Thursday, March 29, 2012

BV Benefit #6 - Tax and Estate Planning

With many business owners planning to transfer the business internally to the next generation over time, one option is through an estate freeze.

In an estate freeze the business owner’s common shares are exchanged for preferred shares of equal value to the common shares.  New common shares are then issued by the company to the next generation family members.  This allows the business owner to "freeze" his/her unrealized gain in the corporation on a tax-deferred basis, with any future growth in value of the company accruing to the children.   As a result, the business owner can estimate and plan for the future tax liability, perhaps with life insurance.

Under an estate freeze the fair market value of the common shares must be established.  According to the CRA [1], the fair market value must be determined "by a fair and reasonable method".  If not, CRA will likely challenge the validity of the transaction alleging that a benefit had been received by a shareholder who acquired property from a corporation at less than fair market value.

In the event of a potential dispute with the CRA, price adjustment clauses (PACs) are sometimes used to retroactively adjust the fair market value to avoid the 'conferral of benefit' problem.  Unfortunately, a PAC may not help if a fair and reasonable valuation attempt was not initially conducted.

In Guilder News Co. (1963) Ltd. et. al. v. M.N.R., 73 DTC 5048 (FCA), the Court rejected the PAC as a basis for adjusting the price and eliminating the benefit on the grounds that the parties had not reasonably attempted in good faith to transact at fair market value.   Other recent case law involving PACs include St. Michael Trust Corp. v. Canada (2010 FCA 309, affirming Garron, 2009 TCC 450) and Krauss v. Canada (2010 FCA 284, affirming 2009 TCC 597).  Potential implications to the business owner of not having a fair and reasonable valuation include additional taxes, interest and penalties.

As such, an independent valuation prepared by a professional valuator can provide a fair and reasonable basis for the fair market value used in an estate freeze, essentially acting as insurance for potential disputes with the CRA.  Inadequate fair market value assessments can give rise to unfortunate tax consequences as well as costly and time-consuming litigation, not only with the CRA but also with the advisors.

Other tax and estate planning mechanisms involving the transfer of assets or shares to a related party include business incorporations, corporate restructuring, share reorganizations or family trusts.  In order to take advantage of tax deferrals, these transfers typically must occur at fair market value.  You will be well served and protected by involving and retaining an independent business valuator to assist with the fair market value determinations for these tax planning purposes.

1.  Source: CRA's Interpretation Bulletin IT-169.

Tuesday, March 20, 2012

BV Benefit #5 - Internal Transfer of a Business

According to recent studies on the business succession market in Canada, between approximately 30% and 40% of business owners surveyed are expecting to transfer the business internally to other shareholders, management, employees or a family member. [1] 

A valuation prepared by an independent business valuator (perhaps annually in accordance with a shareholder agreement) is highly recommended and very beneficial for purposes of transferring business ownership internally.

In order to ensure a smooth internal ownership transfer, it is extremely important for all parties involved to agree on the current fair market value of the business.   The current fair market value can be used to set the price for the transaction in situations where the purchaser (i.e. shareholder, management, employee or family member) acquires the departing shareholder’s shares or in situations involving share redemptions by the company.

In his best-selling book on protecting family wealth, "Every Family’s Business", Tom Deans suggests that all business owners should arrange for an updated annual valuation of the business.   In fact, one of Tom’s 12 steps in his annual checklist for family businesses (referred to as the Wealth Protection Blueprint) states that business owners should:
"… arrange for an updated valuation of the business and calculate whether there is appropriate insurance in place to ensure that estate taxes will not impair the ability of the company to function in the event of the owner’s death."
Tom then discusses the implications of not obtaining a valuation prior to an internal transfer.   There can be serious repercussions to the business and to family members if the company is transferred to the next generation for an amount that is less than or greater than the actual fair market value of the business, particularly when the transaction was financed with debt.

Not only can a business valuation be used to set the price for an internal transfer or buyout of a departing shareholder’s shares but it is clearly a prudent tool for contingency planning to help protect the business and the business owner’s family in the event of the owner’s untimely death.

Next week we turn our attention to the benefits of a business share valuation for purposes of tax and estate planning.

1.   Source: "Quantitative Study of the Business Succession Market in Canada, RBC and CICA/RBC Business Monitor (Q1 2010).

Wednesday, March 14, 2012

BV Benefit #4 - Sale of a Business to a Third Party

According to recent studies on the business succession market in Canada, more than one third of those surveyed are expecting to sell the business externally to a third party. [1]

"We should remember that good fortune often happens when opportunity meets with preparation."

- Thomas. A. Edison

This quote is aptly applied to situations involving the sale of a business to a third party, the fourth benefit of obtaining a professional business valuation.   For business owners today, the opportunity represents the short window of time before the aging baby boomers begin to flood the market with businesses for sale. The preparation begins with a business valuation.  The good fortune comes with a sale of the business for the maximum possible price.

