At long last, I’m celebrating the new year by finishing off this series of succession planning articles. I’ve already talked about the big picture, and how to make sure your business can continue to run if something happens to you. Now it’s time to talk about how you can retire. This isn’t something that should be done in a hurry – it’s wise to give yourself a few months to make the plan and expect it to take years to live out the plan.

There are four main ways that business owners hand over control and operation of small businesses to a successor:

• Passing the business to a family member,
• Selling the business to management or employees over time,
• Selling the business in one fell swoop, or
• Passing the business in your will (if you want to stick it out ‘til the bitter end…)

Despite the different terms I’m using, all of above except the last are selling the business as far as the tax man sees it. Each of these routes allows you to cash out – or extract the value you’ve built up in the business. Even though the end result of each is similar, the legal path you’ll need to walk to get there is different in each case, with some common elements between them. I’ll talk about each option below. What will work for you depends on what you want, the tax costs, and what is realistic for your business, successor, family, and employees.

Before I dig into the guts of succession, I’ll touch on a few issues that will pop up no matter which way you opt to go – both of them have to do with the almighty dollar.

Valuation

No matter what route you choose, valuing the business will be a pain in the behind. Valuing a business for sale, transfer, or estate purposes can be tricky. As you likely know already, “tricky” is usually lawyer-speak for “expensive,” so brace yourself.

There’s no single formula to value a business. The bigger and more diverse the company, the trickier it is to value. “Tangible assets” – like machinery, inventory, and accounts receivable – are pretty easy to put a price on, while “Intangible assets,” – like client lists, intellectual property, social media influence, or a recognized brand – are more difficult. Equally tough is when you, the owner, are a big part of the business’ worth.

Businesses can be valued by a number of different ways, but the two most common are:

• Agreement between the buyer and seller
• Valuation by an accountant, auditor, or certified business valuator

Agreement on price is the cheapest, but the price that you agree to with the buyer might not be the amount that tax is assessed on. You report the sale price, but the CRA will deem the sale to have been made at fair market value. Funnily enough, the CRA rarely finds that the sale happened at a lower value than what was reported. You may end up on the hook for more taxes than you calculated, which cuts into your retirement nest egg.

The CRA and tax courts tend to stick to valuations made by certified business valuators (very expensive), and sometimes accountants (moderately expensive) for tax purposes. Hiring one of those dudes to value your business could cost more than you’re willing to spend… but sometimes the up-front cost of paying a valuator is lower than the potential long-term cost of an extra tax bill. It’s worthwhile to at least have the conversation with your accountant.

Tax Efficiency

Speaking of the CRA, most transfers or sales of businesses can be made cheaper by getting sound accounting advice on how to minimize the tax on the transfer. The more the business is worth, the more likely it is that the transfer will be tax-driven. “Tax-driven” means that your accountant is telling your lawyer how to arrange the purchase and sale so that you (and possibly the buyer) pay the minimum tax possible.

A note of caution on accountants – not all of them know tax. Many small business accountants are good at preparing annual income tax returns, and helping to manage cash flow, but aren’t experts on the tax implications of selling a business. Even if you’ve been with your accountant for years, don’t be afraid to shop around. Moral of the story? Get accounting advice early in the succession planning process.

With that out of the way, here’s the rub:

Four Ways to Transfer Your Business to a Successor

Passing to Family

Selling or passing all or part of the business on to a family member can be a sale, gift, or some combination of the two. There are a number of ways to work this, but what’s best for most small businesses is a gradual transfer of operational control and profit share.

On the operations side, a gradual transfer of responsibility gives your successor a chance to get up to speed on how the business works, build relationships with key customers, advisors, and suppliers, and allows you to pass on the lessons and values you’ve picked up along the way.

As far as profit sharing, if the business’ cash flow can stand it, you may want to continue to draw some sort of income from the company. If not, an incremental buy-out by the next generation or the business itself – usually 5-10% of the value of the business per year – might give you 10-20 years of “income” out of the value you built in the business. That incremental buy-out is usually good for the successor as well, as they don’t have to come up with all the money to buy the company right away. It could also be done as an incremental buy-in, where some of the successor’s pay is in shares, which dilutes your ownership of the company over time.

So long as you own shares in the company, you should consider life insurance. The more your stake is worth, the more this makes sense. Insurance policies pay out directly to the beneficiary – your successor or the company itself – to buy back the shares, and keep those shares out of your estate.

