Like many corporate finance advisory firms, the HMT team breathed a sigh of relief on 30th October when capital gains tax on the sale of a business was raised much more modestly than had been feared. The higher rate increased from 20% to 24% rather than a rate of up to 45% which was threatened with the purpose of aligning capital gains rates with income tax rates.
In most cases, would be vendors and investors seem to have shrugged their shoulders at this increase and whether or not the Government’s PR strategy was intentional here, there is currently a positive sentiment of “Phew ! ….. it could have been much worse” However, there continues to be a risk that future budgets will incrementally move capital gains tax rates closer to income tax rates. The tax burden on the sale of a business will therefore gradually increase beyond the impact of the measures of scaling back the benefits of Entrepreneurs Relief from the recent budget.
Despite strong and growing negative public sentiment towards the recent budget, there is probably more to come in terms of tax increases and we now know that “working people” is a much narrower definition than we might have imagined pre-election. However, looking on the bright side, the Government has demonstrated some concern for the competitiveness of the UK in business tax terms and has, so far at least, ensured that comparatively the business tax burden in the UK remains in line with other G7 countries.
In addition to the risk of an increasing capital gains tax burden, there are other issues would-be vendors need to focus on to ensure that they understand and reflect changes in the budget as they contemplate an exit.
The changes to national minimum wage and the increase in the rate of Employers NI will have a direct impact on the forecast EBITDA for almost all businesses. Raising the salary level for the lowest paid members of staff will, typically, have a knock on effect on salary levels throughout an organisation and we have already started to see this as clients respond to the budget changes. The degree of profit impact this will have will obviously vary with the scale of payroll and perhaps will lead to different decisions around employment vs contracting and offshoring vs recruiting UK teams. The use of technology to drive efficiencies and reduce staffing costs is likely to accelerate, particularly as AI starts to yield genuine use cases.
As the Government strikes a more interventionist note than we have been used to over recent years, it will be interesting to see whether a focus on particular sectors of the economy will have a knock on effect on investor and acquirer appetite. The narrative and energy around the property and construction sector has already seen a discernible positive shift and with the Chancellor’s focus on specific aspects of financial services in this month’s Mansion House speech, we might also see increased interest in aspects of sustainable finance, insurance and fintech (already a “hot” sector).
In the longer term it will be interesting to see whether the Government’s enthusiasm for harnessing accumulated pension pots to support investment in infrastructure, but also in private equity funds, will yield any kind of multiplier effect for the mid-market entrepreneur. The plans so far feel more like sound-bites than strategies and the detail behind the combining of local government pension funds to create a national investment fund suggests that the plans may encounter challenges en route.
The anticipated attack on private equity carried interests has so far been modest, and while further efforts to ensure that income is not able to be taxed as capital are clearly on their way, it is also clear that this will be subject to consultation and there is a wish not to impact the overall appetite for private equity investment while addressing a potential unfairness in the current system. It does not seem likely that for mid market businesses seeking private equity investment in the medium term, this is likely to have any material effect.
Finally, it may be that we are about to see a new corporate finance opportunity in the capital markets arena. Over recent years investors and entrepreneurs have typically ceased to see UK capital markets as a feasible exit route and the path to an IPO has been fraught with uncertainty (and cost). It is to be hoped that the planned PISCES market and other reforms to capital markets which are, as yet, a gleam in the Chancellors eye, might increase the options for UK entrepreneurs as they think about an exit.
In the short term, whilst the direction of travel has been set it seems to be business as usual, albeit with some slightly depressed profits and continued concerns about the balance between the cost of employment and the cost of living. In the medium term there is much that could go wrong with the Government’s strategy, not least the impact of global geopolitics, but there will always be opportunities for the brave and clever and as corporate financiers we look forward to supporting those entrepreneurs to build and realise wealth whatever the backdrop.
Like many corporate finance advisory firms, the HMT team breathed a sigh of relief on 30th October when capital gains tax on the sale of a business was raised much more modestly than had been feared. The higher rate increased from 20% to 24% rather than a rate of up to 45% which was threatened with the purpose of aligning capital gains rates with income tax rates.
