Achieving a successful conversion to a limited liability company
This is the fifth in our series of Strictly Boardroom briefings that take you behind-the-legal-scenes of common corporate and commercial transactions.
Previous issues have looked at company sales, company acquisitions, private equity fundraising and joint ventures. In this issue, we look at some of the main things to consider when converting a business to a limited liability company – whether from a sole trader, unlimited partnership or limited liability partnership (‘LLP’). This type of transaction is commonly known as a conversion or incorporation. For this note, we’ve used the generic term ‘conversion’.
Business owners are motivated to change the legal structure of their business for various reasons. Sole traders and partners in unlimited partnerships are often motivated to convert to an LLP or company by a desire to reduce their personal liability to third parties. Partners in LLPs are often motivated to convert to a company by a desire to build a tax-efficient balance sheet or attract third party investment. In all cases, conversions also present a good opportunity for some succession planning.
In a nutshell, the conversion of a business to a company involves the existing business owners selling the goodwill and assets of the business as-a-going-concern to a newly-formed company (‘NewCo’) at a fair value – or perhaps more accurately, at what HMRC accepts is a fair value. The value is rarely paid by NewCo to the sellers on completion of the transaction but is, instead, reflected in loan accounts in the names of the sellers within NewCo. These loan accounts are typically paid out to the sellers over a period of months or years, depending on NewCo’s cash flow.
Sellers who remain as owners of NewCo will generally pay capital gains tax on their share of the value at the normal rate. Sellers who do not remain as owners of NewCo will generally pay capital gains tax on their share of the value at the Entrepreneur’s Relief rate – assuming they are otherwise eligible for Entrepreneur’s Relief and have not exhausted their lifetime limit.
On the face of it, conversions should be quite straightforward as there is usually some common ownership between the sellers and NewCo. However, there are a few bear traps for the unwary, so here are some TIPS FOR AVOIDING THE DIRTY DOZEN:
TIP 1 – BE CLEAR ON YOUR REASONS FOR THE CONVERSION Conversion can take a lot of explaining to a lot of stakeholders, not least to employees, customers and funders, so be very clear about your reason for doing it and be ready to invest the time needed to bring everyone along with you.
TIP 2 – TAKE EXPERT VALUATION, ACCOUNTING AND TAX ADVICE First, make sure your accountants are familiar with transactions of this type and, if they’re not, consider engaging specialist accountants who are. Ask your accountants to re-draw your latest set of accounts in a limited company format, so you can see how things will look post conversion. Also ask them to flag up any changes in accounting methods, so you can prepare your internal systems. The key advice, however, should be in relation to valuation and tax. Valuation advice needs to be robust enough to withstand scrutiny from HMRC who tend to show great interest whenever their tax take is likely to be reduced. Tax advice should include financial modelling that will show where the cashflow pinch points are in relation to future tax payments.
TIP 3 – DECIDE IF YOU NEED TO RETAIN YOUR PREVIOUS VEHICLE Once the assets of the previous business have been transferred to NewCo, theoretically at least, the previous business vehicle should be obsolete. But watch out. In some circumstances, important contracts cannot be effectively assigned to NewCo and NewCo may need to continue performing them as agent for the previous business. Also, guarantees may have been given by the previous business and closing the previous business vehicle may trigger a call for replacement (potentially personal) guarantees, which may not be possible or palatable. With good legal advice, these issues can be anticipated, considered and managed.
TIP 4 – MANAGE YOUR KEY STAKEHOLDERS CAREFULLY It is important to make early contact with your key stakeholders, particularly your regulators, bankers, other funders, landlords, insurance brokers, pension providers and vital service providers to find out their requirements for a smooth transfer of their arrangements to NewCo. Banks may see this as an opportunity to renegotiate terms and this may trigger a need to review banking arrangements. The sooner you start the process of consultation, the less chance there is of last-minute surprises and delays. Your most important stakeholders are, of course, your employees and you should not underestimate the time and care needed to handle the consultation process during the conversion.
TIP 5 – AGREE OWNERSHIP STRUCTURE & GOVERNANCE EARLY Sometimes parties seek to replicate the ownership of the previous business structure in NewCo, but this is rarely as simple as it sounds due to the way in which companies are governed and employees are rewarded. It is also increasingly common to use conversion as an opportunity to adjust ownership, with some parties retiring/leaving ownership and some new parties being admitted as new shareholders. Whatever the parties wish to achieve, early agreement of the ownership of NewCo is important in avoiding disharmony, as is capturing NewCo’s governance rules in a professionally-drafted shareholders’ agreement. Some industry sectors have special ownership rules that must be followed. For example, non-lawyer ownership of a law firm will require authorisation of NewCo as an Alternative Business Structure (ABS) by the Solicitors Regulation Authority.
TIP 6 – SET A DEADLINE Provided it is realistic and with contingency built in, setting a deadline for the conversion will certainly help to keep everyone focused and motivated.
TIP 7 – REGISTER THE COMPANY NAME & WEBSITE DOMAINS Preferably before you let everyone know what you’re up to and find some scoundrel sneaks in before you.
TIP 8 – TAKE GREAT CARE OVER THE TRANSFER AGREEMENT The transfer agreement is the core document dealing with the transfer of the assets of the current business to NewCo and needs to be drafted very carefully. If assets are to be excluded, they must be specifically referred to in the transfer agreement or will be deemed to be included. For example, the LLP partners may want to retain the freehold of the trading premises and grant a lease to NewCo. This should be dealt with specifically in the transfer agreement. HMRC may wish to see the transfer agreement as evidence of the deal and the price apportionment, so it is important to make sure it is well drafted and accurately reflects the terms of the conversion.
TIP 9 – WATCH OUT FOR CHANGE OF CONTROL ISSUES It is not unusual to find change of control clauses in major contracts with customers and suppliers, entitling the customer or supplier to terminate the contract if the business changes ownership. Falling foul of such a provision may be awkward at best and mission critical at worst. As the timing of a conversion is in your hands, it is wise to conduct a thorough review of contracts to identify any such clauses and, if there are any, ensure that the counterparty pre-agrees to waive the provision.
TIP 10 – PREPARE A CHECKLIST FOR ALL THE PRACTICAL CHANGES There are many small but important changes that will need to be made to reflect your new trading style. For example, changes may be needed to signage, stationery, marketing material, websites, social media accounts, professional bodies, trade associations and directories. It is worth appointing one person to coordinate everything to avoid items falling between two stools.
TIP 11 – EXPLAIN THE BENEFITS TO YOUR CUSTOMERS Having said your most important stakeholders are your employees, conversion can also be an unsettling time for your customers who may suspect something untoward when being told of your change of legal status. So, prepare a simple explanation of what you have done and why and, assuming there are any, what benefits your customers will gain from the conversion. For example, it may be that becoming a company will better enable you to raise funds to expand your range of services or geographical coverage to your customers’ benefit.
TIP 12 – ALL CHANGE CREATES OPPORTUNITY Conversion inevitably involves a period of change and presents the business with an opportunity to refresh its vision, plans and activity. This can create a new dynamic and energy within the business, particularly if new owners have joined the business. So, seize the moment and take the opportunity to involve everyone in the next phase of your business’ evolution.