[EP 292] Shareholder Loans: Why Timing Is Everything in Share Sales

Transcript below!

Ladies and gentlemen, good evening. Are you ready? Okay, here we go.

You’re listening to the Deal Room Podcast. Join us as we bring you the inside scoop on business, sales and acquisitions. Get across trends in the area and hear the industry’s best recount their real life tips, traps and experiences. Now, here’s your host, Joanna Oakey.

Joanna Oakey [00:00:00]: Hi, it’s Joanna Oakey here and welcome back to the Deal Room Podcast, a podcast proudly brought to you by our commercial legal practise. Aspect Legal in this episode, I’m talking with Keza Alencaster from James Noble accountants, all about what sellers need to do, particularly those sellers in the veterinary industry, to clean up their financials in advance of a share sale. Keza is a chartered accountant with a Bachelor in Commerce and more than 12 years of experience and specialises in financial and tax advice for the veterinary sector. And in this episode, Kezra and I talk about the issues that can be created by loans sitting in a business, how they need to be cleared up before exit, and some of the issues that can occur if there’s no time for cleanup.

Joanna Oakey [00:01:17]:
For example, where we have a share sale and no time to properly prepare the business for sale. So let’s roll up our sleeves and jump into our discussion with Kezza. Hello, Kezza. Welcome to the Deal Room podcast. It is such a pleasure to have you on the show.

Kezah Alincastre [00:01:35]:
Thank you. Thanks for having me, Jo.

Joanna Oakey [00:01:38]:
My absolute pleasure. Wonderful. Okay. Yeah, it’s such an interesting podcast that we have lined up today. This is particularly relevant for veterinary practises because, Keza, you work with veterinary practises all day, every day in, day out. But I also just want to say it’s actually relevant to pretty much every other type of business as well. So whilst we looking at it from the perspective of veterinary practises and we might cover a few things that are specific to veterinary practises, I actually think there’s a whole heap in what we’re talking about today that are relevant to all types of industries. So what we’re actually talking about is what are the surprising things or what are the mistakes that some of our sellers make when they head into a share sale as opposed to a business sale? Because look, to be honest, we clients, our buyers and sellers can make lots of mistakes if it’s a business sale as well.

Joanna Oakey [00:02:35]:
But there are a few key things that I think many business owners just don’t realise when they’re heading into a share sale that are different to a business sale. So what kick us off, Caress? And what are some of the classic Sort of issues that you see leading into exit for vats, because you deal with vets. But when they’re looking at a share sale.

Kezah Alincastre [00:03:01]:
Yeah. One of the things that they don’t really realise is what directors loans or shareholder loans that are receivables in the balance sheet. That’s one where, you know what I find is they don’t realise that buyers actually are not favourable. They don’t like seeing those loans there. They don’t like seeing you as a shareholder owing money to the company. And so what we call these shareholder loans, normally the terms that we use is Division 7A loans, which is a tax term, really, and how they end up being a dividend, or they have to be a dividend prior to sale just to clear those loans. So that’s a bit of a surprise for them. And the tax implications, obviously to the shareholders when we do that.

Kezah Alincastre [00:03:45]:
So that’s one of the things that they are unaware of, perhaps. One of the other things that they’re unaware of is what we call a net asset adjustment, especially when it comes to shares. They think that when you sell shares, it’s. It’s just the price, that’s it all done. But what they don’t understand is because it’s shares, it’s whatever sitting on the balance sheet you’re buying into a company, which means that whatever the buyer is paying is whatever is sitting in that company at that point in time. So it’s what we call a net asset adjustment. And that could increase, increase or decrease price, even. So those two things, I think are the ones, the major ones that I find buyers especially are not aware of when they’re selling shares.

Joanna Oakey [00:04:29]:
Okay, wonderful. Let’s start with the loans. I want to dig into each of these because I think you’re absolutely right. These absolutely are areas that are commonly misunderstood. So if we talk about these loans and you talked about Division 7 loans, so why don’t you just quickly explain what a Division 7, 8.

Kezah Alincastre [00:04:48]:
Yeah, Division. Division 7A is actually. It’s a part of a tax Act, Division 7A and it’s shareholder loans that it’s pretty much money that the shareholders take out and they don’t return that money. And the thing is, the way the ATO is, every time you take money out of a company, you need to show that as income somewhere. And most people forget about that because they think it’s my company, it’s my money, I do whatever I. I want with it. But it ends up being a Division 7 loan because you’re not showing it as Income in your personal tax, for example. Right.

