Posted on 25 February 2016
Many people don’t like change. At best it requires hard work and commitment and, at worst, it is to some a frightening chore rather than something to be enjoyed and embraced. I suppose it’s the destabilising effect that most people don’t enjoy and, when it comes to a shareholder’s retirement, the decision and its impacts on life-long routines and wealth can be particularly significant.
Many shareholders beginning to contemplate retirement assume the decision to retire is “binary” but, fortunately, in reality that isn’t the case and there are deal structuring mechanisms that allow the retiree to withdraw gradually, both practically and financially.
There are a number of reasons why gradual exit may suit a retiring shareholder, such as:
the desire not to shift from working “flat out” to full retirement overnight, preferring to adjust at a more controlled pace to full retirement;
turbulent world events, threats to the sustainability of the current benign capital gains tax regime and economic stability may mean that it’s attractive to de-risk by “ring-fencing” a portion of the wealth accumulated in the business, merely running a part of the investment forward – effectively hedging your bets; or
not wishing to exit just as years of hard work are about to start delivering higher profit and value - a gradual exit providing an opportunity to share in some of the future upside.
Equally, there may be practical reasons connected with the business that mean a phased exit is a necessity; these include:
the successors, perhaps the management team, not yet having quite the required skills, knowledge and experience to run the business – the acquirer, or more likely their funder, may demand that the retiree has some continued risk exposure to the company – this gives comfort as the funder knows that if things go wrong the seller has too much to lose and will re-enter the company to sort things out; or
where there is simply insufficient funding available to acquire all the exiting shareholders’ equity at one go.
In these circumstances, the sale of a retiree’s shares on a phased basis can provide the solution.
Usually, the seller will sell enough equity to hand over voting control to the buyer but will retain a minority stake in the business. To ensure this partial sale doesn’t leave either party (buyer or seller) with an unattractively small stake in the longer term, the terms of valuation and transfer of the retiree’s retained shares is negotiated at the time of the initial sale and are enshrined in an option agreement. This option usually allows either the seller or the buyer to “put” or “call” the retained equity to be bought or sold by the other party in the future. In this way, both parties have certainty that all of the retiree’s shares will ultimately change hands so as to complete the intended full retirement and full acquisition.
The option agreement specifies the times or events when the putting or calling of shares is allowed and, usually, the share valuation formula captures any upside in value of the business since the initial transaction – this value uplift being enjoyed by the seller when their retained shares are finally realised – making this a very attractive sale structure where future value gain is anticipated.
In addition, the seller’s loss of control of the business on the initial sale can be mitigated through the Shareholders agreement that will need to be drafted on the first sale; this regulates the relationship and powers of all of the shareholders and will include some protection rights for the minority shareholding retiree – often in the form of a requirement for a majority vote on certain key business decisions and even unanimity on crucial concerns. Unanimity effectively provides the retiree with a right of veto over really important matters that could affect the value of the retiree’s shares, or the timing of their purchase by the acquirer. Examples include the sale of a material part of the business, or the acquisition of a subsidiary, or the curtailment of a core activity.
Shareholders contemplating exit, whether together or individually, are encouraged to seek expert advice from Smith Cooper to ascertain how a deal structured to meet their specific circumstances could provide them the best of both worlds – partial retirement and some ring-fencing of wealth today, but also potential value gain and the certainty of final exit through the option agreement in the future. You might say, they can “have their cake and eat it”.