Employee Ownership Trusts and the Entrepreneur

Tax exemption and employee participation

Which entrepreneur wouldn’t want to sell his or her company at full value, tax free? And even better, without having to find the buyer and negotiate a deal? That is the tantalising prospect if you consider selling your company to an employee-ownership trust (EOT). I recently completed Excello Law’s latest such deal for CDY Ceiling and Partitions Ltd, based in Hull.

The special tax rules were introduced in 2014 to encourage employee ownership, on the John Lewis model. Previous tax reliefs helped business owners to give their company to employees, but there were not many owners willing and able to be so generous. Now the rules allow a sale to an EOT at a full price, funded from the assets and future cashflow of the company. The seller pays no capital gains tax at all on the sale.

What’s not to like? Some of the advantages of selling to an EOT are:

• The CGT exemption.
• The ability to set the price, so long as it is not more than market value, based on valuation.
• No hard-nosed negotiation with a trade buyer or institutional investor over price or warranties and indemnities, saving time and professional costs.
• Deferred payment to match the company’s free cashflow.
• The sellers can stay as directors and keep management control while they are paid out.
• The sellers can retain shares, so long as the EOT has control.
• Employees do not own shares directly and do not have to be paid out if they leave. They do not have to be given a voice in management.
• Improved engagement and incentives for the workforce.
• Income tax free bonuses can be paid to employees of EOT-owned companies of up to £3,600 per person per tax year.
• An EOT can suit even small companies with modest workforces.

There are some possible downsides, depending on circumstances:

• The need to find trustees for the EOT. If professional trustees are used, they will need to be paid and can be costly. Trustees have heavy legal responsibilities and should usually have liability insurance.
• Trustees have to act in the interests of the employees. They may want to negotiate the terms of the sale, even if it is funded entirely by the company. Trustees should have separate legal advice. There may be tensions between the sellers, the trustees, the management and the workforce. There can be conflicts of interests and each group needs to understand its legal responsibilities.
• If the trust is UK resident, the trustees will pay capital gains tax on any future sale of the company, calculated on the original sellers’ base cost. So the tax on the gain has only been deferred, not avoided. Worse, if the sellers would have qualified for business asset disposal relief (the 10% effective rate of CGT) the trustees will be paying CGT at a much higher rate. If it likely that the trustees will eventually seek an exit, an offshore trust should be used – but that may be much more expensive than UK resident trustees.
• Management succession and long-term strategy may suffer. The sellers may be primarily focussed on paying out the deferred price for their shares, and may then retire, or lose interest. External funding may be harder to obtain through borrowing or equity investment.
• If the price is set high, the trustees may struggle to justify the EOT as benefitting employees, or to deliver any actual benefit to them. At least in the early years, any money available is likely to go to fund the purchase price.
• The sellers depend on the future prosperity of the company to enable it to fund the instalments of the sale price. If it does not perform, they could lose their money or have to extend the payment schedule.
• If the sellers retain a shareholding, or management are given equity, they may not be able to realise its full value if the EOT does not want an exit, and the EOT is the only possible buyer for the minority stake.

My 40 years of legal experience acting both on corporate sales and employee share incentives makes me ideally qualified to advise on EOTs. They provide an attractive alternative to a trade sale, an MBO  or an exchange of equity for debt.

Unsigned contracts can be binding

Not worth the paper it isn't written on?

A recent High Court case is the latest reminder that even where the parties intend to enter into a formal written contract, they can become bound by the contract even before it is signed.

Most kinds of contract do not need any particular formality, such as written terms or a signature (property contracts being a notable exception). Written terms can be accepted orally. Contract terms can be accepted by conduct, even where the written terms make it clear that a formal signature was expected, and even where there are remaining terms that have not been agreed.
In A v B the buyer of a large quantity of cotton did not sign the purchase contracts, but did initiate the price fixing mechanism under the contract terms. The court held that this was unequivocal acceptance of the contract terms, so the buyer was bound by the contract. The seller was awarded over US$7m.