In most cases, would be vendors and investors seem to have shrugged their shoulders at this increase and whether or not the Government’s PR strategy was intentional here, there is currently a positive sentiment of “Phew ! ….. it could have been much worse” However, there continues to be a risk that future budgets will incrementally move capital gains tax rates closer to income tax rates. The tax burden on the sale of a business will therefore gradually increase beyond the impact of the measures of scaling back the benefits of Entrepreneurs Relief from the recent budget.
Despite strong and growing negative public sentiment towards the recent budget, there is probably more to come in terms of tax increases and we now know that “working people” is a much narrower definition than we might have imagined pre-election. However, looking on the bright side, the Government has demonstrated some concern for the competitiveness of the UK in business tax terms and has, so far at least, ensured that comparatively the business tax burden in the UK remains in line with other G7 countries.
In addition to the risk of an increasing capital gains tax burden, there are other issues would-be vendors need to focus on to ensure that they understand and reflect changes in the budget as they contemplate an exit.
The changes to national minimum wage and the increase in the rate of Employers NI will have a direct impact on the forecast EBITDA for almost all businesses. Raising the salary level for the lowest paid members of staff will, typically, have a knock on effect on salary levels throughout an organisation and we have already started to see this as clients respond to the budget changes. The degree of profit impact this will have will obviously vary with the scale of payroll and perhaps will lead to different decisions around employment vs contracting and offshoring vs recruiting UK teams. The use of technology to drive efficiencies and reduce staffing costs is likely to accelerate, particularly as AI starts to yield genuine use cases.
As the Government strikes a more interventionist note than we have been used to over recent years, it will be interesting to see whether a focus on particular sectors of the economy will have a knock on effect on investor and acquirer appetite. The narrative and energy around the property and construction sector has already seen a discernible positive shift and with the Chancellor’s focus on specific aspects of financial services in this month’s Mansion House speech, we might also see increased interest in aspects of sustainable finance, insurance and fintech (already a “hot” sector).
In the longer term it will be interesting to see whether the Government’s enthusiasm for harnessing accumulated pension pots to support investment in infrastructure, but also in private equity funds, will yield any kind of multiplier effect for the mid-market entrepreneur. The plans so far feel more like sound-bites than strategies and the detail behind the combining of local government pension funds to create a national investment fund suggests that the plans may encounter challenges en route.
The anticipated attack on private equity carried interests has so far been modest, and while further efforts to ensure that income is not able to be taxed as capital are clearly on their way, it is also clear that this will be subject to consultation and there is a wish not to impact the overall appetite for private equity investment while addressing a potential unfairness in the current system. It does not seem likely that for mid market businesses seeking private equity investment in the medium term, this is likely to have any material effect.
Finally, it may be that we are about to see a new corporate finance opportunity in the capital markets arena. Over recent years investors and entrepreneurs have typically ceased to see UK capital markets as a feasible exit route and the path to an IPO has been fraught with uncertainty (and cost). It is to be hoped that the planned PISCES market and other reforms to capital markets which are, as yet, a gleam in the Chancellors eye, might increase the options for UK entrepreneurs as they think about an exit.
In the short term, whilst the direction of travel has been set it seems to be business as usual, albeit with some slightly depressed profits and continued concerns about the balance between the cost of employment and the cost of living. In the medium term there is much that could go wrong with the Government’s strategy, not least the impact of global geopolitics, but there will always be opportunities for the brave and clever and as corporate financiers we look forward to supporting those entrepreneurs to build and realise wealth whatever the backdrop.
Most of the focus in a transaction process is on maximising the value of the business on an Enterprise Value basis. This is usually arrived at by multiplying a profit number (often adjusted EBITDA) by a multiple. It gives a valuation which is comparable from business to business because it takes no account of individual funding structures or free cash balances.
However, the Equity Value (the amount actually due to the shareholders) has to be adjusted for those factors and the calculations around this adjustment can be a matter for great debate and frequently for disagreement, since there is room in it for interpretation and subjectivity.
