Business Sale Report Blog - News and views on buying and selling businesses

There exists a glaring omission in the new Capital Gains Tax rules - they did not address earn-outs. Thousands of entrepreneurs who sold their businesses in 2005/06 have until 31st January to sort out a CGT tax nightmare for which HMRC issued no guidelines whatsoever.

This affected those people who are receiving part of their payment for their business in shares or loan notes as an earn-out (deferred payment). They had to tell HMRC before the end of January whether they were paying the CGT immediately or deferring it until they are able to cash the shares/loan notes in. The consequences of making a wrong decision can be enormous.

Thanks to PKF (UK), who provided the following illustration of this problem:

• A qualifying business was sold in 2005/06, half for cash and half for an earn-out right in the form of loan notes redeemable in 2009.
• The owner had to pay 10% CGT on the cash part by 31 January 2007 but 18% on the other half of the proceeds received when a loan note matures after 5 April 2008.
• The owner can elect, by 31 January 2008, to treat the loan note proceeds as received in 2005/06 to get the 10% tax rate but will have to pay the tax now, long before he gets the final cash (and pay interest because the tax should have already been paid!).
• If the owner does make the election it cannot (currently) be revoked at a later date - for example, when the position on the new Entrepreneurs’ relief is known.

In a further twist, the Institute of Chartered Accountants of Scotland have claimed that the government’s latest CGT changes could have broken European law.

The EU law states that changes to tax legislation must provide a reasonable time period to claim the money. From the date of Alistair Darling’s announcement, business owners had less than ten weeks to arrange their assets or even sell their businesses to protect some of the indexation relief accruing because of inflation.

Previous tax decisions made under European law have indicated that even by having a transitional period of three months would be insufficient. Icas called for the chancellor to defer implementation of the legislation for two years to give businesses enough time to rearrange their affairs.

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Well, what a surprise. Several hours after the chancellor announced the changes to the capital gains tax regime yesterday, a few very nasty details emerged.

The first startling discovery was that ‘entrepreneurs’ relief’ is in fact a misnomer. The 10% CGT rate turned out to be a lifetime allowance, an effective kick in the teeth for all serial entrepreneurs for whom a one-off £80,000 tax concession will not make a huge difference. They are more concerned about the 80% tax hike they will have to wear for all their hard work for the end of their days.

Secondly, this new two-tier system will require a whole raft of new anti tax avoidance legislation to be drawn up - so much for the supposed objectives of creating a simple system.

Thirdly, the government is striking out one of the chief incentives for retention of key staff. Any employee with less than 5% of the company they work for is ineligible for the Entrepreneurs’ Relief. Not many can lay claim to that level of stake-holding. The vast majority of employee shareholders will therefore face a near doubling of tax rates on share gains.

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Alistair Darling today issued a major concession to the forthcoming capital gains tax changes due to come into effect on 6th April.

A new 10% Entrepreneur’s Relief is to introduced (similar to the old Retirement Relief), for business owners selling up and making gains of less than a million pounds. Under the CGT plans announced at the end of last year, the existing taper relief would have been replaced with an across-the-board flat 18%, meaning an effective 80% hike in tax rates for vendors. This will now be lowered to 10% for business sale gains of under one million pounds.

Small business owners should welcome these changes, as it certainly goes some way to reclaim the ‘entrepreneur spirit’ many outraged business pressure groups have said the government had damaged with the new proposals.

Nobody I have spoken to about this has yet manged to locate the fine print on the government website, so watch out for the devil in the details!

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Getty Images, the market-leading stock photography vendor, is up for sale. Or, at least, it admitted it has hired Goldman Sachs to explore strategic options.

The US-based company was founded in 1995 by Jonathan Klein and Mark Getty, grandson of John Paul Getty, the philanthropist.

Having grown at a cracking pace, mainly through acquisitions, Getty is now the world’s largest supplier of video and digital pictures to ad and media agencies, posting a profit of $130.4m in 2006 on a turnover of $807m. Getty Images owns the UK-based Tony Stone Images, Image Bank and the Hulton Archive.

However, in August last year the company said it was cutting its forecasts, precipitating a slide in the stock price from $50 down to $22 last week.

The cause? The internet, which has done so well for Getty over the years, has fathered a swathe of digital image suppliers who have undercut Getty’s prices and eroded its market share. Nevertheless, the company is still expecting to post higher sales in 2007 of around $850m and is believed to be holding out for a $1.5bn sale price.

Whoever buys Getty Images, and it is thought that private equity groups Bain Capital and Kohlberg Kravis Roberts are circling, will have their work cut out holding up profits in our view, and Getty will be fortunate to achieve this price.

As an occasional Getty Images customer, we pay around £430 for use of an image for use on a website. And this only covers a licence for a 2 month period! Contrast this to most of Getty’s fast-growing competitors, where you can download and use a high resolution image, on a permanent basis, for about £5. And it’s not just the price. There is an arduous, fiddly and non-standardised order process on Getty where you need to specify exactly how and when the image is to be used, the territories it will appear in and more. Other sites have a simple pricing system across all images; the only variable is the image resolution.

Getty has been buying up some of the stronger online competitors (iStockphoto, for instance) and have an absolutely huge media bank. The average quality of its images are, I would have to admit, higher than any of its competitors. But the pricing differential cannot be sustained for long, cheaper competitors are now sprouting up everywhere, and Getty can no longer rely on the assurance of juicy corporate contract renewals from large media owners.

