hand with your tax advisor and accountant to ensure that any plan complies with company law and UK accounting requirements. It is often advisable to seek advance clearance of any plans with HMRC, to minimise the risk of any post-exit tax headaches.
The good news is that one shareholder wanting out needn’t spell crisis for those staying on. With the right structure – whether that’s a staged buyback, an MBO or an EOT, an exit can be planned, funded and delivered without derailing the business, or forcing a sale nobody wanted.
If you would like advice on shareholder exits, please get in touch with Bonnie Jackson or our Corporate Team.