10
Leaving the Practice – Exit Strategies
It may seem strange, but the best time to consider what you want to happen when you decide to leave the practice is at the very beginning when you are just setting up. Professional investors will always have an eye to their exit strategy from the outset before they invest their money in a business.
Chapter 1 discussed the way that you choose to operate, and the choice of business form (i.e. self-employment, partnership, limited liability partnership (LLP) or a limited company) and highlighted that this decision has a variety of far-reaching consequences. One of the most important of these is the way in which it determines the method that can be used to make an orderly exit from the practice.
In reality, of course, few people are that far-sighted, and the last thing on most architects’ minds when they start out in practice is how they are going to leave. Indeed, most only give any thought to the subject at all when the inevitability of retirement or moving on is only a few years away. In general, architects are not good at early succession planning, and many practices fail to survive once the original founders have retired.
So this is an area which rewards careful advanced planning. Given a number of years, you can mould the practice into the optimum shape for a suitable exit. Ideally, you will be able to identify successors from within the business or, if that is not possible, have the time to identify the sort of people that would need to be brought in from the outside.
Bringing in a new person at a senior level is a particularly delicate process in a people-centred business such as architecture and requires careful consultation and communication. It would be wise to invest in the services of a specialist recruitment consultant or head-hunter, despite their fees, in order to ensure that this is handled professionally and does not destabilise the rest of the staff.
With careful planning it should be possible to exit at a time of your own choosing. Ideally this will be when the business is doing well and market conditions are relatively benign.
The consideration of exit strategy and succession planning should certainly be an agenda item for the five-year planning meeting, so that the practice can be gradually steered in the right direction.
What are you Looking for when you Leave?
Most architects are simply passionate about the architecture that they do and the impact that their work has on the lives of other people. They believe that their architectural vision and its inherent values are worth preserving and protecting by being passed on to a future generation.
However, most would also like to realise some financial reward for the work they have put in to the practice. Value will have been added over the course of many years of work, and it seems only fair that this value is in some way paid back to those who created it. From an accounting perspective, this value is reflected in the Balance Sheet of the practice when all of the assets and liabilities of the business are quantified for the year-end accounts. But this is a static view of the business frozen at a moment in time, and business valuations are more concerned with the practice’s ongoing ability to generate profits.
There are three main options when it comes to realising a suitable reward for your labours: closing the practice; selling the practice; or passing it on to the next generation.
Closing the Practice
You could simply decide to select a date from which to cease practising. The outstanding amounts due on invoices from clients are then collected and any supplier’s bills and other liabilities paid. The physical assets such as property, furniture or computer equipment can be sold for the best possible price. When all the outstanding financial transactions have been dealt with, including of course the final tax liabilities, the money remaining in the business can be paid out to the owners or partners. Depending on the residual value of this final distribution, this will be treated either as subject to income tax or capital gains tax. It is wise to consult with your accountant to make sure that you understand the tax implications of the timing of the closure of the business and the method used to take out any money that is left in the bank account.
Trade Sale
A trade sale occurs when the business is sold to an outside party. This can be a good way to extract value from the business, but does of course require the practice to be in a form that would be attractive to a potential buyer. The main value of the business may be in the experience and contacts of a few key individuals and their loyal client following. Any buyer will be very concerned to know how feasible it would be to maintain the level of fees and profits that have been achieved in recent years, when those key individuals are no longer with the practice.
A common way of valuing a business is to apply a multiple of its average sustainable earnings over the most recent three or four years. The crucial word here is sustainable. The potential buyer may well require some form of ‘earn out’ period in which the former owners or directors stay in place for a number of years, until an agreed level of profit has been generated sufficient to justify the buyer’s initial investment.
A prospective buyer is likely to employ their own accountants to undertake a ‘due diligence’ exercise. This is not only intended to check the accuracy of the figures that have been reported in the published financial accounts, but more importantly to take a view on the likelihood of achieving the forward forecasts that have been made for sales income and profits in the next few years.
These are the sorts of positive factors that would make a practice an attractive proposition to a potential buyer:
- Increasing and steady profitability on an annual basis
- Evidence of a high quality of service delivery, ideally with formal accreditation
- A history of innovative design with peer recognition
- Loyal clients who generate consistent repeat business
- A long-serving and committed design team
- Well-maintained premises and physical assets
- A good financial compliance record (i.e. the timely filing of financial accounts and tax returns).
Passing the Practice on to the Next Generation
A common exit method is to find a way to ‘sell’ the practice onto the next generation of management and this is where the choice of business form becomes an important issue.