For many business owners the sale of their business is a once in a lifetime event.   Once a business owner has committed to selling the business the question becomes - for how much?   Many business owners, for various reasons, grossly overestimate or underestimate the value of their business.  Investing in an independent business valuation is an investment that will pay for itself.   Here are 6 reasons why:

  1. An independent valuation helps to manage the business owner’s pricing expectations which increases the likelihood of getting a deal closed;
  2. A professional valuation can help justify the asking price and provide support for negotiating price with a potential purchaser;
  3. Having an independent valuation prepares the business owner for any unsolicited offers received from competitors or other industry participants;
  4. The valuation process can help identify potential purchasers or purchaser categories;
  5. The valuation process educates the business owner regarding "stand-alone value" and "synergistic value" and the notion that value is different to different purchasers; and
  6. A valuation ultimately helps the business owner maximize the sale price, ensuring no money is left on the table.
Many business owners looking to sell their businesses will not take advantage of opportunities in the current marketplace with proper planning, including a professional business valuation.   On the other hand, those that are prepared with a professional valuation and keen sense of market timing will vastly increase the odds of having good fortune bestowed upon them.

Stay tuned for our next discussion on how a business valuation can also be used for internal transfers of a business to existing shareholders, management or employees.


1.  Source: "Quantitative Study of the Business Succession Market in Canada, RBC and CICA/RBC Business Monitor (Q1 2010).

Wednesday, March 07, 2012

BV Benefit #3 - Pre-Sale Planning

The third benefit of having a professional business valuation (i.e. share valuation) is its use in pre-sale planning for business owners.

As previously mentioned, between 60% and 75% of business owners will exit their businesses within the coming decade.[1]   Over $10 trillion in private wealth will change hands in North America over this time frame, the largest transfer of private wealth in history. [2]

The increasing supply of businesses for sale will put downward pressure on sale prices. Buyers will only pay top dollar for the most attractive businesses and preparing a business for sale takes time.

Effective pre-sale planning must begin at least 3 years before the sale and it should begin with a business valuation.   A current share valuation provides:
  1. An indication of what the business owner could reasonably expect to fetch on the open market today; and

  2. A benchmark for enhancing the value of the business prior to an actual sale. 
The business valuation process involves a careful assessment of the company’s risk profile and the key value drivers for the business.   A share valuation conducted by a professional valuator identifies areas of weakness and key value drivers to focus on for the business to be made more attractive to a potential purchaser.   If conducted early enough there will be enough time to implement the key value enhancement initiatives required to maximize the value of the business and the price that is ultimately received in a sale.   This process, which begins with a valuation, leads to a business that is more liquid and more easily monetized.

All business owners will one day exit their business.   The importance of pre-sale planning must not be overlooked. In a Newport Partners survey of more than 100 Canadian business sellers, 62% recommended methodically pre-planning the sale of a business two to three years in advance.   However, less than 25% actually did so themselves.   Business owners today should learn from the mistakes of other business owners that have actually been through the process of selling their business.

Pre-sale planning is especially vital in light of existing demographics and the expected increase in the supply of businesses that will be put up for sale over the coming decade. The planning begins with a business valuation so there is a frame of reference for measuring the effectiveness of the pre-sale planning activities.  Without one business owners may never realize just how much money was left on the table.

Stay tuned for continued discussions on the many other uses of a business valuation.

1.  Various studies including surveys by the CFIB and the CICA/RBC Business Monitor (Q1 2010).
2.  Source: The $10 Trillion Opportunity, Richard Jackim & Perry Phillips, 2007.

Thursday, March 01, 2012

BV Benefit #2 - Wealth Management

The second benefit of having a professional business valuation is its use in wealth management.

The value of a business can represent the largest portion of a business owner’s wealth. According to a publication by Mercer Capital:

"About 75% of all private equity is owned by households for whom it constitutes at least half of their total net worth. Households with entrepreneurial equity invest on average more than 70% of their private holdings in a single private company in which they have an active management interest." [1]
Wealth managers typically focus on managing liquid investments (e.g. publicly traded securities).   Investors pay substantial fees for the services of wealth managers, typically based on a percentage of the value of the assets under administration (e.g. 0.5% to 2.0% or more).   Monthly, quarterly or annual statements indicating the value of these publicly traded investments are provided so that appropriate investment decisions can be made based on, among other things, how values have changed and what returns are being generated.

Privately held business owners spend significant time managing the business.   Many, however, spend little time managing the wealth associated with their business.   A business investment is just as important as (if not more important than) publicly traded investments.   An effective wealth management strategy allocates a percentage of the value of the business to managing the privately held wealth.

The One Percent Solution recommends that privately held business owners invest 1% to 2% of the value of the business towards a budget for the following wealth management activities:

  1. Annual business valuation

  2. Reviewing the buy-sell clause and shareholder agreement

  3. Funding life insurance

  4. Tax and estate planning

  5. Monitoring critical success factors and value drivers

  6. Audited financial statements

  7. Annual legal review

  8. Other pre-sale planning projects
These activities may not be required every year but each of these should be carefully considered and incorporated into an overall wealth management plan.

All business owners will one day exit their business.   The above activities will help ensure that business owners maximize the net proceeds they receive when it comes time to convert their business into a liquid asset.

Traditional wealth management has focussed on the liquid investment portfolio despite the fact that this may account for a small portion of the business owner’s overall wealth. It is time for business owners to protect their family’s wealth by restoring balance and order to their overall wealth management plans.   Start with a business valuation to identify what percentage of the overall wealth is tied up in the business.

Stay tuned for further discussions on the many other uses of a business valuation.

1.   Source:  The One Percent Solution, Z. Christopher Mercer, 2007.