Katie Johnston

Last year innovative and landmark reforms were introduced that gave companies limited by guarantee the ability to raise capital by issuing mutual capital instruments ( MCIs) without risking their status as a mutual. Now 12 months on, we share our top 3 tips for any mutual looking to streamline the process.

Tip 1: Make sure your constitution is ready

Before you can offer and issue an MCI, your constitution must specifically empower the board with flexibility to issue MCIs and facilitate their issue in multiple classes.

Key touch points to cover in your constitution include:

• Giving the board power to issue and allot MCIs;

• Allowing the board the flexibility to determine and approve the class rights of MCIs. At the same time, you should ensure that the proposed MCIs meet the requirements of the Corporations Act, such as to be issued as fully paid;

• Allowing the mutual to accept subscriptions for money for MCIs;

• Facilitating payment of dividends to MCIs;

• Addressing membership of the MCI holder in the mutual;

• Governance points like board composition rights; and

• Setting out the terms of issue of the MCIs (Class Rights), including voting and redemption rights and the transfer of MCIs.

If your mutual has already been formed, you will need to change your constitution to include these points.

If you’re forming or planning a new mutual, you should prepare your constitution so that it facilitates the issue of MCIs from day 1. Even if you’re not planning to issue MCIs, we recommend your constitution is ready to maximise your options and reduce future delays and expense.

Tip 2 – Bed down class rights

It’s important to recognise at the outset that MCI holders are unlikely to be members of the mutual and your class rights should reflect this.

A mutual provides significant financial benefits for members. It offers them the ability to share risk and is designed to promote the interests of the members by protecting their assets and people.

MCI holders shouldn’t expect significant returns on their investment. This is because their investment is primarily made to support the wider interests of the community formed by the members. Their capital provides a sustainable model to offer discretionary protection to members.

The class rights should reflect the context of the mutual. It should also reflect that MCIs offered by mutuals are very different from other forms of capital used by other types of companies to raise funds.

There are 4 key types of class rights that you should consider.

1.   Voting rights

Mutuals do not have to give MCI holders the right to vote at members’ meetings or sit on the board. It’s up to the mutual to determine this in light of the rights of its members and its commercial objectives.

Importantly, if a class of MCI does give its holder the right to vote, the investor will only have one vote for that class of MCI regardless of the number of MCIs they hold in that class.

2.   Dividend rights

The ability to offer and issue MCIs was introduced to accelerate mutual growth and market share. While mutuals can issue MCIs with dividend rights, MCI investors shouldn’t expect significant returns on their investment. If they do, then MCIs probably aren’t the right investment for them.

That being said, we recommend that the constitution and class rights support payments of dividends to MCI holders so that you have flexibility moving forward. These rights need to be compliant with the Corporations Act requirements around dealing with surplus assets and profits and any dividend that is paid being non-cumulative. The point is to maximise flexibility and options for the mutual.

3.   Redemption

The class rights should also set out whether the MCIs in a particular class should be redeemable and what the terms of redemption would be. Redemption terms could include:

• Time: Can they be redeemed at any time or after a set time?

• Who: Who has the ability to redeem the MCIs? Are they redeemable only by the company in its absolute discretion or can the MCI holder redeem them as well?

• Price: What price should be paid to the MCI holder on redemption? Will this be the original subscription amount or something else?

• How: What is the process for redemption? Does the mutual need to give the MCI holder a redemption notice?

4.   Transfer

Your constitution should also contemplate whether MCIs can be transferred to others. If you want to restrict the transfer of MCIs, the specifics of this should be covered off in the class rights. For example, is board approval required? Can you transfer to a related party or within the same corporate group? Are any dealings, such as encumbrances over the MCIs, restricted?

Tip 3 – Streamline your offer and documentation

To have a streamlined process, you need to sort out your constitution and class rights before you set your offer and documentation.

The offer of MCIs is an offer of securities so there are minimum disclosure requirements that you must follow, just like other forms of capital raising. But MCIs are also their own beast that have their own individual disclosure requirements.

When disclosing your MCI offer you should clearly articulate:

• The investment proposition: Investment in MCIs is not about returns. It’s about providing discretionary insurance protection for its members. Where they have discretion, the board will give priority to providing protection to members. Any return on investment for MCI holders will be secondary to the interests of members whose claims are being considered. This should be clearly stated so that investors are not misled about potential returns.

