23/09/2014

By Simon Deans, Partner, B P Collins LLP

Few individuals start up a new business (or indeed continue to run an established business) with a clear exit plan. Instead they focus on the more obvious immediate issues such as funding and product development, customer service, employees and premises. Yet at a time of growing acquisition activity, an attractive offer can create unexpected divisions between business founders and stakeholders, including management and investors.

Whether the vision is to create a family firm that will last for generations or to build up and sell within five years, business owners usually want to create a legacy and ensure continuity for employees. From share options that incentivise management to regular reviews of the business plan and preparing the company for any due diligence activity, it is important to consider the future, now.

Creating the Legacy

British entrepreneurs created a record number of new businesses in 2013.ยน Despite the on-going challenges regarding funding, a strengthening economy and growing confidence are encouraging individuals to take the step to realise what is, in many cases, a long held dream. However, whether the new business is a family affair or a collection of like-minded individuals, in the flurry of decision-making regarding company structure, and operational matters such as premises and employees, it is easy to overlook the wider picture.

What are the long-term objectives? Build up the company and sell? Or create a legacy to pass on to the next generation? While most company founders believe they share objectives, what would happen if an offer of £5 million was made for the business next month – are all the participants aligned on the outcome? It is only when these questions are answered that business owners discover any divergence in long-term goals.

Given the various flavours of company ownership, it is essential to discuss these issues up front. While family businesses underpin the UK economy, creating more than nine million jobs and producing a quarter of GDP, the family business model is slowly changing. The tradition of businesses being passed down through the generations is fading, with Generation Y preferring to follow a different career path. Indeed, even new family start-ups are not looking necessarily for the same legacy – preferring instead for the short term build and sell model.

While it may seem over zealous to be discussing these issues so early in the business’ life, it is one of many key considerations that should not be overlooked. There may be a tax benefit for husbands and wives each holding shares, but what are the risks of doing this? While it may be a painful issue to even consider, what contingency is in place should the business owners fall out? What happens if the husband and wife owners get divorced – will the business be torn apart in the ensuing financial split? History suggests this happens more often than it should.

Similar considerations need to be put in place for businesses employing family members. If the employment relationship has not been formally documented, what happens if the employee is accused of a disciplinary matter or if the business is sold? It may be a rash assumption that employees will be happy simply because they are part of the family. Their jobs may be uncertain, while their parent, sibling or cousin is walking off with a significant sum. Family or not, they may demand to be treated like any other employee or expect a share of the proceeds. The family relationship could be damaged; and the potential sale compromised.

Building for Growth

One of the biggest challenges for any company is moving to the next stage, evolving beyond trusted friends and family to creating a broader management team and looking for external funding. At this point the stakeholders in the business often change, creating new pressures and challenges for future direction. On-going investment and expansion can become a divisive issue: while one business owner may need a higher level of remuneration to support a growing family, another may want to draw less money and reinvest to drive faster growth. Add in new stakeholders, including external investors and new management and these issues can rapidly reveal a worrying fragility and divergence of shared objectives.

It is therefore essential to put in place an ongoing dialogue between stakeholders and legal advisors to ensure potential issues are acknowledged and problems addressed. No business owner should announce his impending retirement only to discover that no one in the business wants to take over nor can a buyer be found – what happens to the legacy, the employees, the business value? It is not always easy to move quickly on these kinds of dilemmas, which emphasises the benefits of planning ahead.

Understanding the changing objectives and motivations of all stakeholders is key. If the owners decide the plan is to build up and sell the business, what is the best way of achieving that objective? An Enterprise Management Incentive (EMI) share option scheme can be a tax efficient way of giving employees a share in the business – it provides an individual with the right to buy shares in the future at a price that is fixed today, enabling the employee to participate in the sale proceeds on exit but at no cost to the employee now. However, it is essential to use these effectively: there is no point using EMIs to incentivise employees when there is no plan to sell within the next 25 years – that is a pretty long wait for any employee and hardly a compelling incentive.

However, for organisations with a clear vision of business growth and defined exit plan, an EMI or other equity incentive scheme can be a highly effective tool since it provides significant tax advantages to employees whilst aligning them to the ultimate objectives to the business. One option is to use the EMI model cleverly, providing the founders with the security of the existing value of the business whilst giving anyone in the management team who is not a shareholder in the business a reward linked to their contribution to future growth in value.

Making the Sale

It is easy to remain focused on the daily operational grind, failing to step away to see the wider context and it can be too late to reap the full benefits of your nurturing of the business if you ignore the wider context until the time you want to exit the business. For any business that may, at some point, look for a buyer it is also important to ensure any refinancing activity, share buy back or forays into international or new markets have been correctly managed and completed. Potential buyers will undertake rigorous due diligence prior to acquisition and problems will not only delay the sale but could result in a drop in price or, in the worst case, a lost sale.

It is also important for a business owner to consider any potential deal not only as a major shareholder but also as a business director with statutory duties to both shareholders and employees. Indeed, a business at this stage is likely to have a number of shareholders and investors, all of whom will have different objectives and risk profiles. Early investors who took a big risk on the business may be keen to accept a tempting offer; while a more recent investor may need to wait a few years to maximise the return and the potential tax relief.

It is important to have open and honest discussions with all business stakeholders on a regular basis to ensure these issues are considered and an action plan is in place: it will avoid unnecessary debate and delay should an offer be received.

Business acquisition activity is picking up significantly – who knows when an offer may be around the corner? Even if selling is not in the plan today, ensuring everything is in order might just make the difference between maximising the value of the business – and losing a life changing opportunity.