By Alex Mitchell, Corporate Finance Director at Harbourside Corporate Finance
When it comes to running a business, one of the biggest challenges facing owners is when and how to pass control of operations to secondary management.
While it can be difficult to identify suitable candidates for management and relinquish responsibilities to them, not only can a strong secondary team benefit day-to-day operations, but it is also often crucial in allowing business owners to get the exit they deserve.
This might be from generating more proceeds from the sale, increasing the likelihood that deferred proceeds will be received, or allowing owners to transition away from the company at an earlier date.
Like with most activities when preparing for an exit, we advise owners that it is never too early to start thinking about the make up of your management team.
Preparing for a sale
We recommend that owners begin thinking about preparations for sale between three to five years from their planned exit date.
Owners often focus on the numbers first, working to grow profitability and improve EBITDA. Operational strength can be overlooked, yet it can be just as attractive to buyers and often makes a real difference during negotiations.
A good secondary management team will hold key relationships with customers and suppliers and bring their own ideas to the business, identifying new growth opportunities and initiatives.
They can also stay in place during and after the handover, which helps the transition run smoothly and protects important relationships.
However, building a second tier of management and embedding it properly takes time and can be a significant investment.
One way to incentivise second-tier management ahead of a sale while minimising the upfront cost is via share options, such as the Enterprise Management Incentive scheme.
Through these, the holders will benefit from proceeds of a sale, ensuring they are incentivised to remain with the business and help it perform as strongly as possible and thereby maximise proceeds.
Impact on business value
Owner dependency can take a significant bite out of the value of an otherwise profitable business. It is also not something that can be fixed overnight.
Relying too heavily on a small group of owners is a common reason businesses fail to sell or sell for less than perhaps they could.
For a buyer, it raises the risk that value will be lost once the owner leaves. That risk is greatest where the owner holds the main client relationships or keeps much of the firm’s commercial knowledge in their head.
Simply hiring a team is not enough. New managers need training and time to understand the business properly and build relationships of their own.
They also need to be given the agency to take some of the day-to-day decisions without oversight from the owners.
Some owners bring in an operations team but carry on making every decision themselves. Buyers are alert to this and it is likely to come to light during due diligence.
Buyers rarely walk away over this issue alone. More often they change the terms of the deal, extending the handover period or moving part of the price into an earn-out.
As a result, owners can find themselves tied to the business for longer than they expected and facing an environment where they are no longer the owner or decision-maker, which can feel more like an employee.
For owners with an eye on their next venture, or even retirement, having these plans put on hold because of the absence of secondary management can mean a significant impact on quality of life.
After a sale, vendors might also be more comfortable leaving the company when it continues to be run by the management team they put in place.
This ‘safe pair of hands’ might help to maintain the culture, champion staff members and maximise the chance of the vendors receiving any deferred consideration after the sale.
Bandwidth during a sale process
When it comes to the sale process, one of the biggest challenges that owners face is balancing the day-to-day running of the company with the additional demands of the transaction.
Secondary management can take on some of the strain of due diligence or maintain the company’s operations when the owner’s attention turns to the sale.
Due diligence and meetings with the buyer, advisors and lawyers take up a great deal of time. All of this can land solely on an owner who has not created a strong secondary management team ahead of a sales process.
Tax considerations
The taxation of some forms of deferred consideration, such as earn-outs, can be complex.
For example, there are particular risks where payments are closely tied to the seller staying in the business, where HMRC might treat this as employment income rather than capital, which tends to be taxed at higher rates.
That makes a strong management team more important in reducing the likelihood of a buyer requiring an earn-out to tie in the sellers themselves.
How the deal is structured makes a real difference, so specialist tax advice is essential.
Time to act
If you are planning to exit your business in the coming years, it pays to start early. That includes building a secondary management team that can run the business without you.
This takes time, so if you would like to talk through your exit plans, please get in touch with our team.
This topic and more are part of a conversation that Alex Mitchell recently had with Chris Dowling, Quilter Cheviot, as part of the Scale Structure Sell podcast series.
