Exit Planning Can Save Significant Taxes

Maximizing the net proceeds received from the sale of a business is a common goal for many business owners.  This will only be accomplished with enough time to implement an effective strategy for maximizing value and minimizing taxes.

 

Business owners generally are aware of the $750,000 capital gains exemption that is available on the sale of qualified small business corporation (QSBC) shares.  This can be an extremely valuable tax shield.  In Ontario, this translates into a tax savings of approximately $180,000 at the top combined marginal tax rate on capital gains (i.e. 23.98% for 2012). 

 

Many business owners assume that this exemption will be available to them.  However, certain conditions must be met in order to qualify.  A cursory summary of these conditions is as follows:

1. Ownership Test – the shares were owned by the person (or a related party) throughout the 24 months preceding the disposition;
 
2. 50% Test – more than 50% of the fair market value of the assets of the business were used principally in an active business carried on primarily in Canada throughout the 24 months preceding the disposition; and
 
3. 90% Test – all or substantially all (90%) of the fair market value of the assets were used in the active business at the time of disposition of the shares.

Assets not used in the active business include excess cash, marketable securities and other investments, vacant land, rental properties, shareholder and related party loans, etc.  From a business valuation perspective, assets not used in the active business are considered redundant assets which are valued separately from the business operations.  An independent business valuation will help ascertain whether or not the business satisfies the 50% test and 90% test.

 

Between 60% and 75% of business owners are planning to exit their businesses within the coming decade. [1]  These business owners must start planning now if they want to maximize the net proceeds ultimately received on exit.  The action items take time to implement and preparation is vital to ensure value is maximized and taxes are minimized.

 

Some business owners have lost out on the $750,000 capital gains exemption because, when faced with an involuntary sale of their business (i.e. illness, disability, dispute, death, etc.) or an unsolicited offer by a third party, the above noted conditions were not met.  Don’t let this happen to you. 

 

Implementing strategies to minimize tax on the sale of a business takes time, including being able to take advantage of the $750,000 capital gains exemption.  The 2 year period prior to disposition is critical.  Not qualifying for the capital gains exemption will take nearly $200,000 out of the business owner’s pocket and place it in the hands of the CRA.

 

Visit us at www.vspltd.ca to learn more about our exit planning process.

 

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[1]  Source: Surveys by the CFIB and the CICA/RBC Business Monitor.

Key Value Drivers – Economic Dependence

Developing a business that is not economically dependent on a single customer, supplier or employee is a key value driver for many businesses.  Economic dependence increases business risk and decreases business value. 

 

Potential purchasers of a business are interested in the extent to which: i) sales are derived from one customer; ii) raw materials are obtained from one supplier; and iii) a key aspect of operations is dependent on one employee. 

 

Each of these is discussed briefly below:

 

1.   Customers

 

If a business is too dependent on any one customer, the loss of that customer can be devastating to the business.  Even with a contract, the customer could renew for a shorter period, renew under less favourable terms (e.g. reduced prices that squeeze profit margins), or not renew at all. 

 

Business owners should quantify the percentage of overall revenue generated by each customer. The strategic plan should address how to increase sales to the smallest customers or find new customers to reduce customer concentration.  The goal should be to have the largest customer represent no more than 10% of the revenues. 

 

2.   Suppliers

 

If a business is too dependent on one supplier, the loss of that supplier could be disastrous.  Alternatively, a price increase could squeeze profit margins (if not passed along to customers) and decrease business value.  A supply delay or shortage that halts production could negatively affect client relationships and destroy the business.

 

Business owners should determine their most important raw materials and, where possible, identify a number of different companies that could supply them.  The strategic plan should set out a plan for approaching and negotiating the same discounted rates from another supplier.  The company may be better off with numerous suppliers, even if some special pricing discounts are sacrificed.

 

3.   Employees

 

If a business is too reliant on one employee (e.g. management, sales, production, R&D, etc.), it is at significant risk if that employee chooses to leave.  The company will also be at a disadvantage when it comes time to negotiate that employee’s salary.

