The trauma of SME succession

For family-owned businesses, handing over to the next generation can be a complex process involving many aspects - not just legal, tax and funding technicalities, but personal issues too. Sarah Perrin explains

Consider a family-owned leisure business based in the south of England, turning over around £25m a year and generating profits of around £650,000. (1) The business has three key parts: a chain of nightclubs, a small UK chain of boutique hotels and a specialist holiday operator. The business had already been passed to the second generation: brothers Bob and Jack James. Both are in their mid to late 40s, with teenage children who may become involved in the business in future.

Bob and Jack have already experienced the problems that can arise as a result of complex ownership structures in family businesses. They recently had to buy out a cousin, and the matter became acrimonious and ended up in court. The question was, should Bob and Jack take action now to try to prevent problems between themselves - and potentially their children - in future?

“The first challenge was to get the two brothers to come to the table and accept they had a potential problem brewing,” says Howard Hackney, head of family business at Grant Thornton. “There was also a sister, who acted as company secretary but didn’t have a shareholding, who kept telling them they should do something; but it still took six months to get them to realise they needed to look at this.” One of the reasons action was advisable was because Bob and Jack found it difficult to work together. They had different management styles, Bob being the louder of the two and prone to ignoring his brother’s opinion.

Hackney’s suggested solution to the brothers was that the separate business operations be split between them. Bob would take ownership of the nightclub and hotel operations, and Jack the specialist tour operator. This would not only allow each of them to run their operations in their own way, but it would also make things easier in future should they want to pass their respective businesses on to their own children. However, they could still draw on each other’s commercial acumen, as Bob remained a director of Jack’s company and vice versa. The proposed split meant Bob would need to buy Jack out, as his combined operations had a higher value than Jack’s.

Establishing value

The next step, once the brothers accepted they needed to take action, was to establish the company’s value. “One brother thought it was worth around £2m, and the other thought about £4m,” Hackney says. “In the end they settled on a compromise figure of £3m.” The role of the father, no longer active in the business but whose opinion both brothers respected, was helpful, as he gave his own valuation. “The brothers saw the father as an independent sounding board, and so his valuation provided a ballpark figure to get the discussions going.”

The next issue was to raise the finance Bob needed to buy Jack out. “We had to go to banks and hire purchase companies to find the best package,” explains Hackney. “This involved putting the business case together and demonstrating that Bob’s part of the business was profitable on an ongoing basis.”

Inevitably, there were also a number of technical tax issues to be addressed. There are two technical ways to achieve a business buy-out or reorganisation of this kind, known as a share buy-in or a reconstruction. “Both have clearance and application procedures,” Hackney says. “In this case, there was insufficient retained profits in the business to go down the buy-in route. Therefore the reconstruction, which is more costly, was the only option. We then had to get confirmation from the Revenue that it [the reconstruction] was not designed to avoid tax.”

The advisers also needed to determine whether there was any problem to do with financial assistance. Under the Companies Act, if a company uses its own assets to buy itself, that is considered to be financial assistance and illegal. “The whole deal can be voided at any later stage,” Hackney explains. “To get round that, you have to go through what’s called a whitewash procedure. The directors put together forecasts and sign a statement to say the business can continue trading for the next 12 months.” The company’s auditors must also give an opinion saying this statement is fair and reasonable. “That can add a significant extra cost, perhaps £10,000 or so, just to get over a Companies Act technicality, and one which will be removed in the next Companies Act,” Hackney notes. “Fortunately, in this case, the lawyers came to the decision that it was not financial assistance, so no whitewash report was required.”

From the time the brothers agreed to sit down together and discuss their problems, achieving the business reorganisation took around 12 months to complete. “It took a significant amount of work, and required the brothers to face some personal issues, but the end result puts both in a better position,” Hackney says. “They have faced up to their succession issues and will be better positioned to pass their businesses on to the next generation when the time comes.”

Reference
(1) Some details have been changed, but the key issues are real.

Sarah Perrin is an accountant and writer.