Selling a business? Cash, Earn Out, Loan Notes or Shares?

Selling a business? Cash, Earn Out, Loan Notes or Shares?

So, you’ve made what is probably the most difficult decision a business owner has to make – to exit the business.  Now what?  There is honestly no substitute for early, pragmatic, professional advice but before taking that step it is worth understanding and considering all the variables:

Cash, Earn-Out, Loan Notes or Shares?

How much of the sale consideration ultimately ends up as cash in your pocket will vary from one business owner to another.

With so many options how do you know which is right for you?  The choice, however, is not always in your hands!

Cash

Pros

  • Straightforward, offering an easier route to a ‘clean break’.
  • If eligible for Entrepreneurs’ Relief, then only 10% CGT (capital gains tax) applies.
  • There is no risk to the value of the consideration, it is guaranteed.

Cons

  • Cash may be tax inefficient, as it limits the ability for tax planning.
  • If not eligible for Entrepreneurs’ Relief, full CGT of up to 20% applies.
  • CGT applies when the contract is signed not when the cash is received, so timing is a vital consideration.

Deferred Cash

For illustrative purposes, let’s assume a cash purchase price of £1,000,000 with the cash received in equal sized, yearly instalments over five years.

Pros

  • This still offers an easier route to a ‘clean break’.
  • If eligible for Entrepreneurs’ Relief, then only 10% CGT applies.
  • There is no risk to the value of the consideration, it is guaranteed.

Cons

  • Cash may be tax inefficient, as it limits the ability for tax planning.
  • All of the tax payable would be due for the tax year in which the contract is signed even though your final instalment will not be paid until four years later.
  • If not eligible for Entrepreneur’s Relief, full CGT of up to 20% applies.
  • Time cost of money.
  • The buyer needs to be around for the full period.

Earn-out

An earn-out is where a proportion of the sale consideration is based on a percentage of future profits, sales or other business criteria, payable only when specified targets are achieved after the sale.

Pros

  • Without an earn-out the price the buyer is prepared to pay may be discounted as a result of doubt about future profitability.
  • It may allow the seller to benefit from changes made by the buyer to increase the value due to future improvements in the business or business environment.

Cons

  • Earn-outs give rise to tricky and complex taxation questions so expert knowledge is a must.
  • If agreed targets are not met the earn-out proportion may not be paid or a reduced figure becomes payable.
  • No ‘clean break’.  The seller is usually obligated to have continual day-to-day involvement in continuing to run the business and maximising profits for a specified number of years.
  • It creates pinch points in the future relationship between buyer and seller.
  • Agreeing the earn-out formula can be contentious.

Loan Notes  

An extended form of an IOU that enables a seller to receive payments over a set period of time, ending with the date at which the entire loan is to be repaid.

Pros

  • Interest is usually payable on the loan notes.
  • CGT may be deferred until you cash the loan notes in.  You could therefore cash these loan notes in over several years taking advantage of your annual allowances.

Cons

  • There are two types of bonds QCBs (qualifying corporate bonds) and non-QCBs so you need to be careful.
  • QCBs can be dangerous as they are exempt from CGT (meaning the loan notes themselves do not trigger a capital gain or capital loss), but the gain that has been deferred into the loan note will be crystallised when the loan note is repaid or is otherwise disposed of. This means if the buyer goes bust the original gain on the sale of the shares becomes chargeable but there is no tax loss on the QCBs that can be offset against the gain coming back into charge, meaning the CGT becomes payable in full. This can result in a large tax bill on money you’ll never receive.
  • Loan notes alone do not qualify for Entrepreneurs’ Relief.  You need to negotiate keeping at least 5% of the voting shares in your company and to remain as an employee or non-executive director and thus be eligible to Entrepreneurs’ Relief and 10% CGT otherwise full CGT is payable.
  • If this isn’t possible it might be more tax efficient to pay CGT at the time of disposal (qualifying for Entrepreneurs’ Relief) even though the loan notes are not redeemed until a later date.
  • The loan notes may be unsecured.

Shares

Shares in the buying company are offered as consideration.

Pros

  • A greater return potential with capital growth (although volatile) and income.
  • Allows for a second exit event at a later time.

Cons

  • The value of shares can go down.
  • Non-quoted shares are hard to value and are illiquid.
  • No ‘clean break’, value is still retained in the continued business.
  • Shares need to be kept for a minimum period before selling and realising the return on a successful exit as there are often selling provisions.
  • Potentially a more complex tax position – Entrepreneurs’ Relief may not be available on sale of the new shares if the 5% ownership condition (and other conditions) are not met.  In order to minimise the overall tax you might elect to pay CGT on the value of the shares received, but you might not have the cash to pay the tax, and you might not receive this value if the shares fall in value.

Planning is everything

Before embarking on the sale process:

  1. Get your business in the best possible shape it can be.  This will probably mean appointing an adviser 12 to 24 months beforehand to help you prepare your detailed exit plan.
  2. Consider if you want to make a ‘clean break’ or continue to be involved with the business after the sale. Consider what will be viable in the eyes of the buyer.
    Consider the typical methods of acquisition for your type of business – share sale or asset sale.
  3. Are you eligible for Entrepreneurs Relief?
  4. Don’t go it alone, appoint an adviser with a solid track record of selling businesses who can guide you through the process.
  5. Appoint a lawyer (selling a business is a legal minefield with many traps awaiting the unprepared) but only do so at the appropriate time – you may need to ‘kiss a number of frogs’.

Please Note: This blog should not be considered as advice from Isosceles.  Always seek professional advice specific to your circumstances.

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