Blend and Benefit
Corporate finance adviser Marc Fecher explains how FM companies that are prepared to modify their business plans could emerge from the recession stronger than ever
by Marc Fecher
Corporate finance adviser Marc Fecher explains how FM companies that are prepared to modify their business plans could emerge from the recession stronger than ever.
TAX AND LEGAL ISSUES
The most common approach to a merger is for two companies under separate ownership to come together under a holding company that is jointly owned. Shareholders of the existing trading companies can exchange their shares for shares in a single new holding company.
This exchange of shares will not trigger any capital gains tax (CGT) as HM Revenue & Customs (HMRC) will normally give advance clearance for this as a tax-neutral consolidation. There is some exposure to stamp duty on the transfer of shares, but as this is at a maximum rate of 0.5 per cent on the value of the shares, this is rarely a material cost.
If the consolidation is under a holding company, it is vital that the combined shareholders of the holding company draft a shareholders’ agreement. This documents how they will deal with decision making, the admission of new shareholders or the exit of existing shareholders. It is far better to make these difficult decisions at the outset rather than leave them to a later date when there is cash on the table and people are feeling less rational.
An alternative approach is not to take the tax-neutral approach and trigger a CGT liability now. This may seem counterintuitive, but given that CGT rates may be as low as 10 per cent compared to income tax rates that are currently 40 per cent (increasing to a maximum of 50 per cent next year), triggering a capital gain now may have future income tax benefits. For example, shareholders of the existing companies may be able to sell their shares to the new holding company and leave this price outstanding as an IOU that they draw down in the future instead of taking a salary. However, HMRC scrutinises this approach very carefully so professional advice should be sought.
Another approach that is less common within the FM sector is the use of partnership entities. One of the disadvantages of a company is that it suffers corporation tax and, when profits are extracted, shareholders must pay tax again. Once the new 50 per cent income tax rate is introduced next year, this could result in a combined tax charge of up to 57.2 per cent.
If a partnership structure or, more specifically, a limited liability partnership (LLP) structure, is used to retain an element of liability protection, the maximum tax rate on profits is currently 41 per cent and will increase to a maximum of 51.5 per cent once the income tax and National Insurance increases come into effect over the next couple of years.
Unlike a company structure where profits are shared in proportion to shareholdings, an LLP is governed by a members’ agreement that sets out the procedure for profit sharing. This flexibility may suit two dealerships coming together where the profit split can, at least early on, be determined by their respective performance before they are fully integrated.
Ultimately, tax planning alone should not drive the business structure. However, it is a vital consideration if the businesses concerned are to ensure that they do not end up in a worse position than would have been the case had the consolidation not occurred.
Over the past 10 years the FM market has grown substantially, fuelled by an increasing trend for companies to outsource their facilities services and instead focus on their core competencies. The buoyant economy had sustained this growth, but with the FM market nearing maturity and with pressure on pricing caused by the economic downturn, competition for existing service contracts has become more intense.
Despite the recession the FM industry is considered to be relatively attractive, due, in part, to the long-term nature of contracts from both the private and public sectors. The companies best placed to take advantage of these opportunities are those that are prepared to modify their business plans in anticipation of the impact the recession will have on the sector. For example, clients are now looking to service providers that offer a range of facilities expertise as a “bundled service”, where real value can be added to contracts by providing integrated facilities management solutions.
A non-cash merger is a creative strategy that FM companies can adopt as a means of widening their service offering and creating a more robust, enlarged business to confront declining market conditions. While such mergers do not necessarily create a full exit at a premium value today, ultimately both parties will preserve their goodwill and asset values until acquirers return to the market and valuations increase.
Non-cash mergers also include the potential to:
- avoid loss of investment when the owner retires
- make overhead savings and economies of scale
- create a potentially new source of working capital
- achieve critical mass
- eliminate a competitor from the sector
- increase the collective experience of the board.
Structure v softer issues
The key issues of non-cash mergers are a combination of the transaction structure and “softer issues” such as company culture, board composition and reporting lines.
Many of the softer issues will be dealt with formally at the integration stage, although they will almost certainly need to be considered before this. Interestingly, the softer issues are often more time-consuming than structural issues because they are ongoing and revolve around the operational aspects of the enlarged business. However, the right strategic partner, a good cultural fit, integration and detailed planning should ensure that these are minimised.
Choosing a merger partner
Identifying the right strategic partner is a key element of a successful non-cash merger. There are various questions that will need to be asked to ensure that any potential merger partner is a strong strategic fit for the business, for example:
- are your goals and aspirations aligned?
- can your partner provide access to new markets?
- can you and your partner provide services that can be readily absorbed into one another’s existing client base?
- can your partner provide cost-saving synergies and economies of scale?
- does your partner’s business generate stable revenues and have the same financial security as your business?
Where there is a meeting of minds between two business owners and synergistic benefit, these transactions can add real value to the combined business in terms of geographical spread, service lines and other efficiencies, leading to greater profitability.
Buy-and-build strategies
If funding is obtainable the FM sector also presents business owners with an opportunity for rapid expansion via aggressive acquisition or buy-and-build strategies, while retaining complete control over the enlarged entity.
Although the current climate has seen a downturn in available finance, debt funders still have an appetite for transactions in high-growth, fragmented sectors such as FM where proposed transactions offer adequate financial returns. FM boasts a number of characteristics that help reduce the risk associated with a potential merger and so make it attractive to lenders. These include:
- high levels of recurring income
- long-term contracts with predictable revenue levels and proven low bad debt levels
- FM contracts servicing critical operational areas such as data centres
- steady growth with a history of client retention
- cost-plus contracts where the business can recover cost overruns.
There are a number of structural options available for bank lending, including government-backed lending schemes, term loans and invoice discounting. But, while many businesses in the FM sector are considered appropriate for invoice discounting, most funders do not look favourably on Joint Contracts Tribunal standard contracts.
Private equity funding
In terms of funding, there are also a number of private equity firms that will provide financial support to companies making acquisitions in the FM sector. They will usually require an equity stake in the acquiring company, but the structure and amount will vary depending on the level of backing they are providing and the value of the proposed transaction. Often, private equity funders can be used to bridge the funding gap on transactions, supplementing bank finance already obtained.
There are a number of private equity firms implementing buy-and-build strategies. As well as providing a potential source of finance, the private equity community may also provide FM companies with a viable exit route.
Professional advisers with specific expertise in the FM sector will be aware of other companies reviewing their strategic options and may be able to introduce companies considering non-cash merger or acquisition opportunities. After assessing the viability of these, a deal may be negotiated on the best possible terms and structured effectively to provide wealth protection.
Marc Fecher is a director of accountancy firm Devonshire Corporate Finance
