At some stage of any business owner’s lifecycle, the idea of expanding the business will come to mind - The owner may be looking for capital to grow, incentivising key employees, or introducing another stakeholder who can offer expertise.
The commercial drivers may be different depending on the business, but the legal, tax and duty issues are very similar and likely to be along the following lines:
Are you structured appropriately to accommodate expansion? If you currently operate in a family discretionary trust, the answer is no. In order to expand, you will need to move the business to an environment that allows you to issue equity, such as a company or unit trust. Companies are becoming increasingly popular given the ever-falling rate of tax.
There are several rollovers that let you move to a company structure without triggering a capital gain and one that lets you move to a unit trust. Depending on your circumstances, you could trigger a capital gain and shelter it using small business concessions which opens the choice of structure.
Stamp duty also needs to be considered where you are based or do business in a State or Territory that still imposes duty on business transactions.
Even if you are structured appropriately, are there items in your financial statements that would cause potential investors to hesitate? Some private businesses often struggle to draw the line between private and business expenses. Cars, private expenditure, under and over-paid associates and loans will need to be addressed and tidied up.
Sale of equity/Issue of equity
Once you are structured correctly and financials are in order, it is time to consider how to bring in the investor. It is not as simple as just transferring existing shares from current shareholders or causing the company to issue shares.
From an existing shareholder’s perspective, if they were to transfer their shares they would be taxed as if they received a market value price for them. An issue of shares by a company can overcome this, but only where the shares are issued for market value.
This raises the question of what is market value for the shares? This is notoriously difficult for smaller businesses that are not actively traded or where there is not a wide market. It may be safe to say that a price agreed between parties where they are acting in good faith and on an arm’s length basis will be enough. Remember though, everyone will go and get their own advice, so how the price is arrived at ‘needs to stack up’; more so if a financier is involved.
The tax issues become more complicated if you are introducing an employee. Unless they pay market value, the market value or the discount to market value will be immediately assessable to them. Depending on how much equity you are giving them, use can be made of the employee share scheme rules that have been amended to be more accommodating for small and new businesses.
With that said, private business owners should not be in too big a rush to issue equity. Fantastic employees do not necessarily make fantastic owners. Once they have equity, you cannot just take it from them.
It is usually the case of first introducing a bonus scheme or a phantom equity scheme to get a feel of how they perform as ‘would be’ owners without giving them equity.
A governance agreement is a broad term that covers shareholder, unitholder and partnership agreements. Once you have decided to expand and introduce other equity owners, it is critical to bed down the rules of engagement for when the dynamics of the business change (someone dies, suffers a trauma, divorces, financial hardship or just wants to exit).
These agreements are not designed to be referred to on a weekly basis to regulate conduct. If that level of detail is needed, you really need to query whether you should be getting into business with that person.
A governance agreement covers a number of matters including:
Decision making – are there particular decisions that require unanimous approval and some that require a special or simple majority
Trigger events – agreeing from the outset the occurrence of events that cause the automatic exit of an equity holder such as death, trauma, divorce etc
Valuation – an agreed methodology to value an exiting person’s interest in the business on the happening of a trigger eve
Funding – how an exiting person’s interest is funded on a trigger event. Some events are easy where insurance can be obtained such as death or trauma. For uninsurable events, usually there are vendor finance terms such as being paid over two years, in equal installments and subject to business viability
Dispute resolution clauses – these are included to keep lawyers out of a dispute for as long as possible to allow parties to hopefully come to a common-sense outcome
It is important that the same rigour that you would apply to who you introduce into your business is also applied to how they are introduced. These matters go to the heart of provenance of your business and due diligence of these matters by others will determine the quality of that provenance. Usually, the better the quality the better the price that can be commanded.