VALUATION ISSUES FOR FAMILY-OWNED BUSINESSES

Transcription

1 TAX-EFFECTIVE SUCCESSION PLANNING FOR THE OWNER-MANAGER MAY 22 AND 23, 2014 TORONTO VALUATION ISSUES FOR FAMILY-OWNED BUSINESSES Partner

2 FAIR MARKET VALUE (REQUIRED BY INCOME TAX ACT) The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm s length in an open and unrestricted market, when both have reasonable knowledge of the relevant facts Chartered Professional Accountants & Business Advisors - 1 -

3 VALUATION APPROACHES Income-Based Market-Based Asset-Based Chartered Professional Accountants & Business Advisors - 2 -

4 WHAT FINANCIAL STATEMENTS OFTEN DO NOT DISCLOSE BALANCE SHEET ASSETS Values of Intangible Assets Marketing related Customer related (relationships) Artistic related Contract based Technology based (software, etc.) Value of goodwill Location Product Service Value of Real Estate Personal Individual Value of Inventories Value of Loans Receivable or Payable Value of Contingent Assets Claims receivable Litigious claims Life insurance proceeds on corporate-owned life insurance Value of Inventories Value of Workforce Chartered Professional Accountants & Business Advisors - 3 -

5 WHAT FINANCIAL STATEMENTS OFTEN DO NOT DISCLOSE (CONT D) BALANCE SHEET LIABILITIES Embedded Taxes on Trapped-in capital gains Recapture of depreciation Eligible capital property Embedded Portfolio Discounts Marketable securities Real estate holdings Provisions for warranties, product liability Chartered Professional Accountants & Business Advisors - 4 -

6 WHAT FINANCIAL STATEMENTS OFTEN DO NOT DISCLOSE (CONT D) INCOME STATEMENT Expenses are based on estimates Amortization of machinery Allowance for bad debts Inventory write-offs Value of services performed by owner-manager and/or other related parties Economic value of related-party transactions Often, tendency is for private company to minimize net earnings and for public company to maximize net earnings Chartered Professional Accountants & Business Advisors - 5 -

7 WHAT FINANCIAL STATEMENTS OFTEN DO NOT DISCLOSE (CONT D) INCOME STATEMENT (CONT D) Shareholder benefits Trips, car, relatives on payroll, club dues, etc. Non-recurring income and expenses included on income statement Contractual obligations e.g., 5-year contract to buy inventories at fixed price New lease at different rental amount commencing postfinancial statement date Key-person effects Concentration/dependence on customers, suppliers Chartered Professional Accountants & Business Advisors - 6 -

8 POSSIBLE EVENTS CONSIDERED AS OF VALUATION DATE EXAMPLES New lease coming into effect? Launching of new product line? Income tax changes coming into effect? Planned retirement of key executive? Chartered Professional Accountants & Business Advisors - 7 -

9 POSSIBLE EVENTS CONSIDERED AS OF VALUATION DATE EXAMPLES (CONT D) Loss of key employee? Any lawsuits (product liability, wrongful dismissal, oppression remedy)? Entry of new competitors into market? Any IPO plans? Prior offers made to sell business? Chartered Professional Accountants & Business Advisors - 8 -

10 METHODS WITHIN THE INCOME-BASED APPROACH Income Approach Determining a value indication of a business (or its underlying assets) using one or more methods wherein a value is determined by converting anticipated benefits. It contemplates a continuation of business operations: Capitalizing operating earnings or cash flow, applying Earnings Method or Cash Flow Method respectively Discounting future stream of benefits, applying either Discounted Cash Flow Method ( DCF Method ) or Discounted Future Earnings Method ( DFE Method ) Capitalizing gross revenues, applying Multiple-of-Revenues Method Chartered Professional Accountants & Business Advisors - 9 -

11 THE CLOSELY-HELD, FAMILY-OWNED BUSINESS CAPITALIZATION RATE OR DISCOUNT RATE INCLUDES FOLLOWING COMPONENTS Risk Components a. Risk-free rate b. Equity risk c. Illiquidity d. Size e. Company-specific risk Chartered Professional Accountants & Business Advisors

