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What’s the true value of a lock in and a lock out?
This article will look at some of the issues surrounding the valuation of a business. In these difficult economic times, it has never been more important to consider values. If the Lockdown is going to lead to an increase in divorce and business insolvencies, as is being mooted in certain sectors of the Press, then now is the time to think about value and who really owns what.
It is usually relatively easy for an experienced qualified valuer to value a business. That valuation will be based on a multiple of the net profits generated from the business. The problem we are looking at in this article arises when the business is run by a limited company rather than a sole trader or partnership.
Once a value has been arrived at by a valuer, that figure is then distilled down with net assets deducted, and the resultant balance is attributed to goodwill. There may be more complicated circumstances that readers will have come across but this article is focusing on the underlying approach to valuations in general.
The traditional approach employed by accountants and valuers when valuing a business carried on in a Limited Company is to state that the ‘goodwill’ belongs to the Company but is that always the case?
On virtually all business sales (rather than a sale of shares) the directors are asked to enter into arrangements to remain on as consultants with the purchaser for a set period (we are calling this the lock in). They would also be asked to enter into restrictive covenants restricting opening a competing business within a certain radius and for a number of years all to preserve the goodwill that is being bought (and this is what we are calling the lock out).
These arrangements are personal arrangements between the purchaser and the directors.
The purchaser is not interested in restrictions with the legal entity (the selling company) as the directors are the ones with all the contacts and know-how!
The individuals could easily set up a competing business very quickly. This must mean that the directors have a value – the questions is how much?
The easiest way to do this is to turn matters around and ask the purchaser how much they would pay for the business if the directors did not agree to remain as a consultant or to agree to restrictive covenants. Not very much would be the answer in many cases. In those cases, our view is that part of the value should be attributed to the directors and the balance attributable to the Company. You may disagree with this point and we know that HMRC take many differing positions on this matter.
A correct apportionment of the business value is very important upon sale of a business by a company. If the company is apportioned all of the value then corporation tax will be payable upon the profit generated predominantly on the goodwill element. The shareholders would then either be faced with extracting the money by way of dividend after payment of the corporation tax, or a solvent liquidation being mindful of the anti phoenixing rules.
If the part of the value is attributed to the directors then Entrepreneurs Relief may well be available leaving them only a 10% tax bill (on up to £1 million of value as the new lifetime limit) to pay with no corporation tax being born first. The company would still have to pay corporation tax on the profit made on its share of the value.
Business Sale or Share Sale?
Up until 2015, the position for a buyer of a business was that they would want to purchase the business only and not the shares as they would be able to write down the whole of the goodwill acquired against future profits. From a seller’s point of view a share sale was preferable as this would mean that no corporation tax was payable on sale and entrepreneurs’ relief was available on many occasions such that only 10% was payable on sale.
Buyers also preferred just purchasing the business as they would not inherit any historical position on tax and have to rely upon tax warranties and other indemnities from the seller. If a share sale did proceed the sale price was adjusted to reflect the fact that the goodwill could not be written down.
The Finance Act 2019 did not made changes to the treatment of relevant assets acquired by a buyer on purchase of a business:
“relevant asset” means—
(a) goodwill in a business or part of a business,
(b) an intangible fixed asset that consists of information which relates to customers or potential customers of a business or part of a business,
(c) an intangible fixed asset that consists of a relationship (whether contractual or not) between a person carrying on a business and one or more customers of that business or part of that business,
(d) an unregistered trademark or other sign used in the course of a business or part of a business, or
(e) a licence or other right in respect of an asset within any of paragraphs (a) to (d).
If a company acquires or creates a relevant asset on or after 1 April 2019 the company is to be treated as having made an election under section 730 of the Capital Taxes Act 2009 to write down the cost of the asset for tax purposes at a fixed rate of 6.5%.
This means that it is still better for a buyer to purchase the assets of a business rather than the shares, even if the tax relief is given over a number of years instead of in the first year as was the case before 2015.
Suppose a buyer acquired a business where there was a ‘Commitment Licence’ in place. They would pay the director’s share of the goodwill direct to the director and he would in most circumstances be able to claim entrepreneur’s relief and pay just 10% tax. In the hands of the buyer the cost would fall under item (e) above on the basis that the licence covered item (c) above.
How do we get value attributed to the directors?
Each case is different, and it is not possible to attribute a value to directors in all cases. Also, all the value may already in fact belong to the directors. We also need to check whether there are any restrictive covenants in existence which may be contained in the articles of association for the company, in the shareholders’ agreement or employment contract. Any or all of which may have an impact on the value that can be attributed to the directors.
ETC Tax can check whether a business type can attribute value to directors almost immediately but checking any documentation will involve some time on research. We would then obtain a quote from one of our expert valuers based on the last three year’s accounts for the company (full not abbreviated) which you would need to provide. We would then provide you with a fee estimate and you could then decide to proceed.
Once the valuation had been provided we would get a legal consultant to prepare a Commitment Licence (on instructions from the Company) under which the director would commit to remain as a consultant for a period after sale of the business and also to enter into restrictive covenants after completion.
The director would also licence their know how to the Company. The Company then has some protection going forward. In return for this protection the Company is obliged to pay a licence fee for their commitment which would be based on the value attributed to the directors by the valuer and would normally be 4 or 5% return. Any licence fee received would be treated as other taxable income and not subject to NIC.
Each director would need to have a commitment licence and the value would be attributed amongst the directors by the valuer. If there is a company with more than one director then it is more important to get these arrangements in place as one director might refuse to sign covenants which could scupper a future sale.
The fee payable to the director under the commitment licence would be tax deductible for corporation tax purposes but would not amount to the payment of a dividend nor would it be received by reason of employment so there would be no NI to pay by either the company or the director.
What does it all cost?
Valuations start at £3,000 plus VAT. 50% of the fee would need to be paid on engagement and the balance when the valuer is ready to deliver his report.
ETC Tax fees for advising on the transaction and for arranging the valuation and organising the preparation of a Commitment Licence is £4,000 plus VAT. Each additional licence costs £500 plus VAT where there is more than one director. If changes are needed to the articles or the shareholders’ agreement then a quote will be given by our consultants for carrying out this exercise.
50% of the fees will need to be paid on engagement. If upon review of the articles or shareholders’ agreement it is assessed that there is not any possibility of attributing value to the directors then half the monies paid to ETC Tax for their advice on engagement would be refunded. The balance of the fees including third party consultant’s fees would be payable when the documentation has been prepared ready for delivery to you.
If you would like to talk to ETC Tax about Commitment License and the valuation of your business for any specific purpose then please get in contact in the usual way. We are here and ready to advise you.