This is not new: if the parties work under the terms of a document, even a draft document, the court is likely to conclude that they intended those terms to be binding. Similar cases include RTS Flexible Systems Ltd v Molkerei Alois Muller Gmbh & Company KG (UK Production) in the Supreme Court in 2010, and it was held long ago that the partnership deed for a solicitors' firm became binding even though it was never formally executed.

Once commercial parties start to work together, the court will be very reluctant to find that there is no contractual relationship. The question then is what the agreed terms are. the most obvious source is the latest draft of the proposed written contract. that seems obvious, if all the terms were in fact agreed; but what if one party was holding out for something they regarded as important, which the other side clearly had not agreed? In RTS v Muller the Supreme Court said "an objective appraisal of their words and conduct may lead to the conclusion that they did not intend agreement of such terms to be a pre-condition to a concluded and legally binding agreement." So it is bad luck, or carelessness, on the part of the person arguing for the extra condition.


The same applies to an agreement that is expressly "subject to contract". If the parties start to work to the terms, the court is likely to say that the "subject to contract" position has been waived.

There would be no contract if all the "essential" terms were not agreed, but what is "essential" is just the legal minimum to create a binding contract. The law does not require all commercially-sensible terms to have been agreed - just price and quantity may be enough.

These cases are over the negotiation of bespoke terms, but they are related to the "battles of the forms" where both sides try to impose their standard terms - usually the buyer is assumed to have accepted the seller's terms by accepting delivery of the goods.

How should you protect yourself? If you must start work on a project before the formal contract is signed, it is best to have an interim agreement (often called a letter of intent) that sets out the terms for the immediate work, and what will happen if the parties fail to reach agreement on the main contract. An agreement to agree is generally unenforceable, so the interim agreement should include terms to unwind the relationship and ensure that no-one loses out unfairly if the terms do not get agreed.

TUPE reform and the small workforce

Reform of TUPE consultation in the small business

Just occasionally, as your lawyer, I find myself having to advise you to do something really absurd, because an absurd law requires it. One of those is where I am helping you with the sale of your business with, say, just one employee. I have to tell you that in order to comply strictly with TUPE, you have to ask that single employee to elect a representative, for you to consult about the transfer of his employment. You are not allowed to consult the workforce directly, even if you can get all of them round a table in the pub. The collectivist approach is compulsory and elections have to be held, potentially delaying the sale transaction. In practice, most small employers have still carried out direct consultation, but it did not comply with the legislation.

Even in a one-man company, the sole director-employee should supposedly elect himself as representative before he informs and consults himself, in a scene reminiscent of Blackadder in the Dunny-on-the-Wold by-election.

Fortunately that particular absurdity is going, when the proposed reforms to TUPE are enacted. Businesses with ten or fewer than employees will be allowed to consult employees direct, without the rigmarole of elections, where there is no union and there are no existing representatives. However, this will apply only to “micro-businesses”, so the absurdity remains when a larger enterprise transfers a business with a small workforce.

The obligation to inform and consult on a TUPE transfer remains important. Employers have to provide the workforce (or their representatives) with information about the proposed transfer and, when “measures” are proposed in respect of the workforce, consult them. There are no fixed time limits, but the consultation must be a sufficient time before the transfer to enable the views of the employee representatives to be taken into account. Failure to comply with these obligations can result in a Tribunal award of up to 13 weeks’ pay to the affected employees.

The intended reforms to TUPE include a number of other (largely pro-employer) technical changes, but the general principles remain unchanged. The Government has abandoned proposals to abolish the “change of service provision” aspects of TUPE which are probably its most controversial aspect, requiring a new contract or to take on the old contractor’s workforce when a contract is re-tendered.

TUPE gets a bad press, but I am old enough – just – to remember how difficult it was to deal with business and assets sales before TUPE came into force in 1982. There was no means of forcing the workforce to transfer, so the transferring employer stood the risk of redundancy or unfair dismissal claims. On the day of completion, the new employer had to write to all staff offering them jobs on the same terms, which could be accepted by turning up for work on Monday morning. The whole thing was complicated and risky, so the legal process for automatic transfer made things a great deal easier for sellers and corporate lawyers, even if not for contractors and employment lawyers.