12 BUILD-UP DEVELOPING RATE OF RETURN(DISCOUNT RATE OR CAPITALIZATION RATE) BUILD-UP METHOD EXAMPLE (After-Tax) FACTOR 18.0% Industry- or Business- Specific Risk Impact of Size Company- Specific Risk Factors Illiquidity Premium 0.4 Equity Risk Premium Risk-Free Rate Market Rate of Return

13 MARKET APPROACH Determining a value indication of a business or an equity interest using one or more methods that compare subject to similar businesses and business ownership interests that have been sold, or to shares of public companies. Examples: Guideline Public Company Method Guideline Transactions Method Prior transactions of ownership interests of subject company Chartered Professional Accountants & Business Advisors

14 Market Approach Guideline Public Company Method Guideline Transactions Method Prior Transactions in Shares of Subject Company February 21 and 22, 2012 Toronto Richard M. Wise, FCA, FCBV, FASA, MCBA, CVA, TEP Chartered Accountants & Business Advisors

15 IN WHICH MARKET WILL TRANSACTION OCCUR? Principal Market Most Advantageous Market Greatest Volume and Level of Activity Price Maximization Including Highest & Best Use Pool of Market Participants Other Market Participants Ordinary Purchasers Special Purchasers 1, 2 or more Chartered Professional Accountants & Business Advisors

16 EXAMPLES OF MARKETS Example 1: Parking lot operation on ABC land vs Apartment building/condo development on ABC land Example 2: Summer camp on XYZ lakefront land vs Condos or resort hotel on XYZ lakefront land ( Highest and Best Use principle.) Chartered Professional Accountants & Business Advisors

17 EXAMPLES OF MARKETS (CONT D) THE MARKET FOR Control of publicly-traded companies and Control of closely-held companies vs THE MARKET FOR Minority interests in publicly-traded companies and Minority interests in closely-held companies Chartered Professional Accountants & Business Advisors

18 IF RELYING ON TRANSACTIONS, YOU MUST HAVE RELEVANT BACKGROUND DATA Seller s motives Buyer s motives Whether distress or duress situation Special/strategic buyers vs financial/ordinary buyers Possible redundant assets included in price Tax structuring Other consideration possibly included in transaction price : Consulting agreement with seller Non-compete covenant with seller Earn-out provision Retirement allowance Chartered Professional Accountants & Business Advisors

19 ASSET-BASED APPROACH Liquidation Orderly Forced Going-concern Chartered Professional Accountants & Business Advisors

20 ASSET-BASED APPROACH The Asset-Based Approach adopted where: liquidation contemplated business not viable as ongoing operation OR holding company asset values constitute prime determinant of corporate worth (e.g., vacant land, portfolio of real estate or marketable securities, etc.) OR no indicated earnings/cash flows to be capitalized Chartered Professional Accountants & Business Advisors

21 VALUATION METHODOLOGY FOR INTELLECTUAL PROPERTY Income Approach: Present value of future benefits Market Approach: Guideline transactions Avoided Cost Approach: Relief-From- Royalty Method Chartered Professional Accountants & Business Advisors

22 TEN MOST VALUABLE GLOBAL BRANDS 2013 (SOURCES: Interbrand, S&P Capital IQ) Rank Brand Estimated Value ($U.S. Billions) Book Value of Intangible Assets (Balance Sheet) ($CAD Billions) Market Capitalization ($CAD Billions) Book Value of Shareholders Equity (Balance Sheet) ($CAD Billions) G.E Chartered Professional Accountants & Business Advisors

23 TEN MOST VALUABLE GLOBAL BRANDS 2013 (SOURCES: Interbrand, S&P Capital IQ) Rank Brand Estimated Value ($U.S. Billions) Book Value of Intangible Assets (Balance Sheet) ($CAD Billions) Market Capitalization ($CAD Billions) Book Value of Shareholders Equity (Balance Sheet) ($CAD Billions) 5 Microsoft Coca-Cola Apple Chartered Professional Accountants & Business Advisors

