Hall and Wilcox on franchises

According to Hall and Wilcox , there was once an ad about an ailment with the catchy line, “Surgery or cream?” Tax can be a similar ailment, but the catchy line might be, “24.25 percent or 48.5 percent”.

If you are looking to sell your business it may be much more efficient to sell the entity, both commercially and tax wise. Take a company owned by a family trust – a pretty common scenario. And let’s assume the small business concessions don’t apply. Selling the shares will attract the 50 percent CGT discount (assuming the shares and the underlying business are 12 months old), so the maximum tax rate is 24.25 percent. Selling the business will attract 30 percent tax plus the 18.5 percent top up tax if you want the cash in your hands.

From a seller’s perspective, there is another reason to sell the entity, rather than the business, which is particularly relevant to the franchise industry.

A sale of shares in an entity is within the CGT regime, so the maximum tax rate could be 24.25 percent. A franchisee selling a business may be selling intellectual property – for example, copyright in confidential information and systems – as well as goodwill. A sale of intellectual property, such as copyright, is not covered by the CGT regime but is treated as ordinary income. The maximum tax rate may be 48.5 percent rather than 24.25 percent so, again, there is a compelling reason to be selling the entity itself.

However, the buyer will probably be advised to say ‘No, we’ll buy the business and you can keep your company and its skeletons’. Is there a way to change a buyer’s mindset?

A buyer effectively assumes responsibility for the liabilities of the company, irrespective of whether they were incurred before or after the date of acquisition. Certain liabilities may only become apparent long after the share transfer has completed. A product liability claim or a prior year tax adjustment is often the scary one.

A buyer must understand the company’s financial and legal history and, where possible, shift the risk of known and unknown liabilities (both past and future) over to the seller.

For the seller, minimising risk means knowing those exposures, particularly the ones US Defence Secretary, Donald Rumsfeld, calls the “unknown unknowns”.

As such, when we are acting for either a seller or buyer, we help them minimise risks. And, for that, there is a process – the buyer undertakes a due diligence, the seller gives warranties, makes disclosures and provides indemnities.

Due diligence

What is due diligence?

Due diligence is a detailed examination of all documents and information related to the company, including accounting and tax records, important contracts (eg. supply, employment and contractor agreements), intellectual property or any other information likely to impact the value of the company (for example, whether it is heavily reliant on key personnel or material contracts).

Undertaking due diligence

To ensure the due diligence process runs as smooth as possible, the parties should agree in advance on matters such as:

• what the buyer can access and how and when they can access it;

• whether the buyer is entitled to take copies of documents;

• whether the buyer can consult with the company’s advisors (and who will assume associated costs); and

• any confidentiality requirements.

Outcome of due diligence

If a share sale agreement is signed prior to completing due diligence, it should address the consequences if the buyer uncovers facts that may impact its decision to buy the shares. For example, does it entitle the buyer to terminate the agreement and/or receive a reduction in the sale price?

Warranties and indemnities

What is a warranty?

A warranty is an assurance or promise that certain facts are as they are expressed to be. In a share sale agreement, warranties are usually drafted by the seller, being the best placed party to verify and warrant the veracity of the information to the buyer (examples of common warranties are set out in the accompanying inset box).

Scope of warranties

A buyer should be aware of any limits placed on warranties, including restrictions on the length of time during which the warranties are enforceable or the imposition of financial limits (both maximum and minimum). For the buyer, it is preferable that warranties, particularly tax warranties, are enforceable for at least seven years, but that could require hard negotiation. It is also preferable, and in certain cases, essential, that warranties be given absolutely by the seller rather than “to the best of the vendor’s knowledge, information and belief”. Proving ‘knowledge’ warranties is much more difficult.

Seller’s disclosure against warranties

A sale agreement may be structured so that the seller makes disclosures against warranties. Such a provision, if drafted broadly, will significantly curb the ability of the buyer to rely on a warranty; essentially, the warranty is watered down. If the buyer is taking the warranties subject to any disclosure, the seller should disclose as much as possible, especially if there is any whiff of a potential liability arising. A buyer should insist on a provision requiring the seller to disclose in writing all material information relating to the company.

What is an indemnity?

An indemnity is an agreement to reimburse another party for losses that have occurred or may occur. In the context of a share sale, indemnities are commonly used to:

• require the seller to reimburse the buyer for any loss the buyer has incurred from relying on a warranty that proves to be wrong; and/or

• shift the risk of past or future liabilities from the company to the seller.

Who should provide the indemnity?

An indemnity is worthless unless the party providing the indemnity is currently, and will continue to be, in a financial position to meet its future liabilities. Will a corporate seller even exist after the transaction? A buyer should consider whether it is appropriate to require an individual or entity associated with the seller to guarantee the seller’s obligations under the agreement.

Managing risk after completion

A seller should endeavour to have control of a liability issue if it subsequently arises. If the buyer has the carriage of the matter – eg. a legal claim – and an indemnity, they will not be overly concerned about fighting right down to the wire, although they will have an obligation to try and limit the liability. The seller has the most to lose, so having some say in the exercise is important.

From the buyer’s perspective, the ongoing risk could be reduced by transferring the business internally and liquidating the company as soon as practicable. This is particularly attractive if the buyer is a company and creates a consolidated group so that the internal transfer is tax free.

Persuading a buyer to take the company means being sensible and reasonable about making disclosures and giving warranties. It should be worth it, even after legal fees.

So, remember, 48.5 percent or 24.25 percent – surgery or cream?

Read more about buying a franchise or running a franchise.