The Takeover Code and unquoted companies

A nasty surprise for the vanity PLC

Changes to the Takeover Code take effect in September. The Code regulates merger and takeover activity, largely between quoted companies. But many people (including many lawyers) do not realise that the Code also applies to some unquoted companies. Complying with it can be onerous: it involves a formal process and detailed documents, as well as large fees to the Takeover Panel. For small companies it is sometimes possible to get a waiver from the Panel with shareholder agreement, but that can be time-consuming and expensive. Otherwise, anyone contemplating buying or selling and unquoted PLC should be aware of the Code and the extra costs and delays it will involve.

Many companies think being a PLC gives them extra kudos. It can make the company seem bigger and more substantial than it is – in reality there may be only £12,500 of share capital paid up. A PLC may find it easier to get trade credit or to avoid needing personal guarantees from its shareholders. That status comes at an expense, because a number of Companies Act exemptions and relaxations do not apply to public companies, but it also brings the company within the scope of the Takeover Code. It applies to takeovers of all public companies (PLCs) whether or not their shares have been traded on a public market.

The Code also applies to a private company which has filed a prospectus, had its shares quoted on a market or had a dealing arrangement for its shares within the last 10 years. An unquoted PLC which has never had a share dealing arrangement can always escape the Code by re-registering as a private company, but any company that falls within the 10-year rule is within the Code for the full 10 year period.

What are the consequences if the Code’s application is missed? First and most likely, it will disrupt a transaction if the Code is raised part way through a deal. It gives minority shareholders in the target company extra rights, so they are the most likely to complain. Failing to comply with the Code is a serious disciplinary offence for parties or advisers in the financial services sector, and can also lead to unregulated companies or individuals being publicly reprimanded or banned from activity in the financial markets. A complaint could be made some time after a transaction. The extra rights conferred on minority shareholders may come as a surprise to a controlling majority, and the extra costs of acquisition could have an effect on potential sale price for the company.

Finally, there is that the dreaded Rule 9: anyone acquiring shares in a company subject to the Code which take him (with his associates) over 30% has to make a cash offer for all the remaining shares. That can come as an enormous shock!

Any unquoted company subject to the Code, and its major shareholders, should be aware of their Code obligations, and perhaps consider whether PLC status is worth it. Do not be caught out when a 29% shareholder buys another 2%, or when the quick and easy takeover deal gets bogged down in process and cost.

Vendor funding of business sales

a substitute for bank borrowing?

The market for company sales is slowly picking up after five long years of slow activity. A measure of confidence is back as the Euro crisis fades from the headlines. There is pent-up demand from sellers and buyers. Investors with cash are looking for a return, and equity markets are booming when other investments look unattractive. Companies are looking for a strategy that takes them beyond the defensive mindset of recession.
 

The major obstacle to mergers and acquisition activity remains the lack of funding from the banks. There is no likelihood of that changing, so parties to deals are looking for other ways to finance deals. Top of the list is vendor funding, by deferring payment of the price.
 

Vendor funding can be attractive. It allows deals to be done with little or no dependence on outside parties, and it may allow the seller to maximise the price through an earn-out arrangement, so that the price depends on the results achieved by the new owners. It can have tax attractions, by allowing the seller to spread his gain over several years.
 

Deferred deals do have some serious drawbacks, which are often not appreciated by the parties at the outset. They include:
 

• The seller can end up paying himself out of his own money. He gives away the upside (future growth) but retains all the risk. If the only source of payment is the earnings of the company, why sell? Why not keep the company and the earnings? 

• Credit risk: the deferred price is often unsecured, so that it will not get paid if either the buyer or the company goes bust. Sellers often ask for security, but often there is none of any value to be had: any assets in the company are likely to be charged to the bank, and any seller debt is likely to be postponed to the bank to the point of making the second charge almost valueless. On the other hand, if the company charges its assets to the seller it may find itself unable to borrow. There may be big, expensive arguments between the seller and the bank about priority of security and whether the seller is allowed o enforce his security.
• Sellers sometimes try to get the company or business back if the buyer does not pay, but that rarely works either. By the time the buyer defaults, the company is usually in a worthless state, and the right to recover it might well be unenforceable if an insolvency is involved.

