Sell up, not out

Richard Levine is counsel in the private client department of the New Haven, Connecticut office of Withers Bergman.

It can be an emotional time and wading through the financial issues involved in selling your business could feel like walking in space. Be equipped, do your research and make sure you maximise your financial return, says Richard LeVine

Selling the family business is undoubtedly a time of great change for both the family and the business. Families seldom sell more than once, so they may not have experience with selling a business. It behooves the family to learn as much about the process in order to maximise its benefits from the transaction.

Key issues to address include:

- ensuring you pay as little tax as possible;
- ensuring that any deferred consideration payments are not at risk;
- retaining freedom to operate the business prior to the closing;
- preparing to address all of the purchaser's due diligence inquiries.

Minimising taxes
Besides maximising the price, minimising taxes is one of the more important issues raised by the sale of the family business. With respect to income and capital gains taxes, liability can often be reduced or deferred depending on the type of consideration received. Taking back shares of the buying company, or a long-term promissory note, may result in a reduced rate of tax or the ability to defer tax until the consideration is monetised. For UK sellers, it is often vital that the transaction qualifies for business asset taper relief. This results in a reduced rate of capital gains tax. Where a substantial portion of the company's turnover is from non-trading activity, or the company owns substantial non-trading assets, it may be necessary to restructure prior to sale. For US sellers, it may be helpful to qualify the transaction as a corporate reorganisation. No gain or loss is recognised from such reorganisation, but the seller must take back shares from the buyer.

For mobile international families, deferring the income or capital gains tax by taking back shares may provide additional benefits. If family members expatriate or change residence to a low tax jurisdiction after the exchange, it may be possible to dispose of the replacement shares with little or no tax cost. However, taking back shares triggers additional credit and financial risk, and one should be careful not to permit tax considerations to outweigh substantive economic concerns.

With respect to gift, estate or inheritance tax (IHT), there is often much that can be done prior to a sale to reduce the burden on the seller or younger generations. For example, UK business property placed into a trust for junior family members prior to a sale might qualify for an exemption from IHT. Whereas placing into trust, cash or marketable securities consideration received from a sale of the family business could well trigger an immediate IHT charge.

In the US, a minority interest in a family business might qualify for valuation discounts that could enable the senior generation to transfer as much as double the value to their descendants without triggering gift tax. On the other hand, transfers of the proceeds of sale would likely qualify for a much smaller valuation discount, and might trigger additional scrutiny from the Internal Revenue Service. Furthermore, often the senior generation can transfer shares into trusts and have the transaction treated as a completed gift for gift tax purposes (and hence outside the parent's estate for estate tax purposes), but the parent retains liability for any income or capital gains taxes on the transferred property. Where a sale of the family business is contemplated, and the family has a low basis in its shares, this technique enables the senior generation to pay the capital gains tax associates with the shares while the trust retains 100% of the consideration from the sale. The payment of income tax by the senior generation is not treated as an additional transfer subject to gift tax, despite being a dollar-for-dollar savings to the trust.

Preparing the business for sale may require that certain lines of business or assets must be redeployed within the enterprise. Personal assets may need to be extracted from the company. Moving to a preferred structure can have significant tax costs unless carefully planned and executed sufficiently far in advance of the ultimate sale. It may be helpful to implement or amend pension or benefit arrangements to maximise benefits to the selling shareholders prior to a loss of control.

Developing an efficient tax strategy regarding the sale of a family business should be addressed as early as possible in the planning phase. This will provide sufficient time to learn about the issues involved and to structure the sale of your family business in as tax efficient a manner as possible.

Securing deferred payments
As discussed above, tax considerations will often motivate a seller to accept non-cash consideration or the buyer's financial circumstances may require that some portion of the purchase price be deferred. In these situations, it is important to minimise risks to the value of the consideration.

If the family is to receive a substantial number of shares in the buyer's company, they should perform due diligence on the purchaser. Buyers will typically require that sellers be locked out from selling replacement shares immediately after the closing. Sellers should negotiate for the shortest available lockup period. It may be possible to secure rights to a secondary offering after indemnity and lockup periods expire.

If the family is to receive installment notes, security of payment should be obtained. The buyer should be limited in its ability to issue further debt in addition to the purchase money notes. Guarantees from a financially secure affiliate or standby letters of credit from a bank are common routes to provide additional security.

There will often be a tension between the desire to maximise the sales price, obtain tax efficiency and secure the payment stream. This is where an experienced advisor can suggest techniques for satisfying the family's competing requirements.

Preparing the company for sale
While a company is owned and operated by a family, activities will be arranged to maximise the benefits to the family. Some of these arrangements may not be appropriate for a financial buyer or a publicly traded purchaser. The family can increase the price received and the odds of successfully completing the sale by grooming their company prior to bringing it to market.

Many family businesses contain assets that may be of little or no interest to a potential purchaser. The family may wish to dispose of these assets or remove them from the company before starting the sales process.

If the company operates more than one line of business, a single purchaser may not be interested in acquiring the entire enterprise. Splitting the business into several entities and selling piecemeal may increase the overall value. This analysis requires time both to obtain valuation of the components and to address the tax implications of any proposed restructuring.

While controlled by the family, prices and profit margins may have been set with the goal of maximising revenue or market share over long time horizons. Once a sale is proposed, it may be prudent to give priority to profit margins in the short term, so as to produce current financial results that will justify a higher sales price.

Any purchaser will want to conduct thorough legal and financial due diligence. They will appoint lawyers and accountants to do this, and in certain cases may also utilise other professionals such as engineers and actuaries. Due diligence is often a gruelling process to endure, and sellers can expect that their business will be examined using a fine toothed comb. The sooner problems are identified, the less likely that they will derail the process or trigger significant changes in the terms of the deal. To avoid nasty surprises later, families would do well to carry out a dummy due diligence review of their own. This enables the family to identify and resolve troublesome issues in advance. Even if the problem cannot be eliminated, perhaps it can be mitigated and self-examination provides time to devise a strategy for bringing it to the buyer's attention and for presenting it in the best light.

A well-groomed company that has performed internal due diligence will be well-positioned to enter the sales process. Lawyers and accountants will be able to handle much of the contact from prospective purchasers. The family will be able to spend less time responding to inquiries and more time managing the business and planning their future.

Managing the company during negotiations
Selling the family business is a time-intensive process but it is important to remember to keep running the company as if the sale will not go through. One of the leading reasons why a transaction fails to close is that the target business worsens between signing a letter of intent and closing the deal. Often this happens when the owners become so preoccupied with the sales process that they lose sight of day-to-day operations. Negotiating and documenting the transfer of a closely held business can take from six months to a year. Negative developments near to the closing date can result in significant price reductions or even cancellation of the entire transaction.

Selling the family business is an emotional event that heralds a new chapter in the family's history. Taking the time to learn about the process, grooming the company for sale and structuring a deal that maximises financial return and tax efficiency will make the process easier and more rewarding.