Selling Your Business – Calculating What You Get to Keep – Part Three

Who cares what you sell your business for? How much of it do you get to keep? This is the final in a three-part series explaining the math behind selling your company.

Part 1 – Enterprise Value
Part 2 – Equity Value
Part 3 – Net Proceeds – Asset Sale vs. Share Sale

Net Proceeds – Asset Sale vs. Share Sale

Enterprise Value of an operating business is typically estimated without consideration of the eventual mechanism of sale, that is an asset sale or a share sale and the associated impact on the tax attributes of the business in the buyer’s hands.

A buyer will typically have a preference for an asset sale as there may be positive tax attributes available (increased depreciation expense allowed in future) from writing up the acquired assets to fair market value. There is also a perception of lower risk since the buyer is not assuming risk for the existing corporation and its historical operations.

Sellers in Canada who qualify for all or a portion of their lifetime capital gains exemption of $750,000 per person on shares of a Canadian controlled private corporation will have a clear preference for a share sale. The magnitude of this tax exemption benefit is such that a share sale becomes a virtual requirement on the sale of a small or medium sized enterprise owned by two or more individuals who qualify, as it is very difficult to bridge the tax exemption benefit gap by any reasonable price increase in an asset purchase offer. Sellers in this position can expect that a buyer will want to discount the purchase price by at least the amount of the lost tax attributes if they are willing to proceed by way of a share purchase. It is customary for the seller to obtain an estimate of the Net Present Value (NPV) of the lost tax attributes for the buyer from their accountant so that they are well prepared for negotiations. Share sellers can also expect a higher holdback against representations and warranties to be required. This holdback may be 15% of the purchase price for 18-24 months to offset the additional risk assumed by the buyer.

Purchase offers drafted by buyers are often specific on price, but are usually deficient in outlining how that price will be paid and the mechanism(s) for any adjustments. Any ambiguity in this regard should be addressed by further communication with the buyer before you and your professional advisors invest time in analyzing the offer and considering a possible acceptance or counter offer.

Asset Purchase offers are more difficult to analyze in that there are unlikely to be any numbers you can directly compare to your expectations on Enterprise Value and Equity Value. The proposed purchase price will typically be for all or a select group of assets and may or may not include provision to assume select liabilities and contracts. It is then necessary for you to estimate the additional proceeds you are likely to realize from the disposition of assets that are not included. A typical example of assets that might not be included would be accounts receivable, as buyers do not like to take the collection risk on past sales. The next step is to consider the extent of balance sheet liabilities (for example accounts payable) you will be required to pay out of the purchase price that would typically have been assumed by the buyer in a share purchase. You will also have to estimate the costs for severance for employees or the exit from contracts such as premise leases the buyer is not assuming. These costs would typically be assumed by the buyer in a share sale. You will then be able to estimate the implied Equity Value after considering any surplus cash, redundant assets and interest bearing debt; the impact of which was reviewed in Parts 1 and 2 in this series.

A Share Purchase offer is easier to analyze as the purchase price will be directly related to Equity Value since the buyer is buying your equity in the company. You will still have to consider any proposed adjustments, excluded assets and excluded costs. Keep in mind the Equity Value (and typically the purchase price) includes all bonuses payable to the owners, shareholders’ loans, related party debt, preferred share capital, common share capital and retained earnings.

Shareholders’ loans, related party debt and share capital represent tax paid money. The following discussion on taxation is relative to the balance of Equity Value arising from retained earnings and any gain on sale.

In the case of an Asset Sale, you will retain your corporation and have the opportunity to continue to use it as a holding company. There is significant complexity in tax legislation and calculations and you will need specific professional advice. It is typical for the total corporate and personal taxes to move the funds to your hands will be 30-40% of the Equity Value arising from retained earnings and any gain on sale.

