Presented by:

Chuck Burkett, CA, CFP, TEP

Mark Grey-Dreaper, CA•CBV, CMAP

Business Succession Planning

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Introduction

• Succession planning is a process – not an event

• Most businesses do not have a succession plan No Succession

Plan

InformalSuccessionPlan

FormalSuccessionPlan

Existence of aExistence of aSuccession PlanSuccession Plan

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Succession Planning…

• Stakeholders in the succession process Customers Employees Suppliers Competitors Family You

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Establish a team of advisors…

• Banker

• Financial Advisor

• Lawyer

• Accountant

• Business Valuator

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Succession Options…

• Transfer to a successor

• Organize a management buy-out

• Sell the business to a third party

• Close and liquidate

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Selling to a successor…

• Often a family member

• Could be a key employee

• Plan for the successor’s development

• Communication is very important

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Management buy-out…• Involves a group of key employees

• Ensures retention of key employees

• Often the management team lacks financial resources

• If vendor is providing financing, he may feel there is less risk in selling to management than to a third party

• Building a cohesive team is key in a successful MBO

• Communication is very important

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Selling to a third party…

• Buyers may include a competitor, an industry consolidator

• May require the vendor to stay on for a period of transition

• Consider things that can be done now to enhance the value of the business in the future

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Close and liquidate…

• Often the result of not having a succession plan

• Normally results in the least amount of value being realized

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Understanding Value…

• The value of a business is a function of: Ability to generate future cash flow The risk of those cash flows Value of underlying assets Presence of purchasers in the market Determined at a specific point in time

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Components of Business Value…

Tangible Assets

Intangible Assets

Goodwill

Asset Approach

Cash Flow Approach

(CCF / DCF)

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Identifying Goodwill…

Commercial

(Transferable)

Individual

(Semi-Transferable)

Personal

(Non-transferable)

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Capitalized cash flow formula…

Value is a function of Cash Flow, Risk, and Growth

Where:

• CF1 represents expected cash flow for the next period.

• R represents the required rate of return to investors.

• G represents the level of long term growth in the core business.

Value =

Cash Flow

or V =

CF1

Risk – Growth

R – G

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Example Appraisal Practice…

Earnings before interest, taxes, depreciation & amortization ("EBITDA")

Revenue 800,000$ 100%

ExpensesOffice and other 120,000 15%Rent and utilities 40,000 5%Wages and benefits - appraisers 320,000 40%Wages and benefits - other 80,000 10%

560,000 70%

EBITDA 240,000$ 30.0%

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Normalizing Adjustments…

Normalized EBITDA

EBITDA 240,000$ 30.0%

Normalizing adjustments:Actual paid to appraisers 320,000 40%Economic for appraisers (480,000) 60%

Normalized EBITDA 80,000$ 10%

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Adjust for taxes and SCR…

Discretionary after-tax cash flow

Maintainable EBITDA 80,000$ Income taxes (10,800) After tax cash flow before SCR 69,200$

Sustaining capital reinvestment, net of tax shield (5,000)

Discretionary after-tax cash flow 64,200$

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Building up cost of equity…

Cost of Equity

Risk free rate of return 4.0%

Equity risk premium 6.5%

Small size premium 9.5%

Additional industry / business specific risk 5.0%

Cost of equity 25.0%

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Develop overall cost of capital…

Weighted Average Cost of Capital

Mix Rate After tax Composite

Operating lines 20.0% 5.5% 4.8% 1.0%

Long term debt 5.0% 7.0% 6.1% 0.3%

Equity 75.0% 25.0% 25.0% 18.8%

20.0%

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Capitalize Cash Flow…

Enterprise Value

Discretionary after-tax cash flow 64,200$

Capitalization rate - WACC 20.0%Implied multiple 5.00

Enterprise value 321,000$

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Rule of Thumb (careful!)…

Enterprise Value

Sellers' Discretionary Earnings (SDE) 240,000$

SDE Multiple 1.35 (1)

Enterprise value 324,000$

(1) Industry metric of 1.25 - 1.5 times SDE for appraisal services businesses with less than 10 professionals.

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Using Market Comparables…

Market Comparables - Offices of Real Estate Appraisers (NAICS 531320)

Range Mean Median

Sale Date 1999 - 2006 N/A N/ANumber of sales 4 N/A N/ANet Sales $73,000 - $929,000 526,000$ 552,000$ Enterprise value to:

Sales 0.27 - 0.70 0.44 0.39 EBITDA 0.32 - 3.91 2.01 1.81 SDE 0.32 - 1.82 1.24 1.57

Source: Pratt's Stats

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Three Types of Sale…

• Sale of assets Proprietorship Partnership Corporation

• Sale of shares Corporation

• Sale of partnership interest

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Consideration may consist of…

• Cash• Bank financing• Vendor take back (VTB)

(3-5 years)• 1/3 - 1/3 - 1/3• Non-competition agreement• Earnout where goodwill is uncertain

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Tools in Succession Structuring…

• Vendor financing

• Tax strategies

• Estate freeze

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Vendor Financing…

• Often necessary, particularly where significant goodwill is being sold.

