Rethinking taxation of work

Many owners of professional services firms – whether accountancy, tax adviser or otherwise – are considering the sale of their businesses. This may be because:

• they are coming up to retirement;
• the market is difficult and they are struggling to survive as a smaller entity; or
• they have been profitable in recent years and wish to capitalise on that profitable period.

Similarly, there is an appetite for purchasing professional services businesses. Many businesses are acquisitive, because of the low cost of borrowing and because they see an opportunity to expand and grow their businesses more quickly than they could do organically.

Preparing for sale

Looking at the transaction from the seller’s perspective, they will be hoping to maximise their potential payout on any sale. While it is traditional for advisers to assist in relation to the commercial terms, there are additional steps that the seller can take in advance to maximise their potential return and minimise the risk of claims being made under any warranties or indemnities they may have to give.

First of all, they should consider the practice areas undertaken by the business. Some of those may be unattractive to potential purchasers. Can they be carved out of the proposed sale in order to increase the overall sale price?

For example, if the seller has, within the business, a practice area that is known to give rise to professional negligence claims and was unattractive to insurers – introductions to tax schemes being a prime example, even if that work is historic – any purchaser is unlikely to want to take on that liability in purchasing the business. If they did, they would require very stringent warranties and indemnities in that regard and would probably take that significantly into account when assessing the value of the business overall.

In advance of the sale, the seller could consider splitting their business into two – the attractive element that they intend to sell on and the less attractive element that they could retain and then close down.

This would take some advance planning. A report could be obtained relating to both elements, considering the risk management processes and system, the likelihood of claims and the value of those potential claims. That report could then provide insurers with a quantified estimate of potential liability to enable them to provide an insurance quote for each element of the business. If the unattractive side of the business is to be closed down, then ‘run-off cover’ can be obtained.

Advice on improvement to the processes and systems can be obtained to reduce the ongoing premium in relation to both sides of the business, which means that, when the owner decides in the future to close the unattractive side, the run-off premium will be less, because it is based on the final year or final years’ premiums.

The more attractive side of the business will also be more valuable, as it will have a lower risk attached to it. Advice in this regard will need to be taken from a risk specialist and an insurance broker – ideally at least two years in advance of sale in order to structure the business in the best way to maximise its potential sale value.

Even if the seller does not intend to carve out any particular areas of their practice before the sale, they would be wise to look at their risk management processes and systems and consider the root causes of claims and notifications in order to identify weaknesses within the business. This will assist in identifying what improvements can be made before sale. A detailed analysis and report that these issues have been resolved prior to sale could dramatically increase the sale value of the business. At the very least, they should reduce the likelihood of any claims under warranties and indemnities by the purchaser.

Buyer beware

Looking now at risk issues from a purchaser’s perspective, why would a purchaser want to buy a professional services firm?

There are a number of reasons why someone would be interested in a competitor or other professional services firm. These could include:

• having access to the target firm’s client base;
• accelerating growth more quickly than growing organically, enabling the firm to benefit from economies of scale;
• quickly establishing a base in a new location; and
• establishing a new product or service that the target offers.

One advantage is the access to the employees in the target firm – this can be far cheaper than recruiting and training employees individually.

It can be seen as less risky to purchase an existing business than setting up a new business in a new location. However, if that existing business has, within it, historic problems, whether they be particular practice areas, individuals, or deficiencies within its risk management processes and systems, the unwary purchaser may find that the ‘great bargain’ it has purchased that is going to move its business on to the next level comes at a very high price.

Those who are looking to buy a professional services business will usually undertake due diligence before making the purchase, to enable them to determine whether the business is worth what they intend to pay for it and to negotiate the appropriate warranties and indemnities.

Due diligence ordinarily looks at the assets and liabilities of a business, its financial management and legal structure. It will consider its property, assets and staff and any litigation the business is currently involved in. All that is very useful and will assist a purchaser in their negotiations.

A purchaser might also review the target’s claims history. However, what steps are taken to review the risk management processes and systems undertaken by the target? Due diligence is not ordinarily undertaken as to ‘how the widgets are made’ within the target practice.

A detailed and analytical review of the target practice’s risk management environment, its processes, systems, culture and risk maturity, together with an analysis of its practice areas and their particular risk profile, can be illuminative.

Combine that with a legal analysis (on a proportionate sample basis) of files to determine the potential quantum of any claims that could arise, together with any defences applicable, and you have a valuable report that not only enables the purchaser to negotiate appropriate warranties and indemnities, but also to agree an appropriate escrow account into which funds can be placed and released as the risk reduces on an ongoing basis.

Further, the purchaser will also then be aware of the shortcomings in any risk management processes operated by the target practice, so that these can be corrected immediately after purchase. This should not only assist in a speedier integration of the two firms, but also minimise risks of new claims arising from the client files taken on from the target practice for which the purchaser will now be liable.

About the author

Karen Eckstein, specialist risk management consultant, solicitor and CTA, Karen Eckstein Limited.

Karen is a popular speaker on risk-related issues and has set up a club for those interested in receiving regular training, with a risk helpline: kareneckstein.co.uk/risk-bites-club