Succession planning for small business

By BCShippingNews
October 31 2016
Catherine Hofmann, Bernard LLP
By Catherine Hofmann, Bernard LLP

Although this space is usually reserved for articles with a maritime law focus, many of the business issues facing the maritime industry are identical to those facing businesses generally — whether large or small. One such issue is succession planning.

The greying of the largest segment of Canada’s population means that the Canadian economy is going to change. Currently, baby boomers comprise 27 per cent of Canada’s population and as of 2015 the number of people over the age of 65 make up 16 per cent of the population. Although many people are retiring later, the workforce is shrinking and it is anticipated that real economic growth will likely suffer as a result.

Moreover, approximately 60 per cent of small and medium-sized business owners are 50 or older and are beginning to consider selling their companies or passing them on to the next generation. The Canadian Federation of Independent Business has projected that as much as a trillion dollars in assets may be transferred over the coming decade. This change in ownership provides both opportunities as well as potential pitfalls for the unprepared.

Succession planning is a general term that can encompass personal financial planning, business continuation planning, ownership transition, management transition, and estate planning; however, for the purposes of this article, I will focus primarily on the transfer of business ownership, whether that transfer is to a family member, internal management (or other employees), or to an independent third party. Some points to consider regardless of the ultimate transferee are valuation, taxes, how much current owners want or need to remain involved in the business going forward and the overall timetable for the transition.

Keeping it all in the family

Family businesses are as unique as the people that run them, often characterized by complex histories and cultures. A family business involves the intersection of three critical and often complicated components — namely, family, business ownership and management. Thus, while the technical components of the transfer of business ownership are always important, in the context of an intergenerational transfer, family dynamics, the various individuals and their current and future roles and responsibilities within the business and the family must also be considered. In order to facilitate a successful intergenerational business transition, management succession, as well as the management of family communication and expectations are critical issues to address prior to the actual transfer of ownership.

The financial and legal issues which necessarily form the backdrop of the business transfer within a family most commonly include the following:

  • Who will own shares in the company and in what proportion to others?
  • Both active and non-active family members?
  • What rights and restrictions will attach to the shares (e.g., voting rights, dividend rights, participation in future growth of the company, priority on wind-up)?
  • What is the value of the company and how will the transfer be funded?
  • What (continuing) role will current and future owners play in the management and running of the business?
  • How will they be compensated?
  • What is the timetable for the current and future owner/managers?
  • Is there a shareholders’ agreement in place or should there be one in the future to account for multiple owners/stakeholders and their varying interests in the company?

A common way in which to effect a business transfer within a family is to use an “estate freeze.” An estate freeze is a share exchange transaction which allows the existing owner to fix the value of the company at current values and transfer all future growth to the new owners without any money actually changing hands. In so doing, the capital gain which will be triggered on the eventual disposition of the “frozen” shares (or the death of the shareholder) will be limited to the unrealized gains which have accrued up to the time of the transfer and any capital gains tax on the future growth of the company’s shares will be deferred until a subsequent disposition by the next generation. While an estate freeze is not overly complicated, it should never be undertaken without appropriate legal and accounting advice to ensure that it does not run afoul of the Income Tax Act. A shareholders’ agreement is also an important component to this form of business transfer. The agreement should include provisions for the eventual disposal of the company’s shares, whether by purchase, redemption or transfer.

An inside job

Another way in which a current owner may wish to plan for the future of the company and to fund his or her retirement is to transfer the company to existing management or other company insiders. They are familiar with the business and this type of succession plan often provides a smooth transition for the company, its employees, its customers and the existing owner.

A management buyout commonly will require some or all of the following: the pooling of resources by the purchasers acquiring the business, financial assistance from a bank (using company assets to secure financing) or some form of vendor take-back financing. In this regard, a clear valuation of the business becomes an important first step in determining which financing mechanism is to be adopted. Moreover, because the prospective purchasers, a bank and the selling owner may have differing opinions, information, and expectations surrounding the enterprise or the equity value of the company, an agreed upon outside and objective valuation may provide comfort to all concerned.

The financial support of the current owner for the transaction may take the form of bank guarantees, share pledges, preferred share issuances, vendor take back loans, or earn out agreements. Each of these measures can assist the prospective purchasers in buying the business and often mean that the current owner will remain involved with the company for some period of time following the initial handover. Regardless of which form of financial assistance is provided, ensure that the risk of the future success of the business is balanced appropriately.

For example, an earn-out agreement usually provides that a portion of the purchase price will be contingent on the business achieving certain financial benchmarks. Typically, the (former) owner/operator will be contractually bound to remain with the company for the duration of the earn-out period to assist the company in meeting the targets required for payment. Because an earn-out clause usually provides for a significant upside potential in the purchase price, sellers will be motivated to work hard to achieve the projected result. While this structure can be beneficial to both buyer and seller, it is not recommended when coupled with additional forms of purchase financing which may ultimately hinder the ability of the company to make the earn out targets and consequently, the ability of the owner to recoup the hoped for purchase price of the business.

Many of the issues raised in the intergenerational transfer of a family business apply in the present context as well. Of particular importance will be a shareholders’ agreement to address concerns involving multiple ownership interests in the company going forward. Matters to be discussed in determining the nature and extent of any on-going relationship between the current owner and the company include compensation, the duration of the transition period, and the scope of any non-competition agreement.

The external exit

The third and perhaps most lucrative form of business transfer involves selling the equity or assets of a business to an independent third party. Whether to sell the assets or shares of the business will likely be the most critical decision in negotiating with any party and much will depend on the particular circumstances of each case. The income tax consequences for each of these two options will usually be determinative of the issue.

In very general terms, from the seller’s perspective, share sales are usually more attractive. A share sale will trigger one level of tax payable by the seller on any capital gain resulting from the disposition. Much of this gain can also be sheltered by the lifetime capital gains exemption ($800,000) provided that the shares constitute “qualified small business corporation shares.” It will be important to consult with a tax advisor early in considering the availability of this exemption in succession planning since the Income Tax Act may require that the company go through certain “purifying” transactions and hold periods in order for the shares to qualify.

Conversely, an asset transaction will result in the imposition of two levels of taxation — namely at the corporate level (as seller) and then again at the shareholder level when the proceeds from the sale are eventually transferred to the owner. In addition, the asset sale may also trigger the payment of provincial sales tax. The upside to the buyer in an asset transaction include, among other things, the following:

  • The buyer does not inherit any of the seller’s potential liabilities, including tax liabilities;
  • The buyer can write up (to increase the depreciation base) or write off (e.g., goodwill) the value of certain assets in order to minimize tax; and
  • The buyer can cherry pick the assets to be purchased.

Whether the transaction proceeds by way of asset sale or share sale will primarily be a matter of price negotiation. What is important is that the deal satisfies both parties needs in order for it to proceed. In addition, most transactions will include some unanticipated wrinkles which will need to be considered and included in the documents which paper the deal.

While it is possible to structure a succession plan on your own, professional (and objective) advice can assist in maximizing the value of your business, minimizing taxes payable as well as avoiding potential problems that can interfere with or even thwart the desired outcome. As the popular saying goes, “by failing to prepare, you are preparing to fail” and by having an appropriate succession plan in place, you will ensure that your business will have a strong foot hold into the future.

Catherine Hofmann is a lawyer with the Vancouver law firm Bernard LLP and can be reached at hofmann@bernardllp.ca.