Company Exit – Sale or transfer within the family:

A challenge in terms of business, law and tax

By Prof. Dr. Günther Strunk / RA Helge F. Kolaschnik

A large number of medium-sized companies in Hamburg and the whole of Germany, whether they are managed by external managers or the owners themselves, family businesses or non-family businesses, are currently faced with the question: How does the company proceed when the current owner - usually due to age-related reasons - departs from the business? Although the family aims at the preservation of the company in most cases, it appears sensible and necessary to also consider the alternative of selling the business. In order to find out which of a number of available options should ultimately be implemented several business, law and tax related questions have to be clarified on company as well as management level.

Company Sale

Is the estimation of the value of the company appropriate and achievable through a sale on the market?

Many companies occasionally rub their eyes in wonder if during the run-up to the process of a company sale they are pointed out to by consultants that the company has a significantly lower value than previously expected. This may be due to the fact that among other factors existing substance is neither evaluated in terms of acquisition or production costs nor in terms of replacement costs but through the resulting capitalized earnings value. Thus a kind of retroactive accounting occurs with respect to the value of the company and therefore in relation to the purchase price to be paid for the existing equity capital. Example: The equity capital on the balance sheet of a company may amount to 500 000 Euro and the hidden reserves in the current assets in use to 200 000 Euro. The company profit minus appropriate salary payments to the management effectively amounts to a purchase price of 50 000 Euro. In the present case the maximum purchase price will be as much as the existing equity capital and there will never be an additional payment of hidden reserves, as the attained returns of the company do not leave any scope for this. The difference with regards to evaluation surely lies in the type of evaluation method that is applied. If a so-called single evaluation method, such as the substance value or liquidation value method, is used, the value may be higher than in an overall evaluation method, similar as in e.g. conventional income evaluation methods, discounted cash flow methods or as in market evaluation, e.g. multiplicator calculation, that have come to occur more and more often over time. Particularly when it comes to the take-over of small enterprises a purchase price evaluation is frequently conducted in accordance with the simplified income evaluation method. Reference value is the average value of profits over the last five years and the next three years. The sum is multiplied. The multiplicator often has a value between two and six. This may also be less for companies with low earnings. Among the reasons for a higher multiplicator are, for example, continually rising turnover or profit, a plausible market potential as well as unique selling points. Reasons for a lower multiplicator are, for example, the above average dependency on suppliers and/or customers, unused capacities and machines as well as stock buildings. In most cases a number of methods are applied to ascertain the company value and the results are averaged. The resulting value does not have to correspond with the achievable price and the causes for this may differ. Hindered or expensive loans for the financing of a company purchase have, for example, the consequence that particular purchase prices may not be paid. The selling entrepreneur may probably have to do without the payment of the agreed purchase price for a shorter or longer duration similar to a seller loan and thus be subject to a higher risk compared to a complete sale with a prompt payment of the purchase price. He would only take this risk if a higher purchase price can be expected and the resulting risk brings on appropriate interest. The skill in terms of contract negotiations regularly lies in the attempt to get as close as possible to the boundary value of the other party, whereupon the decision value from the investor’s point of view may regularly not be generalized, but is individually dependent on the situation and perception of the potential purchaser.

From a legal perspective questions arise in particular with regards to what legitimate interests the buyer and the seller has, what clauses are advisable, common or expendable, whether or not guarantees and promises given can be undermined and how this can be effectively avoided. An emphasis should be given to the following aspects and actions of safeguarding:

Purchaser guarantees and recoverability

Financing covenants from a credit institution (“engagement letter”) in the case of a payment in installments or pension payments

Exchange rate risks regarding purchase prices in foreign currencies can be prevented through escalation clauses
Bonds (e.g. in the form of a bank guarantee, but also through the attainment of bonds through the Hamburg bond association)

Patronage declarations of companies affiliated to the purchaser

At the same time the seller of the company regularly has to give guarantees and assurances for the sold company as well as to secure these with the corresponding instruments. It regularly occurs that following completion of a transaction purchase price adjustment clauses take effect, for example, where the contract agreements do not want to determine the purchase price conclusively, neither during formation of the contract nor during the transfer of the purchase price, e.g. through so-called earn-out clauses. Particular attention should be given to the concrete wording of such clauses. For example, in the case of clauses dependent on turnover it should be clarified whether they are before or after tax (i.e. after deduction of discounts, cash discounts or value added tax). The following questions have to be answered in the case of clauses dependent on profit: According to which accounting rules shall the profit be calculated, how are extraordinary earnings and expenses taken into account and does an assessment base, EBITDA, EBIT or other economically comprehensible value exist?  

From a tax related point of view the following levels of shareholdings have to be differentiated within the frame of a company sale: On the company level it may not lead to tax disadvantages as a result of a change of the owner (e.g. the lapse of an accumulated deficit) or if these are unavoidable they would have to be taken into account when ascertaining the purchase price. On the purchaser level the question arises, whether the acquired assets can be depreciated and whether in this respect a tax financed company purchase is possible, as is regularly the case with private companies. The advantage on the purchaser level, nevertheless, regularly stands alongside a tax disadvantage at the side of the vendor as he has to pay, in contrast to the sale of shares in a capital company, not around 25 percent, but up to 45 per cent tax on a resulting profit from the sale. As a result, both negotiating partners will identify a scope for consensus where tax advantages and disadvantages will be taken into account appropriately (“tax adjusted purchase price”). However, the consequences on the purchaser level should be considered as well. Questions arise not only as to whether tax benefits may be claimed regarding a profit but also with regards to the point in time of the tax accrual and whether taxes have to be paid at a point in time when liquidity accruals are yet to occur.  

Company transfer within the family

The transfer of the business from the active to the subsequent generation is often the option preferred by family businesses. Here the economic substance of the company is generally not called into question or affected. It should, nevertheless, be kept in mind that in cases where the company is source of income for family members who are not active in the operation of the business the financial burden and burden for assets should not be too high for the company as otherwise the solidity of the company may be put at risk through overdrafts or rent or lease payments to other family members for property and business facilities.

To preserve an accord between the interests of the heirs it should be considered to transfer responsibility for the company to one heir, but not to exclude other heirs. In order to safeguard such an arrangement even beyond the death of the business patriarch, agreements under company and civil law are required. In the recent past the partnership limited by shares has proven to be the most sensible option which in addition secures the tax privilege for business assets during in the case of endowment and inheritance. Notably tax privileges with respect to business assets during the transfer to family members is an additional parameter which needs to be considered during the asset transfer as long as the donor/bequeather seeks equal treatment for his relatives also in the case of supplementary taxation. Thereby the complexity of company succession and of the transfer of assets is increased even further.