In the case of a Share Sale, any gain above the cost base of your shares will be taxable as a capital gain. Capital gains are taxed at half rates. If you qualify for all or a portion of the $750,000 lifetime capital gains exemption, then the amount you qualify for will not be taxed. The balance, if any, would be taxed at the favourable 50% of normal rates applicable to capital gains.

An example that is value neutral to the buyer may be helpful. Transaction costs which are likely to be similar for the two options are excluded for simplicity. We’ve assumed a sale involving two shareholders with availability of the maximum exemption of $750,000.

Note: If the vendor were to net $1,724,900 in an asset sale the purchaser would need to pay an additional $882,000.

Lesson learned

It truly is all about what you get to keep and not just what you sell your business for.

Our Corporate Finance team can help you figure out this math and present it to you in a language you can understand. We promise. Why? Because we are business owners, too.

Selling Your Business – Calculating What You Get to Keep – Part Two

Who cares what you sell your business for?  How much of it do you get to keep?  This is the second in a three-part series explaining the math behind selling your company.

Part 1 – Enterprise Value

Part 2 – Equity Value

Part 3 – Net Proceeds – Asset Sale vs. Share Sale

Equity Value

In Part 1, we discussed calculating Enterprise Value and then adjusting for owned real estate, cash and other redundant assets to arrive at total Business Value as the first steps in determining what you get to keep once you sell your business.

This part explores the next important step of determining Equity Value from Business Value.  This is the frequently confusing world of determining how interest bearing debt, working capital adjustments, owner bonuses payable, related party loans, preferred shares and common shares determine net proceeds and what amounts are taxable.

Interest bearing debt – includes operating loans, term loans and capital leases.

Recall that Enterprise Value is estimated using a Net Present Value approach which incorporates a Weighted Average Cost of Capital.    Your business’ capital structure (debt vs. equity) does not impact Enterprise Value and Business Value, but it is fundamental to determining your Equity Value.

Working capital adjustment – A buyer expects a business to have an adequate level of working capital to sustain operations; typically no less than has historically been required, and perhaps a higher level if the business has excessively relied on trade payables.  The minimum level of working capital required is usually specified by the buyer in the purchase offer or Letter of Intent.  Upon closing of the transaction, the vendor will be required to fund any shortfall, typically via a downward adjustment in the Purchase Price.

Equity Value = Business Value – interest bearing debt – any working capital adjustment

If your Business Value is $3.1 Million and you have $1 Million in interest bearing debt, the net of that is $2.1 Million in Equity Value if there is no working capital adjustment.  Alternatively, if the business is debt free, Equity Value would be $3.1 Million assuming no working capital adjustment.

Equity Value is inclusive of all related party obligations – owner bonuses payable, related party loans, shareholder loans, preferred shares and common shares. 

Owner bonuses payable is money owing to you that the corporation has paid tax on and will be taxable in your hands upon receipt in the normal manner.

Shareholder or related party loans payable represent money loaned to the company that can be repaid without tax consequences in your business.  Shareholder loans owed to you personally are tax paid money and can be repaid without personal tax consequences.

Preferred and common share capital represent actual funds invested and is, again, tax paid money that is not taxable, but the amounts involved are typically nominal in a small or medium sized owner operated business.

Retained earnings, recapture of depreciation, capital gains and goodwill represent the balance of the sale proceeds after deduction of the above items.  Detailed tax estimates by your professional advisor based on the specifics of both your situation and the structure of the sale transaction will be required to estimate the taxes payable on this portion of the proceeds. 

Lesson learned

In Part 3 we will examine the tax, transaction and value implications of an Asset Sale vs. a Share Sale; the final piece in the puzzle of what you get to keep.

Our Corporate Finance team can help you figure out this math and present it to you in a language you can understand.  We promise.  Why?  Because we are business owners, too.

Selling Your Business – Calculating What You Get to Keep

Who cares what you sell your business for?  How much of it do you get to keep?  This is the first in a three-part series explaining the math behind selling your company.

