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Selling a business

(Also useful information for when buying a business)

You have established that you want to sell. But how do you achieve the best deal? You need to ensure that your business and its systems are robust enough to withstand the sale process. Importantly, you also need to minimise your tax liabilities - and that may mean beginning your preparations well in advance of the six months that it typically takes to sell a business.

Here are some of the key questions to ask yourself as you prepare your business for sale:

Strategic issues:

  • Do you have an effective strategy for future growth and can you communicate it clearly? Ideally, you need to produce robust and reliable projections that the business continues to meet throughout the sale process. Aim to conclude the deal once there is a fair degree of certainty over the business's ability to meet or exceed these projections.
  • Do you have an effective system of internal financial control?
  • To invest or not to invest? Generally, it is sensible to continue to invest in the business as if you were going to own it in the future. If buyers feel remedial investment is required they would want this reflected in the sale price.

Tax issues:

  • Capital Gains Tax (CGT): to gain the effective 10% rate you need to have held shares in a qualifying trading company for at least two years. Although you may believe your company is a trading company, the tax man may not agree - for instance, if it is cash rich or has significant investment assets (no more than 20% of your activity can be investment or property-related). If you are at risk of breaching this 20% threshold, you can improve your position. Consider paying a dividend or demerging investment assets out of the existing business. Within two years you could be in a position to sell at a 10% CGT rate.

*Current rates at time of writing - check with your accountant latest rates.

Grooming your business

  • Ensure that non-business asset taper relief is not contaminating your shareholdings. For instance, you may hold assets that have only qualified as business assets since the relaxation of the qualifying conditions on 6 April 2000. CGT won't fall to 10% until you have owned them as business assets for 10 years. By transferring the shares into a trust, you can re-start your taper relief clock and achieve a 10% effective rate after just two years. This is a complex area and you should seek specialist advice.
  • Need to sell before the two-year qualifying period is up? Consider selling for loan notes that are non-qualifying corporate bonds, which can keep your taper relief clock running. But you are at the mercy of the new owners: if the business no longer qualified for business asset taper relief, you would lose out.
  • If you have already clocked up two years' business asset taper relief, and you need to sell for loan notes, make sure they are qualifying corporate bonds. These stop your taper relief clock, which means the taper relief you obtain when cashing in the loan notes is unaffected whatever the new owner does with the business.
  • The new rules allowing companies tax relief on acquisition costs of intangible assets may increase tension between vendor and buyer, with the former favouring a share transaction and the latter preferring assets in order to gain tax relief. This may lead to lengthy negotiations at the deal-structuring stage. Share transactions are, of course, the norm - it may take some time for assets transactions to gain popularity. But when they do, your power as a vendor will be determined by how attractive your business is to the buyer. The more you have done to groom your business for sale, the more likely it is that you'll be in a position to dictate terms.
  • Manage your effective corporation tax rate carefully. A lower tax rate can lead to a higher price if a buyer believes such a rate is sustainable. Additionally, a tax rate that does not fluctuate greatly from year to year will give a buyer confidence regarding the financial management of the business.
  • Work with your accountants to ensure all tax liabilities are in order - from PAYE to VAT to corporation tax. There is nothing more likely to dent the sale price than the buyer's due diligence uncovering a problem that leads to an Inland Revenue dispute.
  • If you are non UK domiciled, you have the potential to realise a sale of your business without paying any UK tax. But, you need to ensure the right structure is in place and seek specialist advice.
  • If you are receiving shares or loan notes from the purchaser you will need to apply to the Revenue in advance for clearance that no disposal arises for Capital Gains Tax purposes on the 'paper swap'. Such clearance could take thirty days.
  • You may want to consider a pre-sale dividend (taxed at an effective rate of 25%), especially if you are not entitled to business taper relief.

People issues:

  • Develop a sound first and second-tier management team. This greatly enhances the value of a private company and helps demonstrate that you are no longer critical to the business, thereby reducing the buyer's investment risk.
  • Agree bonus or share incentive schemes to encourage your management team to help with the sale process and to keep them focused on growing the business. Do this well in advance of a sale. Seek professional advice on an appropriate structure, but ensure that there are timing and performance criteria - it is important to the purchaser that your management team has incentives beyond the sale itself.

Legal issues:

  • Legal due diligence: conducted by the buyer's lawyers, it includes a review of all material contracts and title to assets. A common issue is the absence of contracts or documentation - in relation to a key employee, customer or supplier - where they might reasonably be expected to exist. Try to address this before the sale.
  • The sale and purchase contract: will contain extensive warranties and indemnities you must give as the seller - demanding that you have a good understanding of the state of the company and areas such as tax, finance, customer and supplier relationships.
  • Is there any outstanding or threatened litigation?
  • Intellectual property: make sure all patents, trademarks and domain names are properly registered before embarking on an exit.

