Transaction considerations
Prior to the sale of 100% of the company’s shares to an EOT, there were seven shareholders, with four active in the business, one running his own business providing complementary services to those provided by our client and two who were retired and living outside of the UK. The company had been approached several times by both competitors interesting in buying the business and private equity interested in investing in the company. As the controlling shareholder discussed options with his fellow owners, it was readily apparent that there was a strong interest in keeping the company independent and preserving what they had all worked long and hard to build.
The first decision point for the shareholders was whether to raise any outside capital. After reviewing the options, they elected to finance the sale through vendor loans, but on terms that would be representative of commercial financing terms. The vendor loans were structured with senior and junior tranches. The senior debt leverage was 3.0X EBITDA, with the junior debt comprising the remainder of the purchase price. As the senior debt was repaid, the junior debt was “refinanced” by reloading the senior debt and restructuring the repayment schedule. This structure allows the business to pay off the transaction related debt in slightly more than ten years, while not having a negative impact on the business. The capital structure maintained the relationship between senior and junior debt that you would expect to see on commercial terms with respect to leverage, pricing and security.
Complicating the structure further was the number of desired outcomes from the transaction. Due to the different circumstances the shareholders were in, they all had different objectives for the transaction. The biggest complicating factor was the varying level of income each shareholder desired over the years following completion.
The shareholders were flexible in how their vendor loans were structured, which allowed us to meet their objectives through various combinations of senior and junior vendor loans, as well as cash pay versus accrual interest. We used accrual interest rather than Payment-in-Kind (“PIK”) interest to avoid creating phantom income for the shareholders.
Following initial diligence work, we prepared a feasibility analysis showing the owners how a transaction could potentially be structured to meet their needs. As we received feedback from the shareholders, we went through a number of iterations of the structure until we had one that worked for everyone and allowed the EOT (through company contributions) to comfortably service the debt incurred to purchase the shares.
Existing debt needs to be factored into the overall financing structure and available leverage when implementing an EOT. Total debt must remain at commercial levels to maximise financing flexibility going forward.
If the seller chooses to finance all or part of the transaction through vendor loans, he or she may receive equity warrants for a significant part of the company going forward. This is consistent with commercial junior debt and provides equity upside for the patient capital provided by the vendors. The management team and key employees may also receive equity through the use of other share schemes that can be used in conjunction with the EOT.
EOT tax advantages
The most significant benefit of the EOT legislation is the ability of selling shareholders to obtain full Capital Gains Tax relief when selling more than 50% of their company. The CGT relief is only available in the year control is sold, so anyone selling shares in the next tax year will not receive full CGT relief. For this reason, it may make sense for all shareholders to sell in the year control is sold if they are interested in full CGT relief.
The second significant tax benefit of the EOT legislation is the provision allowing EOT owned businesses to pay income tax free bonuses of up to £3,600 per employee per year. The bonuses cannot replace existing remuneration and National Insurance Contributions still apply, but this is still a very meaningful benefit to company employees.
Finally, the EOT is the only structure that permits the use of other share schemes in conjunction with its use. Corporations controlled by other corporations are generally prohibited from using tax-advantaged share schemes, but the legislation explicitly permits their use with EOTs. This allows businesses to use equity upside as a motivating factor for management and key employees.
The process
After being engaged by the client, we took responsibility for all aspects of the transaction. We retained lawyers to establish and document the trust and the loan and security documentation. We also arranged for an independent third party valuation of the business to be relied upon by the trustee. By taking responsibility for all stages of the transaction, our client could continue to focus on running their business.
Conclusion
As a result of the efforts of RM2, our client was able to successfully complete the sale of 100% of the company to an EOT formed to acquire the business. The transaction met all of the objectives of the selling shareholders including:
- Preserving the company’s independence
- Preserving jobs in the community
- Providing the income levels required by the various shareholders through the creative structuring of senior and junior vendor loans
- Executing a tax-efficient transaction
By pursuing the EOT alternative, the shareholders were able to accomplish their personal financial goals, while preserving the company’s legacy that they had worked hard to build over the years. This exact situation was unique, but the goals and objectives are common among all business owners thinking about succession and transition planning issues. A Feasibility Analysis can assist other business owners determine whether an EOT, sale to a trade buyer or sale to a private equity buyer is the best way to achieve their transition planning objectives. It is an important first step for owners considering transition alternatives.