Planning the Sale of Your Business

Sale of your business – Part 2

This article is the second in a four-part series intended to highlight key strategies to consider at different stages of your business. It isn't exhaustive, but it may help you to gain an understanding of some strategies you're already using or that might be suggested to you. Part 2 introduces some issues and tax planning strategies to consider when you're planning a sale or there's an imminent sale of your business. It discusses the typical reasons for selling your business, the concerns you may have about selling your business, your exit options, getting your business ready for a sale and the tax planning strategies to consider at this stage.

The other articles in the series are:

- Part 1: Preparing your operating company for future sale

- Part 3: Year of sale of your business

- Part 4: Year after the sale of your business

In this article, the terms "corporation" and "company" are used interchangeably to refer to a Canadian-controlled private corporation (CCPC). In simple terms, a CCPC is a private Canadian corporation that's not controlled by a non-resident of Canada, a public corporation or a combination; in addition, no class of shares of the corporation is listed on a designated stock exchange. This four-part series does not apply to public corporations or to businesses operating as a partnership or a sole proprietorship.

Typical reasons for selling your business

At some point, you may contemplate getting out of your business. Although the reasons for wanting to sell your business will be unique to you, here are some of the more common reasons business owners have for selling their business:

Retirement/succession

One of the most common reasons for selling your business is retirement. This is because, more than likely, the majority of your assets that you'll need for retirement are in your business. Selling is one way of accessing the value of your business to fund your retirement.

Market conditions – an up economy or market

Periods when there's a strong economy may be one of the best times to sell your business, especially if your business has a good history of positive cash flows with an expectation for that to continue in the future.

Financial difficulty

You may want to sell your business if it's having financial difficulty. However, here's where you have to decide whether it's better to cut your losses or try to turn your business around. If you can turn your business around, you may be able to increase its value and, ultimately, the price you get.

Grow to the next level

You may be ready to move to the next challenge. You have gone as far as you wanted to with your business and you're ready for new opportunities.

Family/health issues

You or one of your family members may be experiencing health issues that make it difficult for you to continue to run your business.

Burnout/personal exhaustion

You may no longer want to continue because your business is too dependent on your personal effort. However, it may be difficult to sell your business if its success is totally dependent on you.

Death of the owner

You may have inherited a business because the owner died and you have no interest in continuing to operate the business.

Shareholder issues

Maybe you have business partners and either you're not getting along or you're part of divorce proceedings which force you to cash out your portion of the business.

Unsolicited offer

You may have no intention of selling your business but you're approached by a buyer that makes an offer you can't refuse.

Issues and concerns about selling your business

As a potential vendor, you may feel very anxious and have lots of questions. Some common questions you may have are:

• What is my business worth?

• How do I find the right buyers?

• What price will I get and when will I receive the payments?

• How long will the process take?

• How long will I have to stay on after the sale?

• How much will I have left after taxes?

• How do I keep the sales process confidential?

• How do I manage my money after the transaction?

This is where having a team of qualified and experienced advisors and professionals can make a meaningful difference. Your team of advisors can help you understand, plan and structure the sale of your business and manage your money after the sale. This team may include professionals such as accountants, business valuators, lawyers, tax specialists and financial advisors who work together and are involved early in the sale process.

Exit options

There are only a limited number of options available to any private owner wanting to exit their business. Each situation is unique, so those options can be limited even further by the specific circumstances of every business. Aside from taking a company public through an initial public offering, there are two basic approaches to exiting a business:

1. Selling or transferring to parties related to the business, such as a family member, management team or another partner or shareholder

2. Selling to third-party buyers, which can include strategic buyers, financial buyers and other interested parties or serial entrepreneurs

Although there are other exit options, this article series only focuses on selling your business to a third party. Generally speaking, selling to third-party buyers is the best option for an owner who wants to exit their business, maximize deal terms and cash out.

You can approach third-party buyers, either strategic or private equity groups (PEGs), to determine their interest in purchasing your business or engage an intermediary to do so on your behalf. If you're attempting to get the highest and best offer for your business, engaging a qualified professional to run the divestiture process can result in the best deal.

Selling to a strategic buyer typically represents a very good option for most business owners. Strategic buyers are often in the same or a similar business to the company being sold. As such, they understand the markets served and the associated risks and have the potential to extract various synergies. Due to their competitive position in the marketplace, a strategic buyer is usually also in the best position to pay a premium for the company. The drawback with opting for a strategic buyer is the requirement to disclose confidential information to the potential buyer — who may, in some cases, be a competitor.

On the other hand, financial buyers, or PEGs, are looking for businesses with quality management teams, a strong earnings history, good margins, a sustainable competitive position in the industry and attractive long-term prospects in which to invest. Often these buyers require the existing management team to stay on after the purchase, as they generally don't have a management team of their own to put in place. PEGs pose less of a confidentiality concern to a seller due to their professional approach. Also, it's less likely they have another investment in the industry.