Kezah Alincastre [00:05:25]:
So we. It becomes a shareholder loan or a Division 7 loan, and that’s what’s sitting in the balance sheet. And it’s sitting as a receivable, the ato. According to ATO rules, there needs to be loan repayments and also interest calculated on those loans. And so it sits in the balance sheet until it gets cleared out by way of dividends to the shareholders. And that’s what. Normally, what I find with our clients, for example, is that they don’t keep track. These loans accumulate over time and they don’t keep track of it until the time where they say, I’d like to sell my shares, and then we flag it to them and say, okay, I’d like to sell these shares.

Kezah Alincastre [00:06:05]:
We need to clear it. And when we clear it means you’ll have to pay a dividend, it’ll have to be a dividend to you. And all of a sudden they’ve got this massive tax bill.

Joanna Oakey [00:06:16]:
And I think that’s really important because that. I think that’s the element that so many business owners don’t realise, number one, they just. They don’t understand how their taxes worked in the past. They don’t understand that they’re building up these shareholder loans that are a way of. I guess, from a tax perspective, they’re a way of potentially deferring the tax input. Really? That. That’s what we’re talking about. Yeah, isn’t it? Is.

Joanna Oakey [00:06:45]:
Is that the best way to discuss.

Kezah Alincastre [00:06:46]:
Yes, that’s what’s happening. You’re deferring it for a term, seven years or 25 years, depending on how you deal with those loans. But yes, it’s. The whole point is you’re deferring it. What they don’t realise is there is an interest component to it too, because ATR rules say we have to calculate interest. You owe the company money, essentially. That’s how they treat it. Yes.

Kezah Alincastre [00:07:07]:
They think they’re deferring it because in their minds they thought, okay, well, if ever I do, it’ll be a business asset sale, for example. And they don’t think that it’s possible to sell your shares. It’s definitely possible to do that. And sometimes what I find as well is it as a succession planning when it to younger vets or junior vets, for example, that like to buy in, but necessarily they want to buy in 25%, 50%. Best way is to do a share sale in that case. And then these are the issues that come up when they do that.

Joanna Oakey [00:07:43]:
Of course, there’s lots of reasons for a share sale more generally from a tax perspective. Quite often you might be able to get your clients, I know you get into positions where they pay very little or sometimes no tax when they’re in a share sale environment, sometimes in a business sale environment as well. Sometimes share sale will be a better outcome from a tax perspective. Is that right?

Kezah Alincastre [00:08:07]:
Yes. Most times it is, yes.

Joanna Oakey [00:08:08]:
Yep. Yep. But the overlay for this is what you might be doing is triggering earlier tax than you’d intended on things like that, shareholder loans. That is sitting in the. In the company balance sheet.

Kezah Alincastre [00:08:24]:
Yeah.

Joanna Oakey [00:08:25]:
And that’s the bit that’s the surprise to the clients, is that right?

Kezah Alincastre [00:08:30]:
That’s right. And that’s the thing now, what we’re doing now is we’re making our clients a little bit more informed when it comes to those shareholder loans, especially with succession planning in mind. It may mean that we need to show a bigger dividend this year rather than having it as a shareholder loan. So sometimes we have to keep track of those shareholder loans rather than making it a surprise at the end when they sell. So instead of doing minimum dividends, minimal dividends, I usually suggest bigger ones so that we avoid this problem. When you’re selling.

Joanna Oakey [00:09:05]:
Yeah, yeah. And when you were talking about dividends, essentially what you’re saying is taking. What do you do with the cash that’s sitting in the company? How do you get that cash to yourself as the owner so you can spend it? You have to get out of the company somehow. So you either get it out of the company in a way that triggers tax. And so that’s where you’re talking about dividends. Kezza. Or you do it by way of loans. But the problem with the loans is you’re building up this loan account in the company and if you sell the shares, you’re going to have to get rid of these loan accounts and suddenly you’re going to hit this taxing point.

Joanna Oakey [00:09:39]:
You’re going to have to pay tax on this money that ultimately you took out a while ago but you didn’t pay tax on at that point. I guess that’s the simple way that we explain it to everyone. And it’s just people don’t realise. Do you know what I didn’t realise when I was paying tax last year, I wasn’t actually paying the full whack of tax that ultimately I will one day have to pay, and maybe I’ll have to pay quicker if I end up in a share sale environment. So it’s the first Thing having those. Making sure you really understand what’s happening for you each year in a tax perspective and what shareholder loans you’re building up and what this means for you at the point of exit and as you’re coming towards exit as well. Because I guess the thing is, if you as a tax advisor know that your client is coming up to an exit in the. In in a particular period of time, you can, you can unwind those shareholder loans slowly and in an organised way, as opposed to if you’re told at the last minute.