• Buyers usually will not give personal guarantees. If they are not risking enough of their own money, they may have little incentive to make the business succeed and pay out the seller, especially if things star falling behind plan. The seller may find he gets his business back by default.

• The seller may be pressurised into renegotiating of the deal partway through, if there is a risk that he will not recover the full amount he is owed.

• Tax structuring is delicate: the seller does not want to pay tax on money he may not receive, but also wants to protect his entrepreneur’s relief.

• A variable price increases the risk of the deal to both parties. Each will be suspicious of the other’s involvement in the business as they try to manage conflicting priorities. Sellers will want some control to protect what is owed to them, and to keep the business largely unchanged so that its performance can be measured; buyers will want freedom to manage the business, including making major changes such as selling or merging.

 

With the risk increased all round, expert legal advice is essential. I have been handling corporate deals for 30 years with a specialisation in earn-outs and deferred deals. I know the practical realities as well as the legal theory. Call me to discuss your project.

 

Out of court

Problems with expert determination clauses

A very common clause used to establish the value of shares or other assets is defective, according to a recent Court of Appeal decision[1].

Contracts and company articles of association often refer share valuation issues to an independent expert accountant. Similar forms of clause are used to settle the accounts of a business, and in property documents to refer valuations or rent reviews to an independent surveyor. The usual form of clause says that an independent expert is to be agreed or, if not agreed, chosen by the President of the Institute.

In this case the court held that both parties have to agree not only to the selection of the expert, but also to all the terms of the appointment, even if he is chosen by the President. So by withholding agreement to the engagement letter, a party could bring the whole process to a halt. The court said the process should be “formal and precise” and, in litigation that had already lasted four years, would only help by declaring that the parties could not unreasonably withhold consent. This case potentially gives the whip hand to the truculent and unreasonable.

I have devised wording to avid the effects of this case and keep disputes out of court. Anyone who might need to rely on an independent expert clause should have it reviewed before a dispute arises.

Non-disclosure agreements (NDAs, also confidentiality agreements or secrecy agreements) are used in a number of commercial contexts, from deal negotiations to technology sharing. But are they worth the paper they are written on? It is sometimes said that the cost of enforcement makes them useless, at least to small businesses.

There are benefits in having an NDA even if you are not likely to sue on it. Foremost is deterrence, and making the other party more aware of the need to respect confidentiality. The biggest downside, in my view, is not cost but evidence, as it's very difficult to prove a breach and even harder to show loss justifying substantial damages. Injunctions aren't much good if the information has already been disclosed (though they can restrain other abuses). I often advise clients not to disclose their "crown jewels" information even if they have an NDA in place.

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[1] Cream Holdings Ltd v Davenport [2011] EWCA Civ 1287

This article in shorter form was originally written for the
Excello Law Limited newsletter and website

Putting the Djinn back in the bottle

Is an NDA worthwhile?

Non-disclosure agreements (NDAs, also confidentiality agreements or secrecy agreements) are used in a number of commercial contexts, from deal negotiations to technology sharing. But are they worth the paper they are written on? It is sometimes said that the cost of enforcement makes them useless, at least to small businesses.

There are benefits in having an NDA even if you are not likely to sue on it. Foremost is deterrence, and making the other party more aware of the need to respect confidentiality. The biggest downside, in my view, is not cost but evidence, as it's very difficult to prove a breach and even harder to show loss justifying substantial damages. Injunctions aren't much good if the information has already been disclosed (though they can restrain other abuses). I often advise clients not to disclose their "crown jewels" information even if they have an NDA in place.

I drafted one for a client only yesterday, though.

 

A new kind of deal for 2012?