24 THREE POSSIBLE VALUE COMPONENTS OF A SHARE TRANSACTION 1. Intrinsic Value ( Stand-Alone Value) of Acquiree Business 2. Net Economic Value Created by Acquisition 3. Value of Identified Redundant Assets included in Share Price Chartered Professional Accountants & Business Advisors

25 SPECIAL PURCHASER OR STRATEGIC BUYER EFFECT ON VALUE $3.5 Million Value-Added (Synergies) $1.0 Million Stand-Alone Fair Market Value $1.8 Million Stand-Alone Fair Market Value $1.8 Million $1.0 Million Business A Business B Combined Business AB Chartered Professional Accountants & Business Advisors

26 RELATIVE LEVELS OF VALUE Strategic Control Value Enterprise Level Shareholder Level Strategic-Control Premium Minority Discount Financial Control Value Marketable Minority Value Discount for Lack of Marketability Financial-Control Premium Non Marketable Minority Value Chartered Professional Accountants & Business Advisors

27 FAIR MARKET VALUE OF SHARES LEVELS OF VALUE EXAMPLE PER SHARE Synergistic (Strategic) value $24.00 Strategic Acquisition Premium (say, 20%) (4.00) FMV of control shares (financial buyer) Minority Discount (say, 25%) (5.00) As-if-publicly-traded equivalent minority share value Discount for Lack of Marketability (say, 30%) (4.50) FMV of minority shares $10.50 Chartered Professional Accountants & Business Advisors

28 CONTROL vs. MINORITY POSITIONS IN PRIVATE COMPANIES Example of Relationships Among Control Premiums, Minority Discounts and Marketability Discounts $20/share 25% minority discount 33-1/3% control premium $15/share 30% marketability discount $10.50/share { Control Premium { Minority Discount Discount for Lack of Marketability Value of financialcontrol shares { Value of minority shares as if freely-traded Value of non-marketable minority shares (N.B.: Discount percentages are for illustration only each case varies.) Chartered Professional Accountants & Business Advisors

29 LEVELS OF CONTROL % 2. Less than 100%, unilateral control and more than what is required to exercise majority (or, if necessary, supermajority) control 3. Less than supermajority control, but more than 50% 4. 50% ownership interest 5. Less than 50%, but having largest ownership block 6. Less than 50%, but having swing vote Chartered Professional Accountants & Business Advisors

30 VALUATION ISSUES SHAREHOLDER LEVEL EXAMPLES Shareholder A Shareholder B Shareholder C Total 66% 34% - 100% 67% 33% - 100% 51% 33% 16% 100% 49% 49% 2% 100% 49% 34% 17% 100% 49% 33% 18% 100% 33 ⅓% 33 ⅓% 33 ⅓% 100% 50% 50% - 100% Chartered Professional Accountants & Business Advisors

31 VALUATOR S JUDGMENT: AT SHAREHOLDER LEVEL Valuation methodology for minority shares: Top down Bottom up Comparison with other private-company minority transactions (however, data rarely available) If owning minority shares of holding company, can shareholder access assets or cause liquidation? Chartered Professional Accountants & Business Advisors

32 CRA POSITION ON MINORITY DISCOUNTS FAMILY AND GROUP CONTROL (Information Circular 89 3) It is a rebuttable presumption that a family group has acted in concert to control a corporation. In a situation where the existence of family control is recognized, [CRA] will employ a rateable valuation for each family group member s shares. Each case will be dealt with on its own merits. Chartered Professional Accountants & Business Advisors

33 FRACTIONAL INTERESTS IN REAL ESTATE Co-owner or joint tenant (assuming no agreement) cannot: direct overall management policy and objectives formulate policies relating to amount or timing of distributions from the company Cause sale of company s real estate Chartered Professional Accountants & Business Advisors

34 FRACTIONAL INTERESTS IN REAL ESTATE (CONT D) Size of discount generally considers: size of co-ownership (joint tenancy) interest relationship among co-owners (joint tenants) whether group control exists whether or not special purchasers in marketplace history and policy cash distribution terms of co-owners buy-sell agreement, if any partition rights of co-owners Chartered Professional Accountants & Business Advisors