Anyone who is considering selling their business should be aware of the elements of this calculation and should think about them in context of their own circumstances. Only with a realistic approach to negotiating the debt free/cash free adjustment will a deal happen. It is also an area where careful planning can improve the vendors’ overall outcome.
The principles underpinning the debt free/cash free adjustment are that an acquirer should inherit a business free of structural debt and with sufficient cash (only) to cope with the normal working capital cycle.
Debt to be paid for by the sellers will usually cover bank borrowing (including overdrafts, invoice discounting and other asset funding facilities), shareholder or director loans, intercompany balances, trade loan facilities, Hire Purchase and finance leases. It will also include a deduction relating to corporation tax due on profits to the date of completion
Depending on the circumstances, debt might also include deferred income (where cash has been received in advance and the business has an obligation to provide future products or services), lease dilapidations, deferred tax, accrued bonuses and any fees due for breaking debt facilities.
In order to calculate the amount of cash that the vendor needs to leave in the business to cover normalised working capital requirements, buyers are likely to look back at least a year to determine the scale of both the highest seasonal balance and intra-month peaks. They will not want to take a chance that they will have to invest further to support normal trading and are likely also to look ahead at short term forecast requirements to ensure sufficient cash headroom. Using this analysis they will set a target level of working capital (which normally includes trade creditors, trade debtors and stock) and there will be an adjustment to top this up with cash if the working capital at completion is lower than it needs to be.
Depending on how much cash is in the business, the agreed debt deduction and the agreed working capital adjustment might be taken either as a reduction in the free cash balance to be added to the value of the deal or, if there is insufficient cash in the business to cover it, there will be a deduction from the price.
So far, so straight forward, you might think. Except that there is often a great deal of discussion to be had to get to an agreed set of completion adjustments. For example:
Does Deferred income still represent a debt if there is no additional cost to be incurred by the company in delivering the product or service concerned ?
Is it reasonable to deduct deferred tax if there is no realistic prospect of the liability needing to be paid ?
What about lease or HP debts in asset heavy businesses (such as leasing companies) where the debt is closely associated with assets which are not separately valued in the deal ?
How to fairly quantify dilapidations if a business is part way through an arms length lease ?
What if trading patterns have changed/are changing and historic peaks are no indication of future ones ?
Should a vendor be allowed to include a potential R&D tax credit in the calculation of net corporation tax liabilities ?
I could go on. When all of these individual discussions and negotiations are set alongside each other the gap between a buyer and seller’s interpretation of a fair debt free/cash free adjustment can be sizeable without either of them being “wrong”.
So what can vendors do to ensure that the debt free/cash free adjustment doesn’t come as a sting in the tail at the end of a deal?
First, they can make sure they understand the elements in the calculation and the best case/worst case interpretation of their figures
Second, They can ensure they understand the principle of a buyer not having to inject cash to trade the business normally post deal and manage their business accordingly. To the extent that deferred revenue (for example) is not matched by future liabilities they should endeavour to track and evidence this over time
Third, they can manage their working capital efficiently in the years leading up to a transaction. A short term focus on debtor collection or a clumsy attempt to string out creditors will not work to minimise the requirement but a sustained effort at efficiency over a year or more should have a positive impact on the cash they ultimately get to keep. Spreading regular payments across the month to minimise an intra month peak might be worth considering.
Fourth, if there are mitigating factors in the tax calculation these should be explored and evidence collected to support the arguments, particularly in context of a changing regime or a potential move from annual to quarterly payments.
In short, this should be a focus for would-be vendors in the same way that maximising EBITDA and optimising a multiple tends to be. Starting from a position of knowledge and evidence and fielding compelling arguments with the relevant data is likely to result in the best possible outcome.
At the very least vendors should be aware of this potential sting in the tail and the debate that surrounds it …..
Most of the focus in a transaction process is on maximising the value of the business on an Enterprise Value basis. This is usually arrived at by multiplying a profit number (often adjusted EBITDA) by a multiple. It gives a valuation which is comparable from business to business because it takes no account of individual funding structures or free cash balances.