Buying companies with cash at bank

You only find out who is swimming naked when the tide goes out, as Warren Buffett said. No-one wants to be vulnerable to further economic shocks. Since 2008, companies have been rebuilding their balance sheets. Many successful companies have built up significant cash reserves. They remain reluctant to invest in major expansion or in acquisitions.

Professionals in the M&A market have been waiting for confidence to return so that companies start to spend this cash on acquisitions. But the continuing Eurozone crisis means that no-one is buying, despite the many businesses available at bargain prices. Lack of demand the absence of bank funding for acquisitions keeps values low, even though many businesses are making good profits.

But will we see a new type if deal emerging in 2012: acquisitions funded partly with the target’s own cash?

Cash-rich companies make juicy low-risk acquisition targets for buyers who might be slightly more vulnerable, or for those looking to expand. Selling a company with its cash is highly tax-efficient for vendors. The legal rules banning financial assistance by the target have largely been abolished. If the price is deferred or settled in paper, or at a discount to the cash, the deal can become partly self-financing.

Wishing all bargain-hunters, keen sellers and market professionals a prosperous 2012.

What's it worth?

How to value property in shareholder disputes  

To value shares in a company, you often have to value the underlying assets, including properties. But how should a valuer do that? What assumptions should be used? What deductions should be made?

When shareholder makes a successful complaint about unfair prejudice in the way the company’s affairs are run, the court will usually order his shares to be bought out at a valuation, as if the unfair prejudice had not occurred. The court is not bound to follow Red Book valuation principles, but instead has "a very wide discretion to do what is considered fair and equitable in all the circumstances of the case, in order to put right and cure for the future the unfair prejudice which the petitioner has suffered at the hands of the other shareholders of the company."[1] In Shah v Shah [2] the court has given useful guidance on the valuation of underlying assets. The case may well have wider implications, affecting any situation in which a property is being valued when there is no actual intention that it should be sold.

The company’s business was loss-making, so the shares were to be valued by reference to net asset value, but it continued to trade, so there was no likelihood that its property would be sold. As well as deciding items disputed between the expert witnesses, Mr Justice Roth decided that:

1.       The values should not be reduced by the full corporation tax liability that would arise upon disposal. For a property very unlikely to be sold, 10% of the liability should be deducted; for one where there was no sale planned but it was possible, 20%.

2.       Costs of sale, and a contribution to the purchaser’s stamp duty, should not be allowed.

3.       Possible void periods and the weakness of tenant covenants should be reflected in the yield, not separately deducted from the estimated rental value.

The case would make an instructive read for any valuer giving expert advice in court proceedings, and for share valuers incorporating asset valuations into their valuations of companies.

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[1] Re Bird Precision Bellows Ltd [1986] 1 Ch 658

[2] [2011] EWHC 1902 (Ch)

Agreeing to differ?

Agreements to agree are unenforceable in England. That includes obligations to negotiate in good faith.

The logic is that (i) an agreement to agree in good faith is too uncertain to enforce, (ii) it is difficult to say whether termination of negotiations is brought about in good faith or not, and (iii) it is impossible to say whether good faith negotiations would have led to an agreement, and if so on what terms, so it is impossible to establish any loss flowing from breach of the obligation to negotiate.[1] To be a binding contract, there has to be an intention to create legal relations and sufficient certainty as to the essential terms.

A recent case [2] has affirmed these principles in relation to heads of terms for a deal: for an agreement to be enforceable, the parties must have reached sufficiently complete and certain agreement on all essential terms. The parties can leave out non-essential terms, but the absence of essential terms means there is no contract, and it cannot be saved by an obligation to negotiate.

A common tourist trap for English companies doing deals abroad is to assume that the same rule applies elsewhere. Our “subject to contract” concept may not be recognised. In many countries the opening of negotiations or the agreement of heads of terms may lead to obligations of good faith, and to possible liability for breaking off negotiations.

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[1] Walford v Miles [1992] 2 AC 128; Petromec v Petroleo Brasileiro [2005] EWCA Civ 891

[2] Barbudev v  Eurocom [2011] EWHC 1560

More stats – what do they mean?