 

Business owners should rank their employees from easiest to most difficult to replace.  The strategic plan should address how the company can become less dependent on those employees most difficult to replace and how to create a bench of potential hires for key roles in the event of an employee defection.

 

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In general, economic dependence refers to the balance of power between the business and a key customer, supplier and/or employee when it comes time to negotiate or renew a contract.  The more dependent a business is on any one customer, supplier or employee, the less power it will have in renegotiating a favourable contract.  This increases the uncertainty associated with a projected stable and/or increasing cash flow stream and inherently decreases the price a potential purchaser would be willing to pay for the business. 

 

If you are building a business to sell one day and are curious about where your business stands today, take the 13 minute Sellability Score questionnaire:

http://www.sellabilityscore.com/vsp/jason-kwiatkowski

Periodic Valuations Help Avoid Costly Legal Disputes

Relationships can break down over time.  Many of us have experienced this with a friend, spouse or business partner.  Shareholder disputes are among the most contentious and frequent types of business disputes.  In addition, over 40% of marriages will end in divorce before the 50th year of marriage. [1]

 

Conflicts between shareholders or spouses can become very emotional.  When shareholders decide to part ways, the value of the business becomes an extremely important issue.  A value is needed for purposes of a shareholder buyout.  In a marital separation, a value is needed for purposes of property division.  Assuming a third party sale of the business is not desired, the parties will need to agree on the value of the business.  Amicable negotiations with respect to business value can quickly turn into a lengthy and costly legal dispute.

 

Where the parties have not obtained any prior valuations prepared by an independent business valuator, or had prior discussions on value, diverging and potentially unrealistic expectations could emerge.  The purchasing shareholder will often expect a much lower value for the business than the selling shareholder.  In a marital separation the business owner spouse will generally expect a much lower value than the non-owner spouse.  Expectations can vary significantly which will exacerbate the legal dispute. 

 

Obtaining periodic valuations from an independent business valuator can be a very useful tool for avoiding a major dispute on value.  At the very least an annual conversation about the value of the business can help to avoid costly legal disputes in the event of a breakdown in the relationship (business or marital).

 

Obtaining periodic independent business valuations is akin to insurance.  Reviewing and discussing the independent valuation can help minimize the likelihood of diverging value expectations in the event of a future shareholder or marital dispute.  The cost of a periodic valuation is similar to the premiums paid on an insurance policy and should form part of the business owner’s overall wealth management budget.  It may hurt a little to incur the cost of an independent valuation when things are fine but it will hurt much more if a relationship breaks down and the parties enter into a lengthy and costly legal dispute over the value of the business.

 

Committing to obtaining a periodic business valuation allows the shareholders to discuss and agree to the current value of the business before any potential disagreements arise.  The valuation can also be helpful in the event of a marital dispute because the valuation issue will have already been dealt with.  The return on investment of an independent and annual valuation can be tremendous if it means avoiding a costly, time-consuming and perhaps devastating shareholder or marital dispute down the road.

　

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[1] Source: www5.statcan.gc.ca, CANSIM Table 101-6511.

Key Value Drivers - Over Reliance on the Owner

Developing a business that is less reliant on the owner is a key value driver for many businesses.  Purchasers are very interested in assessing the extent to which sales will continue and the business will carry on under new ownership. 

 

If sales are generated by the owner’s personal skills, abilities, contacts and relationships with the customers, the ability to transfer those clients to new owners will be extremely uncertain.  Acquirers generally avoid businesses that are too heavily dependent on the owner for its success because the ability to generate future revenues is too risky. 

 

Potential purchasers will assess the extent to which the owner is the main contact person for customers and suppliers when considering how much to offer for the company.  The extent to which employees can operate independently of the owner’s presence will also be considered. 

 

An experienced management team with sufficient depth and breadth and formalized roles and responsibilities and working together in line with the business plan is critical in order to reduce the company’s reliance on the owner.  