Joanna Oakey [00:10:44]:
I’m guessing that’s the case. Is that right?

Kezah Alincastre [00:10:46]:
Timing is everything. Timing is everything. And I always say to our clients, if even the idea of selling enters your mind, you need to let us know, because we need to time it in such a way where the tax is not so heavy prior to sale. A lot of clients, when they’re selling, for example, they think they’re going to get all this money, but then what they don’t realise is some of that money may need to go to tax. And that’s something that we need to prepare for. And who loves, who likes to get surprises when it comes to tax? We don’t like surprises when it comes to tax. We like to be prepared for that. So we need to do it in a timely manner and it.

Kezah Alincastre [00:11:26]:
So that it’s tax efficient for everybody involved. Yeah, absolutely.

Joanna Oakey [00:11:31]:
Makes sense, I guess. And on the flip side, so we’re talking about buy side here. Sorry, sell side. But on the flip side, on buy side, if we’re the buyer, there’s different issues. I guess as buyer, we have to be really careful what’s sitting in that balance sheet. What’s sitting. Are there loan accounts that are sitting in there at the moment that we should be wary of? Actually, from a sell side perspective, it’s probably more concerning because thinking about it, they actually owe the company money. So what happens, Keza, what happens if this loan account is still sitting there and when the buyer purchases the business? Talk us through that.

Kezah Alincastre [00:12:11]:
Yeah, normally we try to avoid that. Jo, you don’t want. Essentially what’s going to happen is it’s going to form part of the net asset adjustment and these loan accounts are sitting there as receivables, hence their assets to the business. So from a buyer’s perspective, essentially what’s going to happen is they’re going to have to pay more because it’s an asset to the business. And who wants to do that? They don’t want to do that. And hence why it’s always something that they address and it’s something that they make sure that it’s not there when they buy in.

Joanna Oakey [00:12:44]:
And I think that’s a really good point, because if. If comes back to misunderstanding of what a share sale is, I often feel, because we’ve got some clients that get into a share sale environment and they don’t realise that everything goes, the whole kitten caboodle goes, including the cash in the bank accounts. If you haven’t considered that and if you haven’t worked out in the contract a way to deal with that. And I think that comes perhaps in a nice little circle to your comment about the net asset adjustments. So let’s talk about that a bit because I think that’s a really interesting. I think it’s an interesting area and I think it’s an area that buyers and sellers both are very confused about. What do you think are the main talk through what a net asset adjustment is, what that means, what happens at completion, and where do you think sellers get most confused? What is it that you think they find surprising? They don’t realise. Leading into a share sale.

Kezah Alincastre [00:13:48]:
Yeah. So usually when you’re valuing a business, it’s the goodwill and the equipment that’s being valued. And what, what I find is when they value the business, they. They say, okay, that’s the purchase price, that’s how much I’m going to sell it for, because it’s the value of the goodwill and equipment. But when it comes to a share sale, what people forget is you’re selling your company and whatever that company holds. So, yes, the company holds the goodwill, yes, the company holds the equipment, but it has cash, it has liabilities, it has trade debtors, it has creditors, it has leave entitlements, for example. So all of this gets taken into account or considered when it comes to the payment of the actual purchase of the business. So whatever is sitting at the point of sale, whatever is sitting in the balance sheet of the company is actually what we call an adjustment to the purchase price.

Kezah Alincastre [00:14:40]:
Either it’ll increase it or decrease it, depending on what’s sitting there. And usually they don’t really understand that because in their minds, I’m selling my business. But the sales structure, it is highly. I suppose it’s the sales structure influences how the purchase price is being dealt with. Yeah. So they don’t realise that. They don’t realise that trade debtors gets taken into account, trade creditors, for example, gets taken into account. All right, Whatever is sitting in the company at that point in time, they don’t realise that all changes how much they get or how much they have to pay.

Joanna Oakey [00:15:21]:
And what do you think is the answer? I guess the answer is early consultation with your accountant. Probably.