Partnership or LLP
For a partnership or LLP this is often a straightforward process and is usually documented in the terms of the partnership agreement that was signed at the outset. The traditional model is for a new partner to buy in to the practice by subscribing an agreed amount of money as a capital contribution that remains in the business until their departure. This is often interest-bearing to give the partner some return on their money. For well-established practices their bank may offer partnership loan schemes, which are underwritten by the practice, to finance this commitment. While they remain a partner, they receive a portion of the profits made each year. In this way, the value they have contributed to the practice is paid out to them as it arises. Thus there is no need to debate this further on departure. When they leave, their original capital sum is repaid, together with any balance remaining on their current account (the amount of any as-yet-undrawn profits). An ‘incoming replacement partner’ then subscribes their initial capital and the overall capital funding level of the practice is maintained.
This model operates on a broad ‘swings and roundabouts’ basis. No account is taken of the consequences of unanticipated events that may have affected the partner, but which took place outside the period of partnership. For example, the firm may receive a refund from a supplier who discovers that an accidental double payment had been received in an earlier year. Strictly, this should be divided between those who were the partners at that time, but this would be too complicated to administer. Instead, the partnership will rely on the working assumption that these sorts of events tend to balance themselves out over a period of time.
Limited Company
As noted in Chapter 1, the limited company format is more formal and legally structured. The ownership of the company rests with the shareholders. These shareholders may well also be the key directors of the practice, but there is an important distinction between these two roles. Anomalies can sometimes arise when a senior director who is an important member of the management team has a relatively small shareholding.
When it comes to the exit process, what matters is the proportion of the business owned (as represented by the shares that are owned), not the importance of the individual to the management of the practice.
It is best practice to have a shareholders’ agreement in place from the outset. This is similar to the partnership agreement described above, which documents how shares – and hence the underlying ownership of the business - –are to change hands. Advice from a solicitor who specialises in this subject is essential, because this can be a complex and difficult area.
The process is somewhat similar to the writing of a will. Although the primary intention may be easily stated (e.g. on retirement shares will be sold for an agreed value to the other remaining directors) there is also a need to consider other possible scenarios:
- What happens if a shareholder or director dies unexpectedly?
- What happens if a shareholder or director becomes too unwell to work?
- What happens if the shareholder or director leaves to join a key competitor?
Even if none of the above applies and the situation is a straightforward one of selling shares on to the next generation, there is the vexed issue of determining the price at which this transaction should take place.
There are many ways to value a business, and this constitutes a whole subject in itself on which many books have been written. There is no single standard method of business valuation, because so much depends on the circumstances of the individual practice. Accountants and solicitors earn substantial fees from advising clients who find themselves without a valid shareholders’ agreement in place, on the possible ways to arrive at a fair value for their shares.
This can become particularly difficult because each person in the negotiation will have different opinions on what the shares are worth. The shareholders’ agreement is designed to deal with all of these potentially conflicting factors, including the method to be used for share valuation. In an ongoing business a multiple of recent sustainable post-tax profits is often used, but there are many ways that this calculation can be performed. The key is to reach an agreed method, to document it, and to insist that new shareholders sign up to its terms before they acquire any shares.
In recent years the government has been keen to encourage share ownership by employees and there are a number of schemes available designed to facilitate this. The schemes tend to change quite frequently, often following the Chancellor’s budget, so it is wise to check with an accountant as to what schemes are currently available and how tax-efficient or appropriate they would be for your particular practice. At the time of writing the government has maintained the generous tax rates available under the Entrepreneur’s Relief Scheme. Under this arrangement those who have been working directors in the business, and who own more than 5 per cent of the shares, can pay an effective capital gains tax rate of 10 per cent as compared to the standard rates of 18 or 28 per cent.
The LLP structure is often simpler and more flexible than the limited company and for this reason may be better suited to the majority of architectural practices, especially those consisting of ten people or fewer.
Leaving the practice is likely to be an emotional time, especially for the architect who has devoted most of their working life to building it up. This challenging period of transition can be made easier if the mechanics of the exit process have been thought through, agreed and documented well in advance.
Summary
- The best time to plan an exit strategy is when you set up or join the practice in the first place, although this will be the last thing on your mind at the time.
- Most architects will be concerned that all of the work and effort which they have put into developing the practice is continued after they depart. However, they would also like to receive some financial reward for all of their hard work over the years.
- The practice itself, or its trading assets, can be sold as a whole to another firm or third party.
- The choice of business form (i.e. LLP or limited company), will affect the mechanics of selling the practice or passing it on to the next generation.
- It is important to take tax advice at an early stage of the process. For limited company shareholders it should be possible for the exit proceeds to be taxed under the more favourable capital gains tax rules.
- Leaving the practice is likely to be an emotional event. It can be made a little easier if the exit mechanics have been worked out well in advance. It would be a great shame if the final act in a long and creative career were to be a dispute over money with your former colleagues.