Key takeaway

A shareholder exit does not always require the remaining shareholders to fund the full buyout personally on day one. Private companies can often use structured mechanisms such as a company share buyback, a staged transfer of beneficial and legal ownership, or a new holding company with loan notes. The right approach depends on the company’s reserves, tax treatment, timetable and shareholder documentation.

Why do shareholder exits often stall over funding?

When a shareholder in a private company decides to exit, whether through retirement, a change in direction, or simply a desire to move on, the negotiation almost always centres on price. What is the departing shareholder's stake worth? These are the right questions, but they are only half of the picture.

The issue that is far too often left unresolved is how that payment will actually be funded. In our experience, this is where exits stall. The remaining shareholders assume they must find the full sum immediately and, concluding that they cannot, the process stops. In reality, that assumption is often wrong. There are well-established structures that allow a shareholder to exit cleanly and receive full value, without requiring the entire consideration to be available on day one.

What is the hidden cost of funding a shareholder exit personally?

Where the remaining shareholders fund the buyout themselves, they will typically need to extract cash from the company first, most commonly by way of dividends. The tax cost of doing so can be substantial.

To illustrate: on a £4 million exit, funding through dividends, after higher and additional rate income tax, can add over £1.5 million to the overall cost of the transaction. That fundamentally alters the economics of the deal.

For this reason, it is almost always worth exploring whether the company itself can fund the exit directly.

How does a share buyback work for a departing shareholder?

A share buyback or company purchase of own shares, is where the company acquires shares directly from one of its shareholders. It is the most commonly used mechanism for a shareholder exit and, when structured correctly, is considerably more tax-efficient than a personal acquisition by the remaining shareholders.

The legal framework is set out in Part 18 of the Companies Act 2006 and is unforgiving. A buyback that does not comply with the statutory requirements is void, it has no legal effect. The company and its officers may face personal liability, including potentially unlimited fines or criminal sanction.

The key requirements are:

•     Shares must be paid for in full, in cash, at the time of purchase. Deferred or staged payment is not permitted;

•     The purchase must be funded from distributable profits, the proceeds of a fresh share issue, or, for private companies only, with additional safeguards, out of capital;

•     The company's articles of association must permit a buyback; board and shareholder approval are both required;

•     Shares are generally cancelled on completion, increasing the remaining shareholders' proportionate ownership.

Stamp duty is payable at 0.5% of the purchase price and the transaction must be reported to HMRC within 60 days.

Are share buyback proceeds taxed as capital or income?

By default, HMRC treats proceeds from a share buyback as a distribution, taxed as income, the same as a dividend. This can significantly reduce the net return to the departing shareholder.

The more favourable outcome is capital treatment, under which the shareholder pays capital gains tax only on the gain above their original acquisition cost, at a lower rate, and potentially with Business Asset Disposal Relief available. To qualify, the buyback must be for the benefit of the company's trade, the shareholder must have held the shares for at least five years, and they must not remain connected to the company post-exit. Advance clearance from HMRC should always be sought where capital treatment is intended.

What if the company does not have enough distributable reserves?

The most common obstacle to a share buyback is that the company lacks sufficient distributable reserves at the time the exit is agreed. This need not prevent the transaction from proceeding.

One established approach is to separate beneficial ownership from legal title, completing the exit in two stages. At signing, the departing shareholder transfers their beneficial interest, commercially, they have exited, no longer participating in profits or growth. Once the company has built the necessary reserves, legal title transfers and the full cash consideration is paid.

This gives both parties certainty early, while allowing the company time to generate the funds. The agreement must be carefully drafted to make the transfer of legal title conditional on the company having sufficient reserves at that point, and the tax timing implications must be considered from the outset.

Our recent article on managing family business succession notes that articles of association are especially important where shares may be transferred and that business handovers require carefully thought-out, legally enforceable arrangements.

Can a new holding company and loan notes be used for a shareholder exit?

Where greater flexibility is required, a new holding company structure can be used. The new company acquires the departing shareholder's shares, with consideration satisfied by the issue of loan notes, a formal debt instrument repayable over time, rather than immediate cash. The remaining shareholders exchange their shares in the original company for shares in the new holding company, typically on a tax-neutral basis, and the loan notes are repaid from business profits over time.

This removes the need for distributable reserves at the point of acquisition and gives the departing shareholder a structured, contractual entitlement to their consideration. There may also be scope to defer capital gains tax, depending on how the loan notes are structured. The trade-off is complexity: an additional layer of corporate structure, separate filing obligations, and more extensive documentation. HMRC clearance should be factored into the timetable.

For more, read our article on the accounting risk in convertible loan notes.

How should shareholders choose the right exit structure?

The right structure depends on the company's financial position, the timeline both parties can accept, and the departing shareholder's tax profile. As a general guide:

•     A share buyback is appropriate where distributable reserves are available and the conditions for capital treatment can be met;

•     Splitting beneficial and legal ownership works well where reserves need time to accumulate but both parties want certainty now;

•     A new company with loan notes suits cases where flexibility is the priority and immediate full payment on exit is not essential.

In every case, the structure and the tax analysis must be addressed before any figure is agreed, not after. These are not transactions that can be approached informally. The cost of proper advice at the outset is modest; the cost of getting it wrong is not.

Where a shareholder exit forms part of wider owner planning, sale preparation or succession strategy, our article on preparing a UK SME business for sale highlights the steps you need to take to successfully dispose of your assets.

Our Corporate team advises clients on shareholder exits, share buybacks, shareholder agreements, corporate reorganisations, loan note structures and business succession planning. For more information, please contact our Corporate solicitors to discuss how we can support you.

Authored by Barnes Law Managing Partner, Yulia Barnes.