The typical legal documents involved in a family succession include:

• Unanimous Shareholders’ Agreement – which can set out the terms of any buy-out or buy-in, valuation, insurance, and your continued role in the company, if any. Each shareholder signing it should have independent legal advice.
• Share Freeze – is a fairly complex transaction where the value of the company “freezes” at a certain date, and you’re issued shares that reflect that frozen value. The successor gets new shares which will capture any further growth in value. The company then buys back the freeze shares over time and cancels them. Your freeze shares could have dividend and voting rights that allow you to continue to share in the profits and management of the company.
• Trusts – where your shares are managed by someone else on behalf of your successor. These are useful when one or more of your successors doesn’t yet have the age or experience to run the company completely. Trusts are also useful if you’re separating ownership and operations of the business between two or more people.
• Will – if you pass away before the transfer is complete, you can set out how your shares are to be dealt with. Ensure that the terms of your will match with the terms of any shareholders’ agreement, trust documents, and so forth.
• Powers of Attorney – if you’re incapacitated before the transfer is complete, who will oversee the management of the company, and manage your shares? Any requirements or restrictions on how the attorney is to act should be set out. This must jive with all the other documents.

On the tax side of things, transfers of property to family members are not at “arm’s length”, and are taxed differently than sales to non-family members.

Selling to Management or Employees

Long-term managers and employees can often feel like family, and a transfer to them can be done much in the same way as to a family member. It can also be done in concert with transfer to a family member – perhaps 51% control of the business will stay in the family, while 49% will go to the employees who will continue to run it. If the employees or managers have the funds available to buy right away, it can be a one-and-done sale, or a phased buy-out or buy-in. These transfers are typically done over 3-5 years, and are “arms-length”, meaning that different tax rules apply than to transfers to family.

Assuming that you’re being bought out, rather than simply giving the shares to the employees, this process will be more formal and legalistic. You should insist that the buyer get independent legal and tax advice so they can’t come back later and say that they didn’t get what they bargained for.

Before writing anything up, you should hash out with the buyer the broad strokes of how the transfer will be structured, and how the buyer will finance the purchase. It can be any combination of:

• Employee stock option plans – where employees are paid shares as part of their pay, and your ownership and control of the company is diluted over time.
• Purchase and sale agreement – a contract between the buyer and the seller that sets out all of the key terms of sale. It can include employee stock options, or it can be a straight up purchase of the assets or shares of the company.
• Shareholders’ agreement – as above.
• Service agreement – especially if it’s a one-and-done purchase, the buyer may want your services and advice as an employee or independent contractor. They may want you to continue to sit on the board, or to serve as an officer of the company.
• Indemnity and releases – where the company agrees to protect you for the consequences of legitimate actions you took while a shareholder, officer, or director of the company, and release you from any liability for actions taken after you transferred ownership or control. These are often included in the purchase and sale agreement.

The buyer should conduct due diligence before buying, particularly if you’ve been the one to handle the back-end workings of the business such as dealing with lawyers and accountants. It’s important that the buyer knows what they’re buying, the financial history and projections of the company, and that the books and records are in good order.

Lastly, you’ll want to make sure that your will, trust documents, powers of attorney, and domestic contracts jive with the deal you’ve made.

Selling to Third Parties

If you can’t find anyone in your family or business who’s willing or able to take over from you, it may be time to prepare your business for sale. I won’t go in to too much detail, as I’ll cover sale of business in a separate article, but it will require some legal work to prepare for due diligence.

Due diligence is when the buyer digs through the corporate records to make sure that they know what they’re buying. You should be proactive to make sure that the minute book, employee agreements, accounting records, lists of assets and liabilities, leases, real estate ownership and mortgages, intellectual property, debts, shareholder relations, taxes, and licenses are in good order.

Passing the Business in your Will

Many business owners approach is “I’ll just pass everything in my will.” This is a mixed-bag approach that chooses to duck the costs of preparing and implementing a succession plan, while sacrificing certainty and control.

The upside to this approach is that there’s minimal headache and expense for you in the here and now. It can work very well when your successor is clear – perhaps an only child who’s been working in the company for years, and knows what you know.

The downside is that you may handicap the next generation’s ability to run the company. If the business is asset-rich, but cash-poor, the tax bill on the estate might cripple the company. You will have no control over what happens after you’re gone. Your beneficiary will be stuck with making the tough decisions you’ve abdicated from. It also risks infighting between beneficiaries, or with the company controlled by people who don’t know or care about the business.

I’m not saying leaving the company in your will is a bad decision – just know what risks and benefits you’ll be passing on to your successor before you make the choice.

Phew, that was a long one… I promise I’ll write something more entertaining soon…

Mike Hook
Intrepid Lawyer
https://intrepidlaw.ca
@MikeHookLaw