 

A list of 5 warning signs that a business is too dependent on the owner along with some suggestions for beginning to enhance the value of the business is as follows:

1. New business is not generated without the owner’s efforts – hire a salesperson or delegate sales responsibilities to key employees; link employees’ bonuses to the gross margin on sales they generate
 
2. The owner is the main contact point for customers and knows all customers by first name - hire a salesperson or delegate some customer relations responsibilities to other employees; have a trusted employee shadow the owner when meeting customers so over time customers get used to dealing with someone else
 
3. Employees contact the owner with various problems constantly – hire more experienced individuals that can be more self-sufficient; develop job descriptions for each position detailing each role’s authority, responsibility and accountability 
 
4. The owner closes up every night, signs all checks and cannot take extended breaks – develop an employee manual of basic procedures and job descriptions; give a trusted employee signing authority for checks up to a certain amount; take one day off to see how it impacts the business and work up to being able to take a few weeks off without it affecting the business
 
5. Only the owner receives tickets from suppliers - appoint a trusted employee as the key contact for a major supplier and give that employee spending authority up to a certain amount

If you are building a business to sell one day and are curious to see the impact of owner reliance on value, take the 13 minute Sellability Score questionnaire:

http://www.sellabilityscore.com/vsp/jason-kwiatkowski

Key Value Drivers - The Hierarchy of Recurring Revenue

The customer base is a key value driver for most businesses.  In addition to a diversified client base and the potential for future revenue growth, purchasers are very interested in companies that have strong customer relationships that lead to repeat business.

 

The extent to which future sales can be predicted with some degree of confidence is a major factor in determining the value of a company.  Projections are inherently uncertain and a recurring revenue stream provides greater confidence in the ability to predict future revenues.  Creating a recurring revenue stream is one of the best ways to increase the value of a business and command a higher price in the marketplace.

 

There are various forms of recurring revenue.  The list below outlines six forms of recurring revenue presented from least to most valuable in the eyes of an acquirer:

 

6.  Consumables:  disposable items that customers purchase regularly that can be, but are not necessarily, "brand-loyal" such as shampoo, bottled water or batteries.

 

5.  Sunk money consumables:  disposable items that require an initial investment in a "platform piece" such as razor blades or electric toothbrushes.

 

4.  Renewable subscriptions:  items that are paid for in advance for a period of time such as magazine subscriptions or monthly passes for public transportation.

 

3.  Sunk money renewable subscriptions:  products or services that require an initial investment and an ongoing user fee such as a Bloomberg Terminal and corresponding subscription fee for access to the financial information.

 

2.  Automatic renewal subscriptions:  products or services for which a fee is automatically charged monthly until the client specifically opts out such as document storage or satellite radio subscriptions.

 

1.  Customer contracts:  products or services that require a hard contract for a pre-defined term such as wireless phone contracts or commercial cleaning services.

The largest transfer of private wealth in history will occur over the coming decade.  The increasing supply of businesses for sale over this time period will create a buyer’s market, in which buyers will only pay top dollar for the most attractive businesses. 

 

Business owners looking to sell (for a premium) over the coming decade must assess the quality of their existing revenue streams and, where possible, implement measures that will help move them up the hierarchy of recurring revenues.

 

If you are building a business to sell one day and are curious to see how the quality of your revenue stacks up, take the 13 minute Sellability Score questionnaire:

 

http://www.sellabilityscore.com/vsp/jason-kwiatkowski

Exit Planning - The Difference Between Value and Price

Some would argue that a business valuation is not useful to business owners for exit planning purposes because the valuation can become outdated quickly and it may not provide an accurate assessment of what a potential purchaser would be willing to pay for the company.

 

Although I generally agree with this reasoning, I believe that a valuation can be very useful to business owners in exit planning.

 

Fair market value (FMV) is a common value term used by business valuators.  According to the International Glossary of Business Valuation Terms, FMV is defined as follows:

"The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts."