Kezah Alincastre [00:15:28]:
Absolutely, absolutely. Talk with me. You need to talk to your accountant. All these issues get threshed out even prior to drafting contracts, for example. These are things that you need to talk to your accountant about. And sometimes I always say to our clients, don’t let tax be the main reason why you make decisions, but sometimes tax does play a huge role in how you’re going to sell. And you’re right in saying that a share sale has a lot of tax advantages to it, but there are other factors involved as well that need to be considered when it comes to share sales.

Joanna Oakey [00:16:07]:
Love it. Okay, wonderful. And looking specifically at vet practises, because actually I said in the beginning we’d be talking about vet practises, but it was relevant to any kind of business. I think everything that we just spoke about now is actually relevant to every kind of business. Right. Certainly not specific at all to vet practises. But let’s talk about some of the particular nuances of this industry. Are there things that you see regularly that are mistakes that you think, or things that are different from an accounting or a tax perspective that are relevant particularly to this industry, that are a bit different to other industries?

Kezah Alincastre [00:16:47]:
That’s a good question. What I find perhaps different, Is it different? I really don’t know if it’s different to other industries, but veterinary practises are known to have their fit outs. For example, all right, you’ve got the clinic building, obviously it specifically fitted out for a vet clinic. And also that becomes a point of contention when it comes to your net asset adjustments and the loans associated with that, whether it’s a lease or whether it’s a mortgage, all of that gets spoken about and points of negotiation, perhaps. I also find that leave entitlements, although that’s probably not industry specific, but it becomes a point of contention, perhaps. And how that. How that gets taken into account, especially if the owners are still part of, you know, if the business owners are employees of the business, what to do with their leave, for example, or if they have long service leave, how that gets dealt with stock is pretty stock like standards. How that gets valued or how the plant and equipment gets valued.

Kezah Alincastre [00:17:57]:
Is there value in plant equipment? How does that. How do you go about valuing that and how does that form part of the purchase price? I find with a lot of veterinary practises.

Joanna Oakey [00:18:09]:
Yep. Love it. Okay, fantastic, Kez. Thank you. So much for taking us through all of these issues in relation to the sale of veterinary practises and particularly share sales and what to look out for there. How can our listeners get in contact with you if they. If they’ve got a veterinary practise and they’re thinking that they might sell at some point in the future and they just want to make sure they’re getting cleaned up well in advance of a sale, which is absolutely what we recommend.

Kezah Alincastre [00:18:38]:
Yeah, no, feel free to shoot me an email. Mackeznobleaccountants.com au obviously our website is made available as well. And yeah, just shoot me an email or perhaps book in a phone call with me. More than happy to speak with them about that. And yes, you’re right, it needs to be early.

Joanna Oakey [00:18:56]:
Early.

Kezah Alincastre [00:18:57]:
And I mean that. Two years, three years. We don’t. We hate surprises and we’d hate to see people be in that position of surprise. Nice.

Joanna Oakey [00:19:07]:
Absolutely wonderful, Kez. Thank you so much for coming onto the Deal Room Podcast today.

Kezah Alincastre [00:19:13]:
Thanks, Jo. Appreciate it.

Joanna Oakey [00:19:15]:
Well, that’s it for this episode of the Deal Room Podcast. We hope you’re now primed for your next deal with these pointers and have enjoyed these fascinating insights. Now, if you’d like more information about this topic, then head over to our website@the dealroom podcast.com where you’ll be able to download a transcript of this episode as well as access any contact details and any other additional information we referred to in today’s podcast. Now, if you’d like to get in contact with our guests today and the services they offer, you can go ahead and cheque out our show notes for a link right through to them and their details. You can also book in directly with our legalegals at Aspect Legal if you’d like to soundboard your next steps, discuss a legal question, or find out more how we can assist, whether that’s with buying or selling a business, or perhaps somewhere in between. Now, don’t forget to subscribe to the Deal Room Podcast on your favourite podcast player to get notifications whenever a new episode is out. We’d also love to hear your feedback, so please leave us a review and rating if you’re already one of our subscribers, or even if you’re listening to this podcast for the very first time. Every review helps our team produce valuable content for you.

Joanna Oakey [00:20:33]:
Well, thanks again for listening in. You’ve been listening to Joanna Oakey and the Deal Room Podcast, a podcast proudly brought to you by our commercial legal practise, Aspect Legal. See you next time, ladies and gentlemen that will conclude this evening’s entertainment. Thanks for listening to the Deal Room podcast. To find out more about this episode and other episodes in the series, cheque out the show notes or head over to our [email protected] auxiliary.