35 VALUATION OF FRACTIONAL INTERESTS IN REAL PROPERTY NEW YORK EXAMPLE The valuation of a fractional interest in property is not necessarily the same fractional part of a value of the entire property. For example, if the evidence should establish that a onethird interest is worth less than onethird of the entire value, the lesser valuation should be adopted. Article 35, New York Transfer-Tax Regulations, Chartered Professional Accountants & Business Advisors

36 KEY PERSON DISCOUNTS May be applied by reduction of: Normalized earnings/cash flow, to arrive at a maintainable level of earnings absent key person Capitalization multiple that would otherwise be applied to unaffected earnings Fair market value of business otherwise arrived at Chartered Professional Accountants & Business Advisors

37 KEY-PERSON DISCOUNTS LES PLACEMENTS A & N ROBITAILLE INC. (APPELLANT) v. MNR (RESPONDENT), 96 DTC 1062 (TCC) In order to take account of Mr. Robitaille s personal goodwill, I believe that it is essential to recognize a key man discount. The evidence clearly established that Mr. Robitaille plays a preponderant role in the operation of this business. I am satisfied that if Mr. Robitaille were to leave the business, Marina-Québec would suffer a substantial reduction in its earnings. In [these] circumstances, I believe that it is reasonable to use a discount rate of 35% [as used in Wise Report]. Chartered Professional Accountants & Business Advisors

38 VALUATION OF RETRACTABLE PREFERRED SHARES MINIMUM ATTRIBUTES a) Be redeemable at option of holder (retractable) for amount equal to retraction amount ; b) Have priority in event of wind up, Liquidation or redemption; Chartered Professional Accountants & Business Advisors

39 VALUATION OF RETRACTABLE PREFERRED SHARES MINIMUM ATTRIBUTES (CONT D) c) Issuer not permitted to pay dividends on other shares, which would reduce fair market value of retractable preferred shares below redemption amount; d) Have voting rights at least on any matter involving a change to preference, rights, conditions or limitations attaching to subject shares. Chartered Professional Accountants & Business Advisors

40 VALUATION CONSIDERATIONS RETRACTABLE PREFERRED SHARES Tax liability to Holdco on ultimate sale of Opco shares to fund payment of retraction amount Lack of liquidity if Holdco is newlyincorporated shell, having no assets other than Opco shares Redemption by Holdco of preferred shares may subject shareholder to personal income tax on deemed dividend Chartered Professional Accountants & Business Advisors

41 VALUATION CONSIDERATIONS RETRACTABLE PREFERRED SHARES (CONT D) Dividends whether fixed, based on percentage of stated value or an adjustable rate feature Frequency of dividend payments whether annual, semi annual, quarterly or monthly If dividends cumulative and, if so, any rights accruing to holder because of missed dividends If shares voting under all circumstances Chartered Professional Accountants & Business Advisors

42 VALUATION CONSIDERATIONS RETRACTABLE PREFERRED SHARES (CONT D) Whether shares are exchangeable Financial ability of issuer to redeem shares upon shareholder s retraction demand Issuer s financial viability, capital structure and staying power under adverse conditions or in cyclical downturns Level of senior ranking charges against issuer s operating cash flow Chartered Professional Accountants & Business Advisors

43 RETRACTABLE PREFERRED SHARES ITAK INTERNATIONAL CORP. v. CPI PLASTICS GROUP LTD CanLII (ON SC) Court s refusal to deny shareholder s retraction request had considered: Company s share conditions Impact of retraction on company s banking covenants, financial position and remaining shareholders Retraction conditions Business judgment of Board Possible oppressive company conduct Scope of company s obligations Expectations of company s shareholders (holders of retractable shares as well as other shares) Chartered Professional Accountants & Business Advisors

44 BUY-SELL AGREEMENT TRIGGERING EVENTS Death Mental or physical disability Bankruptcy Voluntary cessation of employment (retirement) Involuntary cessation of employment (dismissal) Chartered Professional Accountants & Business Advisors