FMV is a notional market concept.  Price, however, is what is agreed upon by parties in an actual transaction.  Under certain circumstances FMV and price will be similar, however, the two will rarely be equal.  This is because certain factors reflected in price are generally not reflected in FMV, including:

 

1. Economies of scale or synergies:  Potential cost savings, increased sales, eliminated competition, etc., that may result from combining the target company with the purchaser’s existing business, are generally not reflected in FMV
 
2. Negotiating strength:  Relative bargaining abilities of the buyer/seller and their individual perception as to the future of the business and risk will affect price but not FMV
 
3. Transaction structure:  Price will often include non-cash consideration whereas FMV is expressed in terms of cash
 
4. Underlying motivations:  Buyer/seller motivations for purchase/sale that impact price are generally not reflected in FMV

 

It is true that an outdated valuation may not be useful to business owners when the facts and circumstances affecting value have changed since the valuation date.  However, a current FMV assessment can be useful for exit planning purposes for the following reasons:

1. FMV can be used in negotiations with a potential purchaser because buyers generally consider the same valuation approaches and techniques used by business valuators in a FMV assessment
 
2. FMV provides a good intrinsic value benchmark (i.e. prior to economies of scale or synergies) that is useful for identifying and implementing value enhancement initiatives
 
3. FMV can serve as a basis for a pricing analysis, which does consider value from the perspective of a specific purchaser and attempts to quantify the economies of scale or synergies that may be realized by incorporating the target business with the purchaser’s existing business

 

At the end of the day price will be determined through negotiations between a buyer and seller which will be influenced by negotiating strength and a supportable value analysis.  A current valuation or pricing analysis prepared by an independent business valuator may provide the business owner with the edge needed in negotiations with a potential purchaser.

 

Exit Planning - Consequences of Not Planning Can Be Severe

According to a 2008 White Horse Advisors' survey of closely-held business owners, 96% percent of Baby Boomer business owners agreed that having an exit strategy was important, but 87% did not have a written exit plan. [1] 

The consequences of not having an exit plan can include, among other things, lost opportunity, wasted time, effort & money as well as decreased business value.  These consequences were illustrated in a recent client matter involving the unplanned exit of a majority shareholder.

The Scenario:

A manufacturing business owned 80% by the majority shareholder, 12% by unrelated individuals and 8% by management. 

The majority shareholder was forced into an unplanned exit when he suddenly passed away.  Basic tax and estate planning was in place but no formal exit plan existed. 

The estate now owned an 80% equity interest in a privately held manufacturing business. The beneficiaries were not active in the business and wanted immediate liquidity.

The Transition:

Management expressed interest in acquiring the estate’s 80% shareholding.  Expecting a smooth and timely process, the beneficiaries decided to pursue a management buy-out (MBO) as opposed to a third party sale on the open market. 

We were retained by the beneficiaries to provide an independent fair market value assessment as support for the price to accept in the MBO.  Although the parties agreed on price, they could not agree on the transaction structure.  After one year of negotiations the deal had not closed and the parties agreed that, due to external factors, the value of the business had declined over this period. 

We were again retained to value the business for purposes of the MBO.  The market value had in fact decreased by approximately 5% to 10%.  Transaction structure was still a major issue as management had difficulties financing the transaction.  Ultimately it took two years to finalize the deal.

The Consequences:

The majority shareholder was not prepared for this involuntary exit.  The beneficiaries of the estate assumed that a MBO would be a quicker and smoother process than pursuing an external sale on the open market. 

Unfortunately this process took two years and the value of the business decreased over the course of extended negotiations.  Significant transaction costs (accounting, legal and other expert fees) were also incurred by the parties over the two year process.  In addition, an external sale to a strategic or financial buyer may have fetched more than that agreed to between the beneficiaries and management.   

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87% of business owners surveyed by White Horse Advisors in 2008 do not have a written exit plan, many of which do not appreciate the potential severe consequences awaiting them - neither did the majority shareholder in the above noted client situation!

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[1]   Source:   http://exitplanningresearch.com/Findings.htm