A business transfer can occur in many ways. A business transfer by means of cumulative preferred shares (cumprefs) is just one of the options. This method of transfer is often used in cases of succession within the family or in management buyouts, when financing the acquisition is problematic.
What are cumulative preferred shares?
Cumulative preferred shares (cumprefs) are shares where shareholders have priority over other shareholders. If no dividends are paid in bad times, they are first in line in better times. Using cumulative preferred shares has several advantages:
- Guarantee a constant income stream;
- Divide control between cumprefs and common shares;
- Give family the opportunity to build equity;
- Gradual transfer.
Why is this a solution?
An advantage for the buyer is that the transfer does not sometimes involve any finances. This ensures that family members do not have to cough up large sums in the event of a succession and do not have to take out an interest-bearing loan. The seller is thus assured of a fixed compensation, namely in the form of dividends. Often a fixed percentage is set, with 7% being common.
If there are years when revenue is disappointing, they do not pay dividends. This is obviously problematic for both parties, but the advantage is that a deferred payment is legally allowed. As a result, the buyer does not have sky-high expenses in difficult times, and the seller is assured of guaranteed income now or in the future. They pay any arrears later, with the arrears coming on top of the continuous amounts.
What is a potential pitfall?
The seller's income is completely dependent on what the buyer performs with the business. So there must be a bond of trust between buyer and seller, because it is an income-dependent agreement. If the new owner does not achieve sufficient revenue, the seller suffers. Should the business go under, the former owner only has a preferential position in liquidation.
In doing so, the tax authorities may look critically at the nature of the payments when it comes to family succession. The payments must clearly be at arm's length. No shuffling of amounts or sneaking around with goodwill and hidden reserves. And remember to arrange and record everything properly, because you cannot avoid the gift tax.
Variants of cumulative preferred shares on business transfer
There are two ways you can arrange a business transfer through cumulative preferred shares:
- An operating company converts the shares into cumprefs, while the business successor receives ordinary shares. After this issue, the seller (DGA) exchanges the shares so that he receives the cumulative preferred shares;
- The seller does not receive money, but shares instead. The former owner hands over the business, but gains cumprefs.
