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Painless extraction

Last week, I started to look at advising owner/managers on building and extracting value from their companies. In the context of extraction, I spent some time looking at the national minimum wage implications for company directors.

Moving on from this minimum, so to speak, much has been written on the subject of maximum tax-efficient extraction of funds from a company. However, financial advisers may be a little less involved in helping the owner/manager build up a capital value for his business and realise it.

When addressing this most important of subjects, the financial adviser will need to ensure he and his client understand where value comes from for private company owners. Of course, the company itself can constitute the value but there could also be a means of building value outside the company.

Most obviously, this will be done by tax-effective extraction by the company owner and investment outside the company.

For every £1 the company receives that is not taken up in meeting its current expenses, the company owner has to make a decision as to whether that £1 is best spent on the company or invested outside the company.

A classic investment decision thus has to be made although I expect that, in most cases, this decision is made more unconsciously than consciously, with investment in the company having a strong emotional advantage. Of course, there is nothing to prevent the owner deciding to strike a balance, that is, to use some of the funds available to build his company value while extracting other funds to invest and effectively diversify outside the company.

If we focus on the value that may be created within the company, it is important to recognise that value stems, essentially, from two sources – first, assets and, second, its goodwill, intangibles and earning capacity. It is the likely future profits that will be derived from the business that gives most businesses a value these days. This is especially true for knowledge-based businesses.

Many owners of private businesses will have at the front or back of their mind that their business will be the means of providing future financial security. This “my business is my pension” attitude is a classic “reason why not” for any pension or other investment funding outside the business. It is important that the financial adviser, in an empathetic but commercial and businesslike way, examines whether this plan is a realistic one.

Factors that make realisation of a capital value difficult include the fact that the market for the products and services the business produces may change. Even overnight, the business may find itself unable to afford to invest in the necessary technology to maintain its market share. The owners (and, in many cases, the main drivers) of the business may suffer ill-health or there may be a general market downturn.

There are more reasons but it should be clear to an investor who is, in effect, dec-iding to invest substantial sums in a single unquoted equity, that investing solely in one&#39s own business may represent a higher-risk strategy.

Naturally, the return can be staggering sometimes but this would go along with the higher risk involved. Also, the tax regime is as favourable as it has ever been for individuals securing capital value from the sale of their business. The new CGT business asset taper relief can mean an effective tax rate of 10 per cent on capital gains on the sale of a trading business.

It is important not to forget that it is first necessary to secure a buyer. However, we have definitely identified a real upswing in interest in the availability and operation of business asset taper relief. Without exactly flooding in, we are asked a steady stream of taper relief-related questions by both our IFA and product provider clients.

In the context of business asset taper relief, particular interest has been shown in how to defer the capital gain that arises on sale while continuing to accrue a qualifying taper period. This is especially interesting to those for whom it is commercially attractive to sell but who will qualify for the full taper relief in 2002.

However, attractive as the CGT system currently is (and important as it is for financial advisers to know about it), business owners must be made aware of the fundamental uncertainty that usually exists for those putting all their financial independence eggs in one private company basket.

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