Valuation

When it comes to selling, the question on most owner's minds is: how much is my business worth? The real test of the value is, of course, what a willing buyer will pay for it. While many factors will determine the final figure, the most common way of valuing a company is to apply an appropriate multiple to the normalised earnings of your company, thereby arriving at a capital value.

Normalised earnings are your business's reported profits adjusted for abnormal or non-recurring costs (although expect any potential buyer to challenge the adjustments). Two multiples are commonly used:

Price Earnings ratio (p/e ratio)
The p/e ratio is the ratio of the market value of the equity of a company to that company's aftertax earnings. Determining an appropriate p/e ratio for a private company is a subjective process as only quoted companies have published share prices. Once you have established the appropriate range of p/e ratios, take your normalised earnings before tax and deduct a notional corporation tax charge at the full rate. Multiplying the after-tax normalised earnings by the p/e ratio results in the valuation range.

Earnings Before Interest and Tax (EBIT) multiple
The principle for the EBIT multiple is similar to that for the p/e ratio, however it is more reliable as it eliminates the effects of varying levels of gearing (debt) and tax rates unique to each company.

p/e ratios and EBIT multiples can be calculated for comparable quoted companies and then a discounted multiple applied to the normalised earnings of your business, giving an 'enterprise value'. Deduct any debt and you have the value of the equity in your business.

Earn-outs
Buyers may want to mitigate their risk by locking you in for a set period and paying you an element of deferred consideration linked to future performance - usually called an 'earn-out'. Earn-outs may increase the final value you receive for the business but they can be risky for you and are fraught with complications. They are likely to be an issue at the deal-structuring stage and are particularly common in deals involving 'people' businesses where the buyer seeks to use them to ensure the owners remain with the business after the sale.

The tax treatment of earn-outs is complex. If not structured correctly, you could pay tax on a valuation of the likely earn-out at the date of sale even though you would not receive the cash for years to come (if at all).

Cash flow valuations
The other common valuation method takes your future cash flows and discounts them to give the present value for your business. As with all valuations reliant on projections, the result is only as good as the assumptions made but this is a useful valuation tool particularly where the trading or profit stream is irregular or there is significant investment required before delivering the full potential of the business.

As well as probably being the most important transaction you will ever undertake, the sale of your business is likely to be the most complex. The keys to its success are identifying the strategic buyers, maintaining confidentiality, controlling the information flow and dictating the timetable. That is why a structured sale process is essential. It requires far more effort than a reactive approach, but we believe the results - in terms of improved deal value - are well worth it.

Step-by-step guide to selling your business:

Prepare an Information Memorandum

  • this provides potential acquirers with enough information to assess their interest and, crucially, estimate the price they would be willing to pay.
  • typically it includes an executive summary and then more detailed information on history and ownership, financials, nature of operations, customers and suppliers, markets and competitors, directors, management and staff, future developments and the reasons for sale.

Identify buyers

  • detailed research using external statutory and corporate finance databases to establish a list of target companies.

Make the confidential approach

  • do not divulge the name of your business to a third party - restrict discussion to the business sector and estimated turnover and profitability.
  • your adviser will contact prospective buyers, initially by telephone. Once their interest is established they will be required to sign a confidentiality agreement before receiving the information memorandum.

The sale process

Seek indicative and revised offers

  • your adviser will invite offers from interested parties on the basis of the Information Memorandum while giving buyers an indication of the kind of deal you are looking for - guiding them towards your preferred structure by highlighting the potential benefits.
  • agree a shortlist of preferred buyers - followed by meetings with them to ascertain what further information they need to submit a formal offer.
  • negotiations to secure the best offer which is formalised in a letter known as 'Heads of Agreement' to be agreed by both sides.

Exclusivity and contracts

  • once Heads of Agreement have been signed and an exclusivity period has been granted, the Purchaser will instruct its accountants and lawyers to undertake an in-depth investigation of the Company. This is known as financial and legal due diligence. Due diligence may be widened to cover such areas as property, environmental, IT and HR issues depending on the complexity of the business.
  • results are often used by purchasers to try to renegotiate terms. This is why it is important to carefully groom the business prior to sale and control the information flow during the sale process.
  • the lawyers on both sides will then draft and negotiate the formal legal documents to effect the transaction, primarily the Sale and Purchase Agreement but also financing documentation and service contracts for directors.
  • it is important that you use your Mergers and Acquisitions (M&A) adviser to co-ordinate the whole process during this period, as there are often a large number of parties and advisers involved and you will have to cope with the demanding provision of information for the due diligence process. The M&A adviser will also be able to identify issues in advance, ensure that their effects are minimised, and conduct negotiations to deliver the best result for you.

The sale process is long and complex and therefore it is important to use your advisers to run the process, leaving you free to focus on running the business.