• The risks specific to mutuals: These include significant claims by members which will impact the mutual’s ability to fund future claims and pay distributions. Other risks may include the loss of members which will mean the amount of contributions that may be pooled to pay claims and fund the purchase of insurance and reinsurance programs will reduce. Market risks may include the availability and appetite of local and global insurers and reinsurers to support the mutual with insurance and reinsurance programs. Other risks include the detrimental impact of external extenuating circumstances such as the current global pandemic and regulatory and compliance risks.

• Class Rights: These are the rights attached to the class of MCIs being offered. These include those noted above on voting, restrictions on transfer and redemption.

This list is not exhaustive and will depend on your mutual and business proposition.

By Katie Johnston and Nicholas Pavouris

The post Issuing MCI securities – Practical learnings 12 months on appeared first on AdviserVoice.

If you purchase a business with a history of non-compliance, ASIC may hold you accountable for regulatory non-compliance.

Exposure to historical non-compliance can be fatal for purchasers but many don’t include it in their due diligence. ASIC is on the warpath and you can be liable even if you weren’t operating the business at the time of the non-compliance.

So before you purchase a business that holds an Australian Financial Services Licence or Australian Credit Licence you need to make sure the compliance records and policies are up to standard.

What is due diligence good for?

Due diligence is crucial to any transaction. As a buyer, it gives you comfort that:

• The value of the business is appropriate;
• You have the appetite for the risks associated with the business; and
• The share sale agreement addresses these risks and exposures in exchange for due consideration.

If you don’t perform due diligence you won’t know what potential exposures you have in the business you’re purchasing.

What are the risks of historical non-compliance?

If you purchase a business with a history of non-compliance, ASIC may hold you accountable for regulatory non-compliance. This is possible even if the acts or omissions that led to non-compliance took place under the previous owner.

If ASIC finds the business guilty of non-compliance, they can impose a range of remedies including:

• Additional licence conditions;
• Requiring you to undertake a client remediation program;
• Publishing a ‘name and shame’ media release. This may tarnish the business’ reputation and cause clients to panic;
• Suspending the licence. During this time the business and its representatives cannot provide financial services or generate income;
• Cancelling the licence; or
• Imposing civil penalties for corporates and financial service licensees for breaching their licence conditions.

Even if the licence isn’t cancelled, you could face significant financial strain or insolvency. This could be caused by:

• Paying the purchase price;
• Incurring additional legal and compliance costs to defend and remediate non-compliance;
• Representatives deciding to transfer to another licensee with a better compliance record and reputation. Operating with a reduced number of representatives may severely impact the business’ ability to generate revenue; and
• Reputational damage and business disruption that stagnates the business.

There is also no guarantee the non-compliance is purely historical – it might be an ongoing issue that needs to be addressed at significant cost.

You can protect yourself in the share sale contract by including specific indemnities, for example. But if these protections haven’t been drafted appropriately, the cost of defending the business may be prohibitive and impossible for you to recover from the seller.

Minimise your compliance risk

As a buyer, once you’ve completed your financial due diligence, there are 4 steps you should take to minimise your compliance risk:

Step 1: Undertake compliance due diligence

• Ask for details of any ASIC investigations or surveillances in the last 5 years.
• Ask for audit reports for each representative over the last 5 years.

Red flag: The business doesn’t regularly audit their representatives.

• Request details of any client compensation paid over the last 5 years.
• Review the business’ breach register.

Red flag: The business doesn’t have a breach register.

• Review the business’ key policies and procedures.
• Conduct sample testing to check the quality of the business’ record-keeping practices.

If you find any issues you can require the seller to update their compliance framework and address specific issues (like client compensation) prior to purchase.

Step 2: Protect yourself contractually

When drafting the contract, include:

• Warranties that you can rely on and indemnities you can enforce.

TIP: Draft specific indemnities for any particular issues identified during your compliance due diligence that aren’t deal breakers.

• A remediation clause that covers any costs including fines, client compensation and legal expenses. Also include requirements for the seller to produce records and information and promise to work collaboratively and in good faith to negotiate and achieve the most favourable outcome possible for you.
• Guarantees that can be enforced against the seller on a corporate and individual level. Obviously, these will only be as strong as the financial resources of the party giving them.

TIP: Ask for guarantees from owner directors.