However, the Equity Value (the amount actually due to the shareholders) has to be adjusted for those factors and the calculations around this adjustment can be a matter for great debate and frequently for disagreement, since there is room in it for interpretation and subjectivity.
Anyone who is considering selling their business should be aware of the elements of this calculation and should think about them in context of their own circumstances. Only with a realistic approach to negotiating the debt free/cash free adjustment will a deal happen. It is also an area where careful planning can improve the vendors’ overall outcome.
The principles underpinning the debt free/cash free adjustment are that an acquirer should inherit a business free of structural debt and with sufficient cash (only) to cope with the normal working capital cycle.
Debt to be paid for by the sellers will usually cover bank borrowing (including overdrafts, invoice discounting and other asset funding facilities), shareholder or director loans, intercompany balances, trade loan facilities, Hire Purchase and finance leases. It will also include a deduction relating to corporation tax due on profits to the date of completion
Depending on the circumstances, debt might also include deferred income (where cash has been received in advance and the business has an obligation to provide future products or services), lease dilapidations, deferred tax, accrued bonuses and any fees due for breaking debt facilities.
In order to calculate the amount of cash that the vendor needs to leave in the business to cover normalised working capital requirements, buyers are likely to look back at least a year to determine the scale of both the highest seasonal balance and intra-month peaks. They will not want to take a chance that they will have to invest further to support normal trading and are likely also to look ahead at short term forecast requirements to ensure sufficient cash headroom. Using this analysis they will set a target level of working capital (which normally includes trade creditors, trade debtors and stock) and there will be an adjustment to top this up with cash if the working capital at completion is lower than it needs to be.
Depending on how much cash is in the business, the agreed debt deduction and the agreed working capital adjustment might be taken either as a reduction in the free cash balance to be added to the value of the deal or, if there is insufficient cash in the business to cover it, there will be a deduction from the price.
So far, so straight forward, you might think. Except that there is often a great deal of discussion to be had to get to an agreed set of completion adjustments. For example:
Does Deferred income still represent a debt if there is no additional cost to be incurred by the company in delivering the product or service concerned ?
Is it reasonable to deduct deferred tax if there is no realistic prospect of the liability needing to be paid ?
What about lease or HP debts in asset heavy businesses (such as leasing companies) where the debt is closely associated with assets which are not separately valued in the deal ?
How to fairly quantify dilapidations if a business is part way through an arms length lease ?
What if trading patterns have changed/are changing and historic peaks are no indication of future ones ?
Should a vendor be allowed to include a potential R&D tax credit in the calculation of net corporation tax liabilities ?
I could go on. When all of these individual discussions and negotiations are set alongside each other the gap between a buyer and seller’s interpretation of a fair debt free/cash free adjustment can be sizeable without either of them being “wrong”.
So what can vendors do to ensure that the debt free/cash free adjustment doesn’t come as a sting in the tail at the end of a deal?
First, they can make sure they understand the elements in the calculation and the best case/worst case interpretation of their figures
Second, They can ensure they understand the principle of a buyer not having to inject cash to trade the business normally post deal and manage their business accordingly. To the extent that deferred revenue (for example) is not matched by future liabilities they should endeavour to track and evidence this over time
Third, they can manage their working capital efficiently in the years leading up to a transaction. A short term focus on debtor collection or a clumsy attempt to string out creditors will not work to minimise the requirement but a sustained effort at efficiency over a year or more should have a positive impact on the cash they ultimately get to keep. Spreading regular payments across the month to minimise an intra month peak might be worth considering.
Fourth, if there are mitigating factors in the tax calculation these should be explored and evidence collected to support the arguments, particularly in context of a changing regime or a potential move from annual to quarterly payments.
In short, this should be a focus for would-be vendors in the same way that maximising EBITDA and optimising a multiple tends to be. Starting from a position of knowledge and evidence and fielding compelling arguments with the relevant data is likely to result in the best possible outcome.
At the very least vendors should be aware of this potential sting in the tail and the debate that surrounds it …..