 Part 1 – Enterprise Value

Part 2 – Equity Value

Part 3 – Net Proceeds – Asset Sale vs. Share Sale

Enterprise Value

 The first building block in selling your company is estimating its value.

Enterprise Value is the total value of your business including all assets that are required for the operation of the business.

Enterprise Value is typically estimated based on the Net Present Value (“NPV”) of the expected after tax cash flow for the business.

Inputs to the NPV calculation include:

-        Earnings before interest, taxes, depreciation and amortization (“EBITDA”);

-        Adjustments to EBITDA to reflect sustainable cash flow for the business;

-        Expected growth rate(s) in adjusted EBITDA;

-        The estimate of the weighted average cost of capital (“WACC”) for like businesses based on appropriate levels of debt and equity and realistic return expectations on that capital;

-        The combined federal and provincial income tax rate;

-        Necessary capital expenditures to maintain this cash flow (usually assumed to at least equal depreciation).

Adjustments to EBITDA, as noted above, are typically required for owners’ compensation and any company owned real estate:

-        Owners’ salaries, benefits, draws and discretionary expenses are adjusted to necessary levels for the business and fair market pricing.

-        Any real estate in the business is typically valued based on a current appraisal and this value is over and above Enterprise Value of the operating business (the real estate may be acquired by the buyer for additional proceeds or retained by the owner).  EBITDA for the NPV calculation is then adjusted downward by an amount equal to the fair market rent estimate on the portion of the building that is owner occupied.

 Enterprise Value is calculated based on the assumption that there is no interest bearing debt, as value of the operating business is independent of the current capital structure of the business.   This is why all interest costs are added back to the cash flow in the valuation calculation.

Surplus cash or other assets that are redundant to normal business operations represent value in excess of Enterprise Value that would typically be stripped out by the owner.

It is important to note here that Enterprise Value is independent of a sale of shares or of assets; it is simply the value of the operating business.

Lesson learned

In Part 2, we will explore the next important step of determining Equity Value from Business Value.  This is the frequently confusing world of determining how interest bearing debt, any working capital adjustment, owner bonuses payable, related party loans, preferred shares and common shares play a role in the pre-tax estimate of how much cash will be left in your jeans at the end of a sale.

Then Part 3 in the series will examine the tax, transaction and value implications of an Asset Sale vs. a Share Sale; the final piece in the puzzle of what you get to keep.

Our Corporate Finance team can help you figure out this math and present it to you in a language you can understand.  We promise.  Why?  Because we are business owners, too.

Reflecting and Moving Forward

At Lazer Grant we had an event filled, wonderful 2011.  We are fortunate to have celebrated the anniversaries of 10 of our loyal, dedicated team members who have been with us for 10+ years.  Pretty cool stuff.  We once again participated in the Great Get Off Your Butt & Ski Event and CA Baseball Tournament, and even brought in a yoga instructor for a lunch hour class during tax season for some well deserved stress relief!  Also, our annual Christmas Cheer Board Hamper was its usual fulfilling pastime at Lazer Grant. 

Last year we welcomed Reese Feder, Louise Cleveland, Thomas Gray and Zoe Rose.  They have filled positions in our accounting, insolvency and administrative departments.  Each is at a different point in their careers and we are delighted to have them join us in giving you our best efforts.

We enjoyed seeing many of you, our friends and clients, at our November Breakfast Session at the Norwood Hotel, featuring a wonderful presentation by Thomas Deans.  We still have some of his book, “Every Family’s Business” available.  Let me know if you would like one.

And now we look forward to an exciting and rewarding 2012!  We expect it to be another great and challenging year and we thank you for your patronage, your assistance, and your wisdom, patience and acceptance.  We appreciate your friendship.  We appreciate your business.  We truly do look forward to continuing a mutually beneficial relationship for many years to come.

If you have not yet been to our premises here on McDermot, please call me and I would be delighted to show you around.