Public deals up, private deals down

There were 34 public takeovers (listed and AIM) in 2010, compared to only 21 in 2009.[1] That may reflect the effect of surging stock markets, with companies looking to use the value of their paper to make acquisitions.

But if so, it hasn’t trickled down to unlisted companies. Q3 statistics show only 38 acquisitions of independent UK private companies over £1m.[2] That must be an under-estimate, but the level of activity is still paltry, and a decline on Q2.

Good news for everyone except insolvency practitioners: corporate insolvencies were down to 15,894 in 2010, a fall of 3,618 on 2010, with Q4 figures down 19% on Q4 2009 and down 6% on Q3.[3] Ever since the beginning of the recession people have been predicting a huge surge in insolvencies in three months’ time, but there is no evidence of it happening, or that it ever will. Corporates are limping out of the recession, slowly rebuilding their balance sheets, and lenders are waiting patiently for their customers to recover, taking the modest profits and leaving the equity holders waiting more patiently still. HMRC may be trying to claw back their time-to-pay arrangements, but there is little evidence that they are aggressively pushing companies under; now that they are ordinary unsecured creditors, they don’t get much out of a liquidation.

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[1] Source: PLC

[2] Source: ONS

[3] Source: PWC as reported in Insolvency News

How can I sell my business?

The state of the mergers and acquisitions market
for private companies in the UK

As we enter 2011, is there hope on the horizon for entrepreneurs looking for an exit?

Not much, it seems. The national statistics and the mood amongst corporate finance professionals show the same gloomy picture for M&A activity. Q2 2010 saw only 47 UK acquisitions of independent UK companies over £1m  – perhaps one for every four law firms specialising in this work!

There is little doubt that the UK corporate sector is recovering from recession. In many sectors, notably those manufacturing for export, modest profitability and stability has returned . But that is not fuelling acquisition activity, and it remains very hard to sell your business.

The key to the problem is bank lending. UK banks continue to be extremely cautious, and are generally not willing to support expansion through acquisition, nor to provide leverage for private equity investment. That destroys the investment model for private equity – without a high level of debt, the investor cannot make the equity returns needed. Although the banks say their approval levels are at record highs, bank lending is focused on supporting existing customers and avoiding driving businesses under. The UK clearers have also had to take up lot of capacity from foreign banks withdrawing from the market, notably the Irish banks.

Almost all buyers need funding, and there are still no obvious alternatives to the banks. As most of the world has the same problems, there has been no influx of foreign lenders. In the old days the fall of sterling might have attracted them, but not now. Nor are foreign buyers flocking to the UK. Cash buyers should be able to pick up bargains, but those with cash are hoarding it, perhaps concerned about whether they will be able to raise finance for their own businesses over the next few years.

In the past, rising stock markets have led to booms in acquisitions by listed companies, but that isn’t happening either. The record sums being raised are going to bolster corporate balance sheets and reduce dependence on bank funding. There are some signs of personal or corporate cash balances being used to provide debt funding to corporates, cutting out the banks as middlemen, but not on the scale needed to make a difference.

Uncertainty and lack of business confidence make potential buyers or private lenders just as wary as the banks’ credit committees, so prices are driven down and even good businesses struggle to convince investors of their prospects. The uncertainty flowing from the public spending cuts is particularly destabilising.

In the SME market there is now a backlog of entrepreneurs looking to exit or retire, and few prospects for realising value. Most deals we are seeing are self-funded partial exits, with vendors handing over to a new generation of management for a deferred price paid out of the company’s cashflow. Inevitably that limits the price the seller can expect for his lifetime’s work, and leaves him with much of the risk while sacrificing the upside. The beneficiaries should be the next generation of management, who can gain ownership with little personal risk and good long-term prospects. We keep hoping for an improvement, driven by competition from outside the UK banks, but it isn’t here yet.

So for the time being there are bargains to be had, but few buyers with the resources to pick them up.

[1] Office for National Statistics Statistical Bulletin: Mergers and acquisitions involving UK companies 2nd Quarter 2010

[2] Eg CBI press release 18 November 2010 Demand improves for UK-made goods