Getting your business ready for sale

There are a number of items you should consider when preparing your business for sale. The most common factors to review and analyze are the management team, the company's management information systems, the customer base, the timing of the sale and cash flow.

Management team

As an existing business owner, you should evaluate the depth and breadth of your current management team and consider making changes that would improve the business and its potential saleability. In addition, businesses that rely on one key shareholder or manager can create significant issues for a buyer, as this can increase the operating risk of the business and the potential that problems will arise if that key person leaves.

Management information systems

Well-managed companies usually have well-developed management information systems. The "it's all in my head" approach to management information is never the ideal answer when you're asking a top price for your business. Investing in and developing good management information systems will pay dividends, as it gives the management team the tools to effectively manage and improve the business. This will hopefully lead to a higher value when the business is sold. The due diligence process can be onerous at the best of times, so accurate information can make this process much easier during the review.

Customer base

Customer concentration is one of the most common problems in businesses. A potential buyer is ideally looking for a growing and diversified customer base. A business that's heavily reliant on one customer or a small number of customers presents a substantial risk due to the potential that the business's value will decline if a major customer leaves.

If no action is taken to improve this aspect, you may be limited in the number of divestiture options for your business; or, when the business is divested, the value will be low and the seller will ask to have the sale proceeds paid out over time.

Where possible, bring on new customers and expand relationships with existing customers. This can result in a higher-quality business and improved value on sale.

Timing of the sale

Although it's not always possible, being able to decide when to sell the business can almost certainly lead to an improved value. Avoid selling when overall valuations are depressed or when results are poor because the business is going through a rough patch. Generally speaking, if a business is implementing a turnaround, one year of good results and good visibility of future results are necessary to shed the negative impression created by a bad year. In general, selling when the business is on the way up can give you better results.

Cash flow

Companies that attract a higher "multiple" when sold generally have a high-quality cash flow that's very visible to the buyer. High-quality cash flow is consistent, recurring, high-margin and growing. A multiple is simply an expression of the market value of the business relative to a key statistic — whether earnings, cash flow or some other measure — that's assumed to relate to that value.

Cash flow tends to determine value and the higher the quality of the cash flow, the greater the value. There are a number of factors that impact the quality of cash flow. One of the best ways to improve cash flow is to put yourself in the buyer's position and critically review the risks attached to the cash flow in the business. Issues may be related to customer, supplier or key employee reliance or declining markets for certain aspects of the business. Where possible, take steps to reduce or mitigate those risks. Anything that creates a sense of risk or uncertainty in the buyer's mind will have an adverse effect on value. Once the offer arrives, it's very difficult to make any meaningful changes to the business that will result in an improved value, so do it before.

Executing the sale of your business

The purchase and sale of a business can include the following steps:

1. Determine market value of business and assess current market dynamics

2. Prepare marketing documents to present the business for sale

3. Complete research to identify possible buyers

4. Manage the market approach to the prospective buyers

5. Negotiate, oversee due diligence, structure and close the deal

Some of the professionals discussed previously will be instrumental in assisting you through these stages. The sale of a business is a complex process and it's highly recommended to engage a qualified mergers and acquisition specialist to advise you throughout the transaction. If you would like to speak to an RBC specialist regarding the sale of your business, your RBC advisor can refer you to RBC Mid-Market Mergers and Acquisitions to discuss its services.

Tax strategies to consider

When you're selling your business, the purchase price you get is less important than the after-tax funds you retain after the sale. Tax planning may allow you to sell your business at a lower price and still end up with the after-tax cash you expected. Because of this, it's important that buyers understand your tax objectives and work together with you to create tax efficiencies for all parties. Here's where it's critical for buyers and sellers to get professional tax advice early in the transaction process so the deal can be structured properly. The following is a discussion of the various tax strategies that may be considered at this stage of selling your business.

Incorporate your business before sale

If your business is currently not incorporated but there is a prospective purchaser, think about incorporating the business and selling the shares of the corporation to utilize your lifetime capital gains exemption (LCGE). You can find the current-year LCGE amount on the Canada Revenue Agency (CRA) website. Speak with a qualified tax advisor to determine if you can benefit from the LCGE.

Sale of assets

Determine if the purchaser is interested in purchasing the assets of your business or the shares of your business. If they're interested in purchasing the assets of your business, you'll generally not be eligible to claim the LCGE. As a result, you might be able to negotiate a higher sale price so the after-tax proceeds of an asset sale are similar to a share sale.