• Structuring the purchase price payment so that part of the purchase price is held in escrow for a set period of time. If compliance issues arise during that time this amount can be used to address the issue. Once the escrow period has lapsed, the amount can be paid to the seller. The length of the escrow period is a commercial point of negotiation between the parties. The longest we’ve seen them run for is 2 to 3 years.

TIP: This arrangement works best if the exposure you’re protecting against has a set ceiling. If not, indemnities are optimal contractual protection.

Step 3: Be vigilant when running the business

• If your due diligence has identified gaps in compliance, you should address these immediately. Your compliance framework should be sufficient to prevent recurrence.
• Consider engaging an external compliance consultant to help you determine the extent of a compliance issue and how best to fix it.
• If clients need to be compensated for historical compliance breaches, you should expedite this program and notify the seller as early as possible.

Step 4: Review the representatives of the business

• If you’re retaining representatives, you should review their individual compliance history. You may need to terminate a representative if they have a poor compliance history or require the seller to do so as a condition precedent.
• You may need some employees or representatives to stay on after the purchase to assist with remediation or oversee improvements to the compliance framework. You will need to identify them and make sure they aren’t planning to terminate their employment or authorisation upon sale as this may impact your valuation of the business.

By Simon Carrodus, Katie Johnston and Lydia Carstensen

The post History repeats – The risks of inadequate due diligence appeared first on AdviserVoice.

Waiting it out may not be viable for your cashflow, could be detrimental to your strategy or put your first to market position at risk. In this blog we share 3 tips to raise funds efficiently in a tough market.

1. Structure your raising right

There needs to be a balance between raising the amount you need to thrive and giving away too much equity cheaply. Strike a balance by considering:

• How much cash you have in the bank;
• What you need to do next in your business plan; and
• How much runway you need to achieve your next significant business milestone.

Other key things to consider include:

• Any capital raising requirements or limitations your business has. For example, you may have pre-existing contractual obligations like pre-emptive rights or anti-dilution protections.
• What legal limitations you may have. For example, if you’ve already exhausted the ‘personal offers’ disclosure exemption under the Corporations Act, you will not be able to rely on that when making your capital raising offer.
• Your target investor. You will need to decide if you want to raise from current shareholders or new investors. Now may be a good time to bring on board a strategic cornerstone investor but you may also want to keep your current support network confident and content. You could do this by including a rights issue component, for example.
• Whether you can explain your structure. The structure of your raise needs to be simple. Overcomplicated structures are likely to stifle investment and add to the costs of the raising.
• Alternatives to your existing investors. There may be other options you could explore like crowd-sourced equity funding.

2. Get your documentation ready

With the structure set you need to have your documentation ready before you go to market. This will help you net interested investors without losing momentum or experiencing unnecessary delays. Your documentation should:

• Consider any requisite disclosures that apply;
• Consider what disclosure exemptions you’re relying on for the raising. This will dictate the minimum documentation you need; and
• Clearly and concisely articulate what your business does, how you intend to use the funds and the risks to investment.

3. Think about your timing

While COVID-19 restrictions are easing, the economic fallout continues. Given the uncertainty around economic recovery, whether government support will continue and the possibility of second wave infection, there may never be a ‘good time’ to raise funds in the short to medium term. But if your business is well prepared before you go to market it will have the best prospects for success.

By Katie Johnston

The post 3 tips to raise funds efficiently in a tough market appeared first on AdviserVoice.

If done right your business will be ready to ramp up quickly when the economy takes off again …whenever that is.

What cash incentives can you use?

There are many ways you can retain and incentivise staff and referral partners that don’t require immediate cash payments – you’re only limited by your imagination. These can include:

Shadow Equity or Phantom Plan

Usually a medium to long term play, shadow equity works well in established businesses that want to keep key personnel or lock-in referral partners who contribute substantial revenue or growth.

This involves:

• The employee or referral partner agreeing to receive an amount in the future when a specific event happens.
• The amount is linked to equity but they don’t actually hold any equity. For example, it may be equivalent to an agreed percentage of equity but no equity is transferred, issued or diluted.
• The future event could be anything, such as a business sale.
• When the future event happens, the employee or referral partner receives the agreed amount as a reward for helping the business achieve the milestone or for enhancing the value of the business.

The business retains an engaged and motivated employee or referral partner and the individual shares in the upside of the business.

Equity Incentive Plan

This model works best for organisations working through COVID-19 who want to reward individuals in the future in more of an ongoing way. We’ve seen this approach work well in the start-up space to facilitate initial traction and to accelerate growth and maintain ongoing momentum with channel partners.

