My first blog in this series considered the extent to which goodwill exists in your practice. We also briefly touched on, strategy dependent, whether goodwill ought to be recognised in your shareholders’ or partnership agreement and thus whether there is an expectation to sell it on.
In this next installment, I aim to give an overview of the typical routes to exit.
Tenancy businesses and stepped retirements
As explained in my last post, a ‘tenancy’ type professional practice model requires each partner to provide their share of working capital and no more. This could still be a significant sum of money, and well beyond the means of many professionals.
Often this money is provided by a bank as a loan to the professional who then puts the money in to the practice. In reality the loan is a working capital loan to the practice, and in established practices can be secured against practice assets. In newer or smaller practices the new partner may need to give a personal guarantee or charge over their assets.
When an equity partner retires or leaves the practice, the key considerations are:
- Over what period can their equity be repaid, given the need to replace the working capital?
- Is a new equity partner appointment to be considered, to take on both their responsibilities and to replace lost working capital?
- Is time phasing of retirements needed, to allow equity repayments to be spaced out?
An equally important consideration is the strategic direction of the practice after the retirement. Departing partners can take specialist knowledge, operational experience and client relationships with them. A tenancy model is designed to offer stability, ease of partner appointment and retirement, and to be attractive to talented future partners. Strategy should be reviewed regularly and should not turn based on the retirement plans of the incumbents.
Tenancy style practices are traditionally structured as general or limited liability partnerships. Completely bespoke arrangements for succession can be codified in the partnership deed. There are however examples of corporate practices which replicate the tenancy approach using shares. This can be of particular interest to practices with 3 or fewer principals or those claiming R&D tax credit.
Goodwill – third party sale
Rare in professional services, but perhaps becoming more common, is the outright sale of the whole business to a third party. Generally the third party will be a business in the same industry (a ‘trade’ sale) or a private equity investor.
Although unsolicited offers do occur, most third party sales are planned years in advance in order to maximise enterprise value and thus the achieved price. Before embarking on this strategy it is crucial for business owners critically to think:
- Are there buyers for my type of practice?
- What is the current value of my practice and is it enough to justify selling?
- Can I improve the value of the practice before disposal?
- What consideration could I accept? Do I need cash now, or could I be paid over several years?
Whole books have been written on the topics around grooming a business for sale and marketing it. Suffice to say you must take professional advice from the moment it becomes your exit route of choice. After all, your future depends on it.
Goodwill – the Management Buy-out (MBO)
In a goodwill situation, the most common outcome is undoubtedly an MBO. Where the outgoing business owners want to maximise their consideration for the business, the most obvious way to achieve this is to sell to the people who understand and appreciate it.
MBOs can be financed usually in two ways: by borrowing a lot of money and using this to acquire the shares or partnership equity, known as a leveraged buy out; or by using post sale profits to pay the previous owners, often known as an earn out.
A mix of both may also be necessary; some cash borrowed to fund an up-front payment, with the rest deferred and paid out of future profits.
MBOs can be transacted for both companies and LLPs, although buyers may have a strong preference for one particular structure, and so it is important to bear this in mind. It is of course possible to change the businesses structure prior to sale but the change can itself require several years to enact, and so it is not something to leave until you have a sale contract.
In terms of price, there is often a trade-off between how quickly a seller is paid and the sale price achieved. A classic earn out arrangement would be for the current business owners to ask for the upper end of a market value range, but to sell the business with consideration by way of loan notes which are redeemed over say 3-5 years.
The sellers would also undertake to consult for management for a fixed period of, say, 2 years to ensure that client relationships are handed over smoothly. This maximises the cash for the sellers but minimises risk for all concerned.
Fully leveraged buy-outs are sometimes necessary where the sellers need the money quickly in order to fund retirement plans or meet other obligations. Lenders can be brought on board to provide cash immediately, although management might reasonably push for a lower price tag for the business given the finance costs and risks they take on.
Employee ownership trusts (EOTs)
EOTs are a relatively new option. For all intents and purposes they are just a flavour of MBO, with very specific rules and tax treatment.
They are starting to become more common for architects and consulting engineers, and I expect they will soon be seen in all the professions. The specifics will be covered in a separate article in this series.
There are a number of succession routes open to the professional practitioner with structural considerations that will arise, depending on your strategy.
For help and advice on exiting your professional practice or any business, get in touch.
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