• A vendor’s willingness to offer financing will depend on the % of the transaction to be financed, amount of equity invested by the purchaser, and the vendor’s assessment of the buyer’s ability to be successful

• Issues include: security, interest rate, repayment period, recourse in event of default

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• Sale of the assets of the corporation • A purchaser will generally prefer an asset

purchase Generally a more straight forward transaction Purchaser does not assume contingent liabilities of

the selling corporation Purchaser gets to bump the tax basis of the assets to

what was paid for them

Income Tax Issues…

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• Sale of the assets of the corporation Generally will result in a higher tax liability to the

vendor Which assets are included in the sale? Are any

liabilities being assumed?• Accounts Receivable• Prepaids• Tangible Capital Assets (equipment, land, buildings)• Goodwill & other Intangibles

Income Tax Issues…

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• Sale of assets of the corporation After-tax proceeds remain in the corporation Additional personal taxes are payable on

distribution

Income Tax Issues…

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• Asset Sale – Planning• Allocation of the purchase price• Timing – CCA and recapture• Retiring allowance if company is being wound up• Owner-manager remuneration planning

– Individual Pension Plan– Salary vs Dividends– Capital dividend elections

Income Tax Issues…

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• Sale of the shares of a corporation Calculation of capital gain / loss Tax is payable by the exiting shareholder

• Individual• Holding company

Income Tax Issues…

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• Strategies to reduce tax on a gain of sale of shares Sale of any unrealized losses in the year Use net capital loss carry-forwards Minimize income from other sources in the year Claim Capital Gains Exemption Make RRSP contributions Claim a reserve for deferred proceeds (max. period

5 years)

Income Tax Issues…

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• Capital Gains Exemption Lifetime limit of $750,000 of exemption available The exemption is more properly described as a

deduction. (the gain is reported and included in total income, then a deduction is claimed to offset the gain)

The deduction is only available to individuals, not where there is a sale of shares by a holding company

Income Tax Issues…

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• Capital Gains Exemption The company sold must qualify

• Must be a Canadian Controlled Private Corporation

• At the time of sale, ~ 90% of the fair market value of the assets must be used in an active business

• 24 months prior to sale, 50% or more of the fair market value of assets must have been used in an active business

Income Tax Issues…

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• Capital Gains Exemption All or some of your claim will be denied if

• If you have previously used all of your $750,000 lifetime limit

• If you have claimed an Allowable Business Investment Loss if the past

• If you have a cumulative net investment loss balance

Income Tax Issues…

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• Planning for Capital Gains Exemption Ensure you are eligible Ensure the company qualifies

• If the company has non-active assets, consider strategies to remove these assets

Income Tax Issues…

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• Estate Freeze Used very often in family successions Can be a tool in an arm’s length sale Generally structured to be a tax-free

transaction

Income Tax Issues…

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• Pre FreezeDad & Mom

Opco

Common Shares ($1mm)

Estate freeze illustration…

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• Steps in the Estate Freeze The company creates a class of preferred shares A valuation is prepared to determine what the existing common

shares are worth The corporation makes an exchange with the common

shareholders. The common shareholders receive preferred shares that have a value equal to their former common shares

The successor can then buy common shares for nominal value since all of the corporate value belongs to the preferred shareholders

Preferred shares are redeemed over time

Estate freeze illustration…

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• Post-FreezeSuccessor Dad & Mom

Opco

Preferred Shares ($1mm)

CommonShares

Estate freeze illustration…

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Enhancing Value Prior to a Sale…

• Appropriate management and staffing structure

• Contracts and non-competition agreements with key staff

• Up-to-date Information Systems

• Labour-saving Technology

• Processes and Training Systems to improve efficiency and reduce required level of skill and judgment

• Transactions at economic rate

• Efficient operations and stable margins

• Upgrades well in advance of sale

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Other Planning Prior to a Sale…

• Eliminate or separately ID non-commercial Related Party Transactions and Redundant Assets

• Books and legal affairs in order

• Up-to-date Business Plans

• Resolve / Identify and quantify high risks and contingencies

• Appropriate tax structure and leverage

• Realistic view of value and transaction structuring

• Hire your Buyer!!

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Valuation Summary…

• Valuation issues are key to any succession plan

• The issue should be addressed early and revisited as time passes

• Value is not static; it is an on-going process

• Value can be enhanced through strategic planning

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Other resources…

• Canadian Association of Family Enterprises (CAFE)

• Canadian Federation of Independent Business (CFIB)

• Others..

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Thank You for Your Time!

• Questions?

Mark Grey-Dreaper, CA-CBV, CMAP

XPS Group Inc.

Ph: 250-383-4135

Email: mark@xpsgroup.net

Chuck Burkett, CA, CFP, TEP

Burkett & Abercrombie

Ph: 250-370-9178

Email: chuck@burkettabercrombie.ca