This involves:

• An incentive that is cash, equity or a combination of both.
• The incentive could be structured:

(i)   As an annual reward that is payable upon achieving specific targets each year such as client retention or revenue.

(ii)   To be fluid in terms of time, but payable upon reaching predetermined targets.

(ii)  With a ratchetted or stepped system where the reward directly correlates to the level of achievement of targets.

• Non-cash rewards could be shares or options that can be structured in many ways including:

(i)   Loan-funded equity.

(ii)   Bonus equity.

(iii)   Options with initial consideration and an exercise price.

Equity plans can have significant tax consequences, so preliminary tax and accounting advice is recommended.

Don’t get tripped up

Setting a non-cash incentive that works for both you and the participating individual can be tricky. Whilst the commercial agreement between the parties usually comes down to open and frank commercial discussions around what works best for each, there are a myriad of issues, laws and other obligations to consider, and everything needs to be documented properly before commencement.

Points to consider include:

• Disclosure requirements: These must still be observed including:

(i)   If your incentive is equity, disclosure (such as via a prospectus) is required unless there’s an exemption.

(ii)  Considering any on-sale activity.

(iii) Maintaining a watching brief of equity issued without disclosure or where exemptions have been relied upon.

• Pre-existing contractual obligations: Pitfalls and traps include:

(i)    Pre-emptive rights under pre-existing agreements or equity issuances.

(ii)  The requirement to be joined to an existing equity holder or shareholder agreement.

• Entitlement and eligibility criteria: Make it clear what conditions must be satisfied, such as:

(i)   Continuance of engagement.

(ii)  Compliance with confidentiality requirements.

(iii)  Achievement of milestones or other hurdles that are usually linked to the financial performance of the business.

• Nominees: If you want to allow someone else to benefit from the incentive consider: 

(i)   Whether the person you’re incentivising can nominate another party to be the equity holder. For example, a referral partner may want to nominate a director rather than themselves.  

(ii)   The risks of having a nominee. For example, if a director is a nominee and they leave the referral partner, then the partner will no longer be motivated to keep performing, unless appropriate provision for compulsory transfer back of equity is included in the documentation.  

• Termination: Outline what happens when the employee leaves the company or the commercial agreement with the referral partner ends, by considering:

(i)   What happens to any benefits applied upfront (such as sign-on equity).

(ii) Whether it’s appropriate to include clawback rights if the arrangement is terminated within a specific period after the reward is paid.

• Regulatory issues: Non-cash incentives paid to employees must be checked carefully to make sure they comply with regulatory requirements, for example:

(i)   Conflicted remuneration laws may affect the nature and type of arrangements that can be offered by financial advisory businesses.

(ii)   The arrangement needs to be structured correctly from the outset to ensure it forms part of a balanced scorecard approach.

• Documentation: Arguably the biggest downside to non-cash incentives is the documentation and administration required. It needs to be:

(i)   Balanced.

(ii)   Legally enforceable and practical.

(iii)   Clear and concise.

This list is not exhaustive but includes some common non-cash incentives structures and issues we see and advise our clients on. If you want to incentivise and retain employees and referral partners, we can help structure and document your arrangement in an efficient, simple and compliant way.

By Katie Johnston

The post Retain staff and increase business with non-cash incentives appeared first on AdviserVoice.

Katie Johnston

We’ve recently noticed that both buyers and sellers have heightened concerns about their risks and exposures when transferring financial advice portfolios. Both are looking for different ways to manage their financial risk of recovery. Sellers want to know what their liabilities and obligations to the buyer are and when they will end. While buyers want certainty about what they can make a claim for and whether the seller has the financial resources to meet their indemnity and warranty liability.

Following on from my recent post on warranties and indemnities in the sale of financial advice portfolios, in this post I outline five ways that the financial risk of recovery can be managed in these transactions.

1.Professional Indemnity (PI) Insurance

It’s standard for a seller to be required to hold PI insurance in sale agreements for financial advice portfolios. But for PI insurance to be effective in mitigating risk, the buyer must have confidence that it will cover the seller’s exposure for a period of time after the sale. Without this, the indemnities are worthless because there is essentially no safety net if the seller can’t fund the payment of a claim. The PI insurance run-off period is a critical element of this.