Hybrid asset sale structures

There are some sophisticated tax strategies that may allow you to claim both the LCGE for part of the proceeds as a qualified small business corporation (QSBC) share sale and treat the remaining proceeds as an asset sale. A discussion of hybrid asset sale structures is beyond the scope of this article, but if you're interested in finding out more, you should consult with a qualified tax advisor.

Sale of shares

If the purchaser is willing to purchase the shares of your business, you may want to ensure the shares qualify as QSBC shares in order to utilize your LCGE. If there are passive assets in the corporation, such that less than 90% of assets are being used in an active business at the time of sale, your qualified tax advisor may have to restructure or "purify" your corporation prior to sale to ensure the business qualifies for the LCGE. However, if there's a pending sale, it may be more difficult to restructure the business on a tax-effective basis.

Here's a brief outline of the various purification techniques that a qualified tax advisor may implement:

Non-taxable methods

• Reduce liabilities, for example, repay shareholder loans or reimburse shareholders for business expenses paid by them

• Pay out capital dividends if there's a positive capital dividend account balance in the corporation

• Make return of capital payments to shareholders

• Purchase more active business assets

Taxable methods

• Pay salaries or bonuses

• Pay taxable dividends

• Sell passive assets and pay down debt or invest in active assets

Tax-deferred methods

• Transfer passive assets to another corporation

• Other corporate reorganizations

Ongoing purification techniques are discussed in Part 1 of this article series.

The definition of QSBC shares is beyond the scope of this article. For more information, ask your RBC advisor for a copy of the article that discusses the capital gains exemption on private shares.

Safe-income strip

In addition to claiming the LCGE on a QSBC share sale, you may be able to effectively receive some of the sale proceeds tax-deferred in a holding company instead of paying tax immediately at capital gains tax rates. This strategy is commonly referred to as a "safe-income strip" (safe income is generally a corporation's retained earnings accumulated after 1971 restated on a tax basis). The logic behind this strategy is that you transfer assets on a tax-deferred basis from the company you're selling to a holding company. This reduces the value of the sale company and therefore reduces the capital gain that results on the sale of its shares. You will need to speak to a qualified tax advisor to determine if this strategy is available to you.

The portion of the proceeds that can be received tax-free by your holding company depends on the amount of safe income available. This portion of the tax on the sale proceeds received in a holding company is deferred until either death or when you withdraw the assets from the holding company during your lifetime. Although dividend tax rates are generally higher than capital gains tax rates, the tax deferral, which can last many years, can be advantageous. You may also consider using the funds in the holding company to purchase life insurance. Life insurance can be a tax-effective vehicle to minimize the taxes on the holding company shares at death and may allow your beneficiaries to withdraw monies from the holding company on a tax-free basis. You have to consider the cost of insurance to determine whether this strategy is cost effective.

There are various ways to access safe income. The following are the major components of one way to do so (the step-by-step procedures are beyond the scope of this article):

1. You incorporate a holding company, Holdco

2. You transfer shares of your operating company, Opco, to Holdco on a tax-deferred basis; you may choose to keep a portion of the shares personally to utilize your LCGE and transfer the rest to Holdco

3. Holdco can then access safe income through the following methods:

• Opco pays a cash dividend to Holdco

• Opco pays a dividend in kind to Holdco

• Opco increases its paid-up capital

• Opco purchases Holdco shares for cancellation (redemption)

Generally, the dividends paid between Opco and Holdco are tax-deferred if they're connected corporations. However, if your corporation pays a dividend greater than safe income, that dividend could be re-characterized as a capital gain resulting in an immediate tax liability even if the corporations are connected. Therefore, great care must be taken in calculating safe income and the exact amount of the dividend that may be paid on a tax-deferred basis.

The rules that determine whether two corporations are connected are complex. One instance where corporations are considered connected is where a corporation owns more than 10% of the issued share capital (having full voting rights) of the other corporation and it also owns more than 10% of the fair market value of all of the issued shares of the capital stock of the other corporation (i.e. more than 10% of the votes and the fair market value of all share capital).

Other tax minimization strategies

If the capital gains on the sale are expected to be substantial, speak to a qualified tax advisor regarding your advanced tax strategies that can be considered to reduce and/or defer some of your capital gains tax.

Financial planning

As you prepare for the sale of your business, you'll want to determine how the sale will affect you financially. You may want to consider having your RBC advisor prepare a financial plan for you to determine if the expected after-tax sale proceeds will be adequate to enable you and your family to meet your retirement income and estate planning goals.

This article may contain strategies, not all of which will apply to your particular financial circumstances. The information in this article is not intended to provide legal, tax or insurance advice. To ensure that your own circumstances have been properly considered and that action is taken based on the latest information available, you should obtain professional advice from a qualified tax, legal and/or insurance advisor before acting on any of the information in this article.