Management Buy Outs: Problems below the Bottom Line
This article takes a look at the items below the balance sheet ‘bottom line’, i.e. share capital and reserves in the context of share buy backs.
In the UK, the concept of having to have a minimal share capital so that there is a ‘pot’ available to creditors before the shareholders get to take it back has been gradually diluted so that many directors are unaware that share capital is not just another asset that can be freely dealt with to suit commercial circumstances. This is important when it comes to buying back share capital where the consequences of getting it wrong mean that the share buy back is ineffective.
There are 2 particular rules that cause problems:
- On a share buy back the consideration must be paid on purchase. Normally this means paid in cash in full by transfer of funds. This causes problems if the parties want to pay by instalments over a period of time. There are solutions, one being to pay the whole of the purchase price and then lend back the element that would otherwise have been the deferred part of the purchase price payments but for this to work the cash to make the payment in full must be available and it must actually be paid and lent back (it cannot just be a series of accounting entries);
- There must be profits available for the payment. This rule is the corollary of the idea that the share capital of a company represents the shareholders personal commitment and therefore distributable profits are to be used first in funding any buy back before (but after protecting creditor’s interests as described below) any capital can be used. This rule means that any contract to buy back in the future must be contingent on there being profits available at the time of that future buy back. In effect this means that there is no binding contractual commitment to buy or sell at the time the contract is made.
Buy back out of capital is a potential solution for private companies where shareholders are in support (75% resolution) but it involves the directors making a solvency statement supported by an auditor’s report (and if there are no auditors they will have to be appointed), an advertisement in the London Gazette and a national newspaper inviting creditors to apply to court to raise an objection to the buy back over a 5 week window. For obvious reasons private company directors want to know about other solutions.
One of these is available where there is a significant amount of paid-up share capital in the company. This can be used as part of a share capital reduction using the (relatively less onerous) requirements associated with that step. These involve a directors solvency statement and a shareholders 75% resolution but not the advertising to creditors associated with the buy back out of capital route.
In a share capital reduction, the terms of repayment can be tailor made to suit the particular requirements and therefore for instance the company can agree to repay capital over a period of time and unlike the buy back route, the commitment to pay takes effect as a debt.
In many cases, and in any case where there is not a significant paid-up capital, a preferred solution is to introduce a purpose formed new company (newco) to effect the buyout. The newco can agree to buy all the shares in the ‘target’ company with the exiting shareholder(s) receiving cash, often part or wholly funded by the target company and the continuing shareholders receiving shares in the newco. The buyout terms can be adjusted as required to include deferred payments and contingent payments, interest and security for payment and once agreed they will be contractually binding.
An often unwelcome effect is to createthe creation of a two company group structure but that can be addressed in the future by either transferring the target company business to the newco holding company or by a demerger of the target company once all deferred payments have been completed.
Returning share capital to shareholders is restricted and must be done in compliance with the technicalities of company law, however there are solutions available some of which require a bit of lateral thinking.
This is an area where tax considerations play an important part in the solution and specialist tax advice should be sought.
Specialist legal advice
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