Traditionally, sale agreements have required PI insurance to be current at completion and maintained in run-off for a minimum of 6 years. But following the Hayne Royal Commission we’ve seen a hardening in the PI insurance market for the financial services industry. This has made it difficult for most sellers to obtain PI run-off insurance for more than 3 years.

PI Insurance also may not cover the seller if they haven’t complied with community standards or practices, or if they’ve breached the law. For example, if they charged clients for services that were never provided. The government has also recently extended its reach to consider eligible financial disputes dating back to 1 January 2008.

These issues are making it difficult to determine what is an acceptable PI insurance run-off period. So I’ve had to identify other creative ways to help buyers limit their exposure and mitigate their risk of financial recovery.

2.Warranty and Indemnity (W&I) Insurance

W&I insurance is often used to cover the buyer for financial loss when the seller breaches the specific warranties and representations they gave in the sale agreement. This is often referred to as a buy-side policy.

In a buy-side policy, the buyer may recover directly from the insurer for any loss suffered. This mitigates their risk that the seller won’t be around or have sufficient funds to cover a claim. This makes W&I insurance a useful tool to bridge the divide between the seller’s need to limit their liability and the buyer’s need for comprehensive warranties and indemnities that they know they can recover financially.

W&I insurance isn’t a new concept but it’s been gaining favour in Australia recently and I don’t see this changing. But it isn’t easy to obtain and can be expensive. Whether it’s suitable for your transaction will come down to a number of factors including:

• Deal value: The cost of the insurance may exceed the amount you’re insured for
• Your commercial drivers: It’s often looked to when there are multiple sellers or the seller wants a ‘clean’ exit
• Other available options to reduce the financial risk of recovery
• Whether the parties are willing to do a deep dive due diligence: Insurers will require this before providing a W&I policy

3.Escrowed funds

Holding a portion of the purchase price in escrow is a relatively simple way for the buyer to know that there will be funds available to meet any warranty and indemnity claims. Obviously the level of comfort depends on the amount held on escrow and how long it will be held there.

When negotiating an escrow fund, parties need to agree:

• Who controls the escrow account
• The amount to be held on escrow
• How long the funds will remain in escrow
• When the funds can be paid out
• Who the funds can be paid out to
• When unused funds can be released to the seller

All these details can be covered in the sale agreement.

If the deal is complex or high value, you could use an escrow agent. You may also need to put in place more complex documentation to regulate the arrangements. For smaller deals, the escrow account could be jointly directed by the buyer and seller, or at the sole direction of the buyer.

4.Payment by instalment

When you pay by instalments, the buyer essentially defers payment. This reduces their upfront payment and increases their subsequent payment(s). Paying instalments over a period of time is a well accepted practice in the financial planning book buy/sell space.

Current deals I’m seeing are pushing these out to 60% upfront with the balance paid over 12 to 24 months. This is usually on a 20%/20% basis. In the past, the norm was a 70/30 split over 12 months. The current trend keeps the seller at risk for longer and gives the buyer a longer period and larger amount to claim back.

I’m also seeing new and extended clawbacks and adjustments. These are being added to the traditional ‘rise and fall’ protections. This is being achieved with bespoke provisions that cover specific risks including:

• Remediation costs
• Extension to breach of warranty claims
• Changes in the law affecting remuneration, including fees for no or limited services and possible changes to life insurance commissions

The challenges faced by sellers are compounded by buyers expecting to pay lower multiples. Transactions are currently trending at the 2 to 2.3 x multiple. Fixed purchase prices are also gaining favour.

5.Personal guarantees

As noted in my last post, buyers are now also asking sellers to give personal (owner/director) guarantees. But these are only worthwhile if the buyer does due diligence on the guarantors and their financial position to make sure they can pay a claim.

If you’re negotiating or preparing to sign a portfolio transfer agreement, you should seek legal advice to make sure you’re mitigating your risk and exposure under the agreement.

By Katie Johnston

The post Managing the risk of recovery in financial portfolio transfer transactions appeared first on AdviserVoice.

Following the Royal Commission, and as we move towards the deadlines for new FASEA requirements to be implemented, it’s become a buyers’ market. Buyers are keen and empowered to limit their exposure and risk to changes to remuneration and poor advice. One way they’re doing this is by imposing more stringent warranties and indemnities in their portfolio transfer agreement.