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The importance of due diligence to the success of a transaction is often underestimated. I thought it might be useful to put together a few pointers to keep in mind while running a due diligence exercise on a business you are intending to buy. It is not a checklist – there are a few good due diligence checklists around – there is a good booklet available to subscribers of the Business Sale Report entitled ‘Due Diligence - over 1000 Key Questions to Evaluate Any Business For Sale’. You can download an extract here.

Plan it, scope it
Define the scope of the due diligence exercise and clearly mark out who is doing what, when. Work to a timeline. Don’t waste time on areas that are not likely to cause any real issues or have any effect on the final sale agreement.

Employee issues
Thorough due diligence should pick up any issues, risks and potential liabilities relating to the seller’s employees. For instance, check if there are any past or present employees litigating against the business. Do any of the employment contracts have unusual clauses i.e. over-the-top redundancy packages? What are the specifics of the pension plans?

Move fast, top down
It is important to spot any issues early on so that the appropriate warranties and indemnities can be quickly put in place. Focus on major issues first. As with any aspect of due diligence, the late uncovering of issues which lead to changed warranties and indemnities at an advanced stage can reduce strength of the negotiating hand and, (i.e. in the case of pensions) in some cases, even scupper the deal.

Communication is vital
The flow of communication between the buyer and his/her solicitors is of paramount importance, for if they do not work closely together, the process can quite simply fail.
Buyers must communicate the key issues of concern to the solicitors; they should not just assume that all areas are of equal importance, and that everything will be dealt with in good time. The solicitor must be told what the key commercial reasons are for the purchase, which areas are high-risk and which areas should be prioritised.
Continually monitor the activity of the solicitors and accountants carrying out your diligence and make sure they are giving you regular feedback.

Don’t forget the culture
Funny how the lack of understanding of the target’s company culture is one of the main reasons for failed acquisitions, yet has been notoriously ignored in the due diligence process. Don’t make the same mistake. This is usually one for the purchaser’s management to consider, rather than delegating to legal or financial advisers. Map out the management styles of your business and the target business. Look at the core values of each and analyse the differences. How do the communication structures and styles differ? Look at the dispute policies.

Collect information, then analyse
Don’t let any of your advisers analyse whilst collecting the information. These are two distinct activities within the due diligence process. First find out where the required information is, then collect the information, recording its source and noting whether it is fact or hearsay. Then start an objective analysis.

Don’t panic, take your time
A focused but comprehensive approach is better than taking shortcuts in order to reduce costs. Often the buyer discovers that ‘thin areas’ of diligence need to be covered again in more detail. It will end up taking more time overall and costing more money.

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Last year saw a wave of consolidations across the media and technology sectors, and my view is that 2008 will see this trend continue, perhaps even more dramatically.

My hot category picks are:

• Mobile – particularly location-based devices and applications
• Energy and green technology
• Micro devices and nanotechnology
• Online video
• Social media
• Search engine optimisation

Many medium to large companies are struggling to keep up with new areas of specialist technology and organic growth strategies are just not keeping up. My colleague attended the Library House Mediatech event in November last year and quoted one of the speakers announcing that M&A is the new R&D, which sums up the prevailing attitude succinctly.

So you have a number of these switched-on companies keeping close tabs on smaller tech and media businesses ( including start-ups ), with a view to taking over the specialist technology and the trained specialists with it. Experts in the hot tech areas are increasingly hard to find, and buying a tranche of them in a single acquisition is sometimes an easier option.

Larger technology businesses have particularly highly active over the past six months. Witness Microsoft snapping up in November of UK-based Multimap, one of the world’s leading internet mapping businesses. Or Warner Bros recent acquisition of the UK’s largest independent interactive games publishers, TT Games. Nokia Siemens is about to swallow up Apertio, the telecoms data platforms provider.

Mid-cap companies are also starting to enter the arena in quantity and this is where I predict a new wave of merger activity over the next twelve months. ESRI (UK), the GIS ( geographic information solutions) company has just taken over the geospatial division of Tadpole Technologies. Ingram Micro has announced it is buying Paradigm Distribution, the point-of-sale (POS) technology company.

Pressure to create scale is also coming from the VCs who have backed the myriads of technology and media start-ups over the past two years, and are happier seeing no more than a handful of businesses dominate each sub-sector.

Whether the credit crunch continues or not, the driving forces behind the technology and new media industries are too strong to prevent a storming round of consolidations throughout 2008.

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It’s prediction season again; one just has to glance through any financial or business publication for lists of what’s going to be hot or cold in 2008, which shares are going to explode and where to buy or not to buy your next investment property.

As far as I can see, the only sure thing is that there will be a massive shakeout of futurologists.

But on closer inspection, if we limit our assessment to the more sober UK publications, we soon realise that not many have much confidence in the present state of the British economy.

So it was no surprise to learn of the results of a survey of 55 of the country’s leading economists by the Financial Times. Around 90% thought that the nation’s finances are in a poor condition. Over 60% thought that there will be significant falls in house prices this year.
The determining factor will be the availability of credit to banks and businesses, together with the impact of economic conditions in the Americas, Asia and Europe.

Any continued downturn in the UK economy will have a immediate impact on those businesses that have a higher reliance on debt.

Already we are seeing a rise in the number of corporate insolvencies – I predict a five year peak this year, with smaller businesses and the services sector dominating the figures.

Later this month the Business Sale Report will be releasing figures for administrative receiverships for the last quarter of 2007, and early signs are that the credit squeeze has had and will continue to have a sudden and fatal effect on many medium-to-highly geared private businesses.

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