In this edition, we are interviewing Keith Melling, Head of Corporate at Napthens. Keith has over 30 years of experience in private practice. He has overseen hundreds of transactions, including internal exits to both management teams and Employee Ownership Trusts (EOTs), and trade sales, acting on behalf of both buyers and sellers.
As Keith says: “For buyers it’s about holding their hand during the acquisition process, trying to streamline the documentation, making sure the due diligence process runs smoothly, and getting from A to B as quickly as we can – with as little disruption as possible.
“From the seller’s side, it’s educating business owners who perhaps haven’t been through the process before, preparing them for the amount of information that’s going to be requested, and being there to make sure that they can remain focused on running the business.
“From both perspectives, our role is to make the journey as smooth as possible.”
Here at TEP, we recently polled over 300 firms about their desired exit route. An overwhelming number of respondents said right now they’d have to sell on the open market, but if they had five years or more to achieve their preferred route, the majority would choose an internal exit either through a Management Buyout (MBO) or an EOT.
What are the reasons people normally pursue an internal exit?
“Owners often want to sell their businesses to their staff or management team because it ensures continuity, preserves the company culture and rewards loyalty. It can also boost staff morale and can lead to increased productivity and long-term success for the company.
“Some of the downsides of an external exit or trade sale can be the extensive due diligence that’s involved and the length of the process.
“This is often the situation where buyers may be preoccupied, or they rely on external support. You have no control over the buyer.
“On balance, I would also suggest selling to an external third party involves giving far more warranties, indemnities, and contractual protections to the buyer.
“It’s clear to see why a sale to management or the team is attractive, but this takes time and any shareholder worth their salt will be having conversations with their senior managers and identifying those people who they see as the future of the business and would be key to the success of an internal sale.”
Keith, what would you say are the prerequisites for a successful internal sale?
“Strong leadership across the management team. Can they:
- Drive the business forward?
- Balance the management of client relationships with being fully compliant?
- Implement and maintain appropriate operation procedures?
- Recruit and retain the right staff?
- Keep a handle on the funding options for the business?
- And do they actually want to take the mantel?
“It all starts with clear communication; the owner saying to their management team: ‘This is my 5- or 10-year plan, this is what I’m looking to achieve, and this is the role I see you playing.’
“It’s also being realistic about the skill set of the existing team, and undertaking a recruitment exercise to attract, retain and develop a team capable of ongoing success.
“Training and development is a big part of this. You might have some really good managers who maybe aren’t ready right now and need some training and mentoring over the period before the sale.”
Businesses need to look at their leadership team and understand if this is what they really want.
“You’ve got to understand what makes your team tick, what they’re interested in, and what their ambitions are.
“If you make a decision that an internal exit is right, but your team doesn’t share your ambitions, good luck achieving your future payments.
“In summary, it’s about having the right people in the right places, highlighting gaps and training needs, and making sure they really want this.”
An MBO has always been the predominant route to sell internally. What are the key features of an MBO?
“Typically, you would be selling your shares to your management team. They’d normally create a brand-new company – a holding company – and you would sell your shares in your trading company to that holding company.
“It’s often funded by third-party investment, debt, or a combination of those. Alternatively, it can be funded – in part or in full – by something called vendor deferred consideration.
“Vendor deferred consideration is a deferred purchase price. If you valued the company at, say, £5 million, unless the buyer has the cash hanging around, then much of that £5 million will get paid out of the profits of the business going forward.
“A key feature of an MBO, as opposed to a trade sale, is that you’re not likely to get as much cash up front because of the need for it to be a deferred payment structure.
“On the risk front, an MBO looks good from a seller’s perspective because you’re not likely to be giving as many warranties and indemnities.
“If you’ve got a leveraged buyout, or a buyout with private equity behind it, they are going to want you to give warranties and indemnities. So, those reduced risk areas that sound great from an MBO perspective, aren’t so great if you’ve got third-party finance involved.”
In terms of valuing the business, can a price just be agreed directly between the management team and the current owners?
“If this is going to be a straightforward internal MBO with no third-party finance, then yes.
“But if you’re looking at third-party finance, then it can’t just be any number because the bank or backer will want a formal valuation to support their investment.
“With MBOs, the new owner(s) have a lot of flexibility post-transaction.
“This is probably the biggest attraction of an MBO compared to an EOT – we’ll discuss EOTs in more detail later. There is clarity around the new owners, they are masters of their future income, and they can scale and exit the firm themselves in the future.”
“EOTs are certainly gaining momentum. Is this the answer owners have been looking for, or dare I ask, do the tax benefits make this route appealing?”
“If you look back to 2012 and the Nuttall Review, there was an analysis done that said companies which were owned by employees had greater longevity. So, the government had to think about how to encourage people who own businesses to sell to their employees. I suspect the answer was: ‘don’t ask them to pay any tax’. And that is something which has seen EOTs become incredibly prevalent.
“I’m not a tax adviser, but in broad terms, if you meet certain criteria, then you should receive a zero Capital Gains Tax (CGT) rate when you sell to an EOT compared to CGT on the sale to shares in an MBO, albeit, owners may benefit from the 10% Business Asset Disposal Relief allowance on the first £1 million.
“We’re seeing more businesses follow this route, possibly for the tax-free treatments, but also because there’s a sense that this is a way of encouraging employees to stay with the business.
“And there are also tax benefits for the employees. Up to £3,600 of bonus income can be fed through the trust and paid out to the employees tax-free each year.”
With an MBO you can clearly see who you’re selling your shares to. With an EOT, is there a way to determine who will receive what?
“One of the common misconceptions is that an EOT has to pay all employees the same.
“In reality, it has to conform with the equality principle, this means employees have to be treated consistently when working out what they’re entitled to out of the trust assets. However, you’re entitled to measure them based on length of service, hours worked, and remuneration. It does however remain more restrictive than an MBO.”
When you sell to an EOT could you end up with an issue of ‘knocking heads’ between what the trust can do and where the superstars in the organisation want to take the business?
“This is one of the key challenges around EOTs and one of the main risks.
“The seller’s out of the way, but how do you incentivise the expected future owners of the business, how do you ensure an EOT can continue to meet high ambitions?
“They may be entitled to trust profits but often, in the context of the remuneration packages your top producers and management are entitled to, that’s not going to be a huge amount.”
“If as a seller, you are accepting a longer-term payment strategy from future profits, but an EOT restricts the ambitions of your key people, while the tax benefits are attractive, there may be negative financial consequences. This shows the importance of considering both an MBO and EOT, and not letting the tax tail wag the dog.”
You’ve completed a lot of sales on the open market, and a lot of internal buyouts. In your experience, which route tends to work out best?
“In terms of happy and satisfied clients, if you’re selling to trade, you have the right price, you have a good business that you know, and you can get a decent amount of cash on day one, then those are the happiest campers because they’re de-risked immediately.
“Internal sales can work well if everything’s been planned well in advance, and everybody understands what they’re getting into. While there is limited upheaval initially, there is usually a longer term to be fully ‘out’ of the business.”
If business owners are looking at an internal sale, what’s the first step to making it a reality?
“Open a dialogue with the people who you need to make it work – a conversation with the management team to discuss their longer-term ambitions, commitment and the appetite they have to own the business.”
Get in touch
If you want to sell your business and would like to discuss your exit opportunities, we can help. We’ll provide you with honest and comprehensive support throughout and help make the transition as smooth as possible.
Please email contact@theexitpartnership.co.uk or call 0113 4656 111.
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