Buyers are asking for deeper warranties

A warranty is a promise by one party that a particular statement is true and may be relied upon by the other party. For example, a seller may warrant that certain compliance requirements have been met (for example, opt-in and Fee Disclosure Statements), or warrant the levels of recurring revenue to support the purchase price/value of the sale.

Following the Royal Commission, buyers are more vigilant than ever about the quality of the portfolios they acquire. They are conducting a more extensive due diligence process and asking for better warranties than they have for similar transactions in the past. Buyers also want more certainty around the payment of any PI claims, especially with so many advisers leaving dealer groups who are shutting down their FP operations entirely.

Buyers now expect warranties to cover things like:

• Conduct in servicing clients: This may include the type of services provided, what advice was given, the products issued, compliance issues and even the ‘client to advisor’ ratio.
• Remuneration: They often want confirmation that fees were not charged where no services were provided, no grandfathered remuneration is included and no clawbacks for overcharging fees.
• Records: Warranties that electronic records are complete and in a satisfactory state to service the clients and deal with client complaints/claims.

To mitigate their risks, buyers are also asking sellers to give personal (owner/director) guarantees for these types of warranties.

The rationale behind these requests is to push the risk exposure back onto the seller as much as possible for poor advisory and compliance practices, allowing the buyer to reduce the purchase price for any adverse impact on recurring revenue and retention of the acquired client base. This isn’t entirely unreasonable given the seller is the one who ‘knows’ the clients, the business and its risks.

Sellers can still limit their exposure and risk

Sellers can counter warranty extensions requested by buyers to limit their exposure and risk. My recommendations for this include:

• Cap the amount the buyer can seek for breach of warranty: Determining the amount of the cap is almost always the subject of much negotiation. My view is that a seller shouldn’t accept a higher exposure, and a buyer shouldn’t accept less protection, than the purchase price paid.
• Cap the time period to make a warranty claim: This gives the seller certainty around their exposure. How long this period should be is usually dictated by any period of deferred payments of purchase price. If it is in instalments over 2 years for example, then a 2 year time period is probably a good compromise, but the exposure for indemnity claims (i.e. 6 years) may be longer, so this needs to be considered carefully.
• Set a minimum loss threshold: This can be drafted so that the buyer must suffer an individual loss or an aggregate amount of $X before they can make a warranty claim. What $X is will be contingent on the purchase price and subject to negotiation between the parties. I suggest 3-5% of the purchase price is fair and reasonable in most transactions. Noting that sometimes the parties will set it as the amount of the excess/deductible under the Seller’s PI insurance.
• Set the process: Sellers may want to impose a formal process for how buyers can make a warranty claim. This should be in the agreement and include what notice and information the buyer must give to the seller before they can make a claim and during the process. This is particularly important if the warranties are extensive, the warranty period is long, or the monetary warranty cap is high.

Indemnities are also gaining favour with buyers

Indemnities are a contractual obligation by one party to reimburse the other when an agreed event happens. In the current risk-averse landscape, buyers are seeking to impose catchall general indemnities for any liability arising from the seller’s activities. A better compromise is for the indemnity to cover any breaches of the law, legal negligence, or claims involving clients. Arguably, some of these indemnities are excessive and go beyond what is really needed to protect the buyer, so sellers should resist these and only agree to specific indemnities.

Specific indemnities are items identified or disclosed in the due diligence process that can’t be resolved because the issue is ongoing where the potential loss is not quantifiable at that time. If the issue can be finalised before completion or dealt with by adjusting the purchase price then it should be done through a reduction to purchase price, rather than relying on indemnities.

In every sale transaction, counterparties obviously have competing interests. The key is understanding these interests and appropriately addressing them in the sale agreement. As a buyer, you want to have certainty about your rights to claim against the seller and the seller’s financial resources to meet indemnity and warranty liability. It is essential that the buyer has confidence in the PI insurance arrangement for the seller’s exposure in the period after the sale. Without this, the indemnities are worthless because there will be no safety net for these risk exposures. Equally, as a seller you want to know what your liabilities and obligations to the buyer are and when they will end.

If you’re negotiating or preparing to sign a portfolio transfer agreement, you should seek legal advice to make sure you’re mitigating your risk and exposure under the agreement.

By Katie Johnston

The post Deal trends: Warranties and indemnities in the sale of financial advice portfolios appeared first on AdviserVoice.

Katie Johnston

As the level of M&A activity increases in the financial services industry post Royal Commission, it’s time to put in place incentives so you don’t lose key employees.

