Debt leverage at the heart of business transfers  

At certain important stages of their lives, shareholders and managers sometimes wish to diversify their risks, remove from their personal situation the weight of their own company, and organise their transfer for the benefit of the next generations. In this situation, they are often faced with the problem of whether or not to keep their company within the family circle or, on the other hand, to sell it to a third party. Would it be possible to “split the difference” by recovering the proceeds of the sale on the one hand while retaining control of the company sold, or even keeping the management within the family?

Applying the generic Leverage Buy Out (LBO) scheme that combines the various legal, financial and fiscal leverage effects, the answer appears to be “yes”. It can be based on a so-called “Owner Buy Out” (OBO) or the variant known as “Family Buy Out” (FBO) that integrates the next family generation, to which we can reasonably add a fourth lever, called succession.

For the reference shareholder of a family business, this type of operation consists in the buyout of the latter (known as the target company) via a holding company by combining:

• a contribution[1] of part of the target's shares - which is tax-neutral under Luxembourg conditions -,  constituting the equity of the taking-over holding company, its minimum financial base for absorbing debt and sustaining future development.
  
  
• a sale, via recourse to debt, to buy back the remaining shares, the financing of which may be multi-form (junior, senior or mezzanine) and must be suited to the financial capacities of the family company acquired.

If the manager wishes to integrate their family, they can then gift shares in the family company (the holding company or operating company) to the next generation (or any other person they wish to reward) with or without retaining the usufruct for themselves. Governance of the taking-over holding company may have several forms, in order to separate the economic and legal ownership of the assets definitively received, should the subject arise, in the presence of a minor child or minor children, for example.

As regards the shares gifted, despite the potentially low value of the shares of the holding company that are gifted, for Luxembourg residents, direct-line gifts of shares are not very onerous (sometimes free under certain conditions) and, in general, the tax rate is 1.8% of the value of the shares gifted, on the legal part.

For a family that is international, the tax cost beyond the national border must be taken into account. In France, this cost can be high if certain legal measures are not implemented that are meant to ensure the survival of family businesses when they are conserved and managed by the family; when these measures are used, the transfer cost is considerably reduced (i.e. Dutreil pact)[2].

In the case of a cross-border gift of shares in a Luxembourg company, families are not always privileged, with gifts of shares to non-residents normally leading to the discovery of unrealised capital gains. Thus, unlike in France, a gift does not eliminate taxation of the capital gain.

Where there has been no anticipation, the shares of a company in a Luxembourg estate would be exempt from duties in the direct line and for the spouse. This is unique compared to other countries.

The tax impact on the part sold will vary depending on the jurisdiction. In Luxembourg, on significant shareholdings sold[3], residents are taxed at half the overall rate with an allowance of 50,000 or 100,000 euros (per 10 years) and the final maximum tax rate is nearly 24%, unlike for non-residents, who are exempt in the Grand Duchy[4] but not necessarily in their country of residence.  In addition, families should be aware of the cost price to be considered.

However, in Luxembourg as elsewhere, businesses are traditionally owned by intermediary structures and not in their own right. In such a situation, capital gains on sales of qualifying holdings are conditionally exempted. The tax impact is therefore different depending on the prior arrangement. 

Debt leverage can have different origins: bank, family or third-party via the use of a specialised private equity (PE) fund. Bringing in an investment vehicle such as this facilitates financial support for the operation in some cases and requires planning for the final exit. For this equity-related strategy, it is vital that shareholders and managers accompany the future development. In addition, the taking-over holding company can be financed with convertible bonds. In this case, the seller and head of the business, instead of taking out a vendor or family loan, can opt for these instruments to finance the buyout and exercise their conversion right at term (or before) and regain control, if necessary, especially in the event of unforeseen circumstances.

The key stage of debt (often between 5 and 7 years) taken on by the taking-over holding company is paid off until its term thanks to the recurrent cash flow of the operational company bought out. 

It is the dividend distributions paid by the daughter to its tax-neutral parent company[5]  that will be the primary source of deleveraging. Often part of the company's available cash is used to finance takeover of the family business. Deductibility of the interest on the loan(s) taken out can also tend to produce a certain tax neutrality[6], subject to compliance with the rules on recapture and deductibility limits.

The terms of repayment of the debt, whether amortising or mezzanine, are essential and must be established in accordance with the repayment capacity and solvency of the operational company acquired.

Selling and transferring are suited to the Luxembourg environment. Thus, it is possible to sell one's business to oneself, with or without the involvement of the family, by gradually or partially giving away shares in the business depending on the degree to which the family is involved. Ultimately, the historical shareholder recovers all or part of the transfer price of their operational company in a favourable framework while retaining control (alone or with the family), with the possibility of using the cash received to diversify their assets and investments, or to develop their personal projects.

The potential of these transfers is interesting, but precautions must be taken and prudent structuring that takes into consideration the legal, fiscal and financial aspects is essential. Many factors must be taken into account beforehand for the financial part to be carried out successfully, including good economic profitability, sufficient development capacity and cash flow generation, or even surplus cash.

Finally, business transfer is a made-to-measure topic in which each participant has an added value to propose to complement the generic framework set out above.