45 BUY-SELL AGREEMENT TRIGGERING EVENTS (CONT D) Dissension or deadlock among shareholders Criminal conviction Matrimonial property claim Desire to sell shares and withdraw from company Chartered Professional Accountants & Business Advisors

46 BUY-SELL CLAUSE OBJECTIVES Increased certainty as to (a) quantum and (b) liquidity with respect to deceased s shares Assured market for shareholding Fair selling price for terminating shareholder as a result of death, incapacity, retirement, withdrawal or inability to continue in the business Fair purchase price Chartered Professional Accountants & Business Advisors

47 BUY-SELL CLAUSE OBJECTIVES (CONT D) Price-setting mechanism for shareholding acquired by continuing shareholder(s) In case of death, to provide vehicle to assist in timely administration of deceased shareholder s estate Control of corporation by remaining shareholders assured, without involvement and possible interference of outsiders who might otherwise acquire terminating shareholder s shares Chartered Professional Accountants & Business Advisors

48 BUY-SELL PRICE: WHAT VALUE? Adjusted book value? Fair market value? Fair value? Value to owner? Formula price? Chartered Professional Accountants & Business Advisors

49 VALUATION CONSIDERATIONS How is price/value determined? As of what date? Date of specified/triggering event? End of immediately preceding month? End of last completed fiscal year of the business? End of last regular accounting/reporting period (e.g., fiscal quarter)? How often should buy-sell clause be reviewed/ updated (changing circumstances, conditions)? Chartered Professional Accountants & Business Advisors

50 SETTING BUY-SELL PRICE Fixed price negotiated in advance by parties, and updated periodically (e.g., annually) to be used when specified event subsequently occurs Price determined by independent third party, such as CBV Price established by formula Price determined by shotgun (put-call) clause Price established by right of first refusal Chartered Professional Accountants & Business Advisors

51 SUGGESTIONS FOR MINORITY SHAREHOLDERS Consider buy-sell clause instructing valuator to value terminating shareholder s interest as if part of controlling group having 66-2/3% of votes in all circumstances If agreement employs term, fair market value, it should specify without the application of either a minority discount or marketability discount (if intended). Chartered Professional Accountants & Business Advisors

52 SHOTGUN PROVISION You cut the pie in two, and I will choose my slice! SAFEGUARD: If offeror asks too high a price, offeree may respond by requiring offeror to pay that same price for offeree s shares If offeror offers too low a price, offeree may respond by buying out offeror at that low price Chartered Professional Accountants & Business Advisors

53 ADVANTAGES OF SHOTGUN PROVISION If parties have equal financial backing and are equally informed as to future prospects of business, shotgun approach should establish a fair price, since offeror will be: forced to sell if his/her valuation is too low; or forced to buy if his/her valuation is too high Chartered Professional Accountants & Business Advisors

54 DISADVANTAGES OF SHOTGUN PROVISION Assumes respective shareholdings are of similar size. However, if two shareholders, one owning 85% and other 15%, might be easier for 85% shareholder to buy; 15% shareholder might not have resources to acquire 85% holding. Chartered Professional Accountants & Business Advisors

55 COVENANT NOT TO COMPETE Assumptions underlying projected earnings of subject business under each of two scenarios: 1. Without competition 2. With competition Financial projection period used Quality of projections Estimate of lost sales absent non-compete covenant Chartered Professional Accountants & Business Advisors

56 COVENANT NOT TO COMPETE (CONT D) Projected sales with non-compete covenant in place Costs of implementing appropriate countermeasures (such as increased advertising, price reductions, etc.) absent covenant Capitalization multiple to apply to earnings of business under each scenario, considering different risk profiles for each Chartered Professional Accountants & Business Advisors

57 LAROCHELLE v. THE QUEEN 2005 DTC 5197 (FCA) Court: In arm s length transactions, non-compete agreement would be required by purchaser and... a valid assumption for seller to obtain highest price under fair market value definition. Chartered Professional Accountants & Business Advisors

58 CRA S POLICY ON PRICE-ADJUSTMENT CLAUSES Agreement must provide bona fide intention of parties to