Many business owners count on key employees being there to take over the reins. But often key employees leave to work for a competitor or start their own business.

When a key performer leaves your business it can significantly impact both you and the future of your business. As a result you may:

• Lose income;
• Incur additional or unbudgeted costs finding a replacement; and/or
• Lose focus on your business while you find and train a new person.

You can stop key people from leaving with succession agreements

You can stop key people from leaving your business by giving them an incentive to stay. With a succession agreement you can lock key performers in without necessarily giving up equity or your business.

The upside can be significant, including:

• Reducing the risk of key performers leaving;
• Giving key performers security over their future; and
• Allowing you to plan for your exit without any time or sale pressure.

How do you choose an appropriate succession agreement?

There are several different ways that you can structure a succession agreement. The choice you make depends on a range of factors. Before you decide on the right type of agreement you need to decide:

• How the arrangement will be structured (having regard to tax for example);
• What milestones each of you need to reach;
• What benefits the employee will receive;
• How the benefits will be valued; and
• How the benefits will be paid for.

Once you have decided these issues you can choose the best type of agreement. There are three common ways to structure your succession arrangements.

1. Shadow or phantom equity

This involves giving key employees a cash incentive rather than equity. The cash incentive is calculated as if it were equity, so it may look like a dividend or payment for the sale of equity. The incentive payment is triggered and payable when specific predetermined events happen, like if the business achieves a set of KPIs or targets.

Shadow equity can be a good option if equity cannot be transferred now because of CGT or other tax issues.

A Shadow Equity Agreement is between the business owner and the key employee(s). It doesn’t generally require much ongoing administration.

2. Employee share schemes

Also called employee share purchase plans or employee equity schemes, an employee share scheme gives key employees the ability to become shareholders in the business. How they get that equity is up to you. You can:

• Gift it to them;
• Sell it to them at a discount; or
• Sell it to them at market value. You can also help employees fund this through dividends or salary sacrifice, for example.

The type of equity that you offer employees can be in the same class as your equity or a different class. For example, you may choose to give employees a class of shares that doesn’t have voting rights so you can maintain control.

As securities are offered and issued under this arrangement, the documentation and ongoing administration will be more complex than for a Shadow Equity Agreement. Some of the legal documentation that may need to be arranged includes:

• An Information Memorandum;
• A Subscription Agreement;
• Class rights if you create a new class of shares for the employee share scheme; and
• The company’s Constitution and Shareholders Agreement may need to be amended.

3. Agreement to sell down

An agreement to sell down lets you sell your equity to your key employees. This gives you the opportunity to plan a complete exit without having to find another buyer. It’s also a good way to incentivise key performers now without diluting your equity holding.

The sell down could happen over several tranches linked to set milestones. For example, a certain amount may be transferred or sold to an employee each year over five years or be triggered upon meeting specific EBIT targets.

Like employee share schemes, you can decide how the sale is priced and funded. It could include:

• A combination of free transfers and market price tranches;
• Sale of equity at a discount; or
• The use of dividends or salary sacrifice to fund the purchase.

This type of agreement will involve documentation and regulatory requirements including:

• A Sale Agreement;
• Changes to your company’s Shareholders Agreement;
• Updates to your company register; and
• Notifications to ASIC when each tranche is transferred.

Protect your business

These agreements allow you to protect your business from the impact of losing a business owner and can give key employees comfort that your business is protected. If your business has more than one partner, you should also put in place a Buy/Sell Agreement, backed by insurance. This agreement may also need to be amended to take into account the succession agreement that you have in place for your key employees.

By Katie Johnston, senior associate

The post Don’t lose tomorrow’s leaders, lock them in appeared first on AdviserVoice.

Now the Royal Commission’s Final Report has landed, we expect to see more changes in the way financial planning businesses are bought and sold in the coming year.

The financial services industry has seen blow after blow recently with the introduction of new Financial Adviser Standards and Ethics Authority (FASEA) education standards and the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (the Royal Commission).

The flow-on effect already experienced on the way financial planning businesses are bought and sold is expected to intensify further now the final Royal Commission Report has publicly released yesterday.

Some of the key changes we’ve already seen, which we expect will only gain in momentum after the final report is released, include:

• It’s now very much a buyer’s market. The supply of client books and AFSL companies is greater than demand and we expect this will only intensify further as we approach the FASEA exam deadline of 1 January 2021.
• There’s been a movement away from large dealer groups to AFSL companies and shared services hubs.
• New ways to value businesses, use price adjustment mechanisms and structure payment terms.

One thing for certain is buyers will be very discerning about what they buy. Sellers will need to prepare…

Whether you’re buying or selling a business, these changes mean due diligence, deal structure and the contract recording the deal are more important than ever.

Due diligence is an important part of the purchase process

From a seller’s perspective, they need to have comfort that the buyer has the money to fund the purchase. On the flip side, buyers need to be sure that they’re getting what they pay for.

Regardless of which side of the transaction you’re on, due diligence can help you determine:

• Whether to walk away: Buyers can now choose to be hard-nosed in their transaction negotiations. Deals have fallen over at the due diligence phase as buyers look closely at factors like:
  • The quality of the books – age of clients and revenue model.
  • How the business generates its revenue. Following the Royal Commission, the deals we now see no longer attribute any value to trail commissions and greater scrutiny of fee models for service.
  • Cultural fit, including how clients and staff will move across and the gender diversity of staff.
• If you need conditions precedent: These are things that need to be resolved (or waived) before the deal is completed. These may include: – Removal of encumbrances over assets that may negatively impact title and access to revenue streams.
  • Prepayment of PI insurance.
  • Requiring key people to remain. This is something we’re seeing more and it can benefit both parties. For the buyer, it can bridge the time divide between the new FASEA education requirements and the seller’s retirement (which is often the reason for the sale). Having the contribution, knowledge and client connection with the existing advisor over a longer period of time can also maximise the value of the purchase and help cement the client base. For sellers, this can also be an effective way to maximise the earn-out of their final instalment purchase price adjustments.
• Whether to restrict the business between signing and completion: Prudent buyers may require sellers to: – Maintain and comply with their AFSL.
  • Maintain professional indemnity insurance and let it run-off for a fixed term, often 3 years or more from completion.
  • Have standard corporate and financial restrictions on changes to share structure (like restricting further share issues) and liabilities (like taking on further debt or changing current payment obligations).
• What warranties to impose or accept: Warranties are a contractual statement of fact that can lead to an award of damages if breached. Common warranties include: – Tax compliance.
  • Proper accounts and financial reporting compliance.
  • AFSL maintenance and compliance. This includes understanding when the last time services or advice was given under the AFSL.
  • Corporate compliance.
  • Share capital.
  • Whether there is any litigation or client disputes.
• If specific indemnities are necessary: Savvy sellers will often refuse general indemnities. Buyers can often reach an agreement by being specific about what indemnities are required (for example protection from liability for advice given before the client is next reviewed). Common issues identified in the due diligence process that may lead to specific indemnities include tax and AFSL related matters.
• What price adjustment mechanism is appropriate: It’s more common for buyers to push risk onto the seller using price adjustment mechanisms. These include: – Pushing instalment payments out to medium or long-term payments.
  • Using retention or escrow accounts in larger value transactions. These can reduce repayment risks if there are purchase price reductions in favour of the buyer.
  • Using punitive clawback clauses to protect against future changes to the law in relation to remuneration/ fees (e.g. Royal Commission risk).

How much due diligence is enough?

There’s an extensive list of things that buyers could investigate during due diligence. The key things to take into account are:

• What is at risk: If the purchase price is relatively low, buyers may try to rely on the warranties and indemnities in the transaction document to cure all unidentified ‘evils’. However, buyers will get better protection by identifying issues in the due diligence phase and adjusting the deal for these. For example, excluding certain clients from the calculation of the purchase price.
• The target: Buyers can generally limit due diligence investigations to clients they want to buy and take ‘the good’ and leave ‘the bad’. At a minimum, buyers should confirm the seller is the legal owner and that there are no encumbrances registered over the business that may impact the buyer’s title. If the target is the company, then buyers will need to do more due diligence like those outlined above.
• The buyer’s budget: If the budget is trim, buyers need to have a laser focus on key issues like clear ownership, litigation risk and FSR compliance.

Now the Royal Commission’s Final Report has landed, we expect to see more changes in the way financial planning businesses are bought and sold in the coming year. If you need advice on the best way forward, get in touch. We’d be happy to help.

By Katie Johnston

The post Deal breakers and deal changers in the financial planning M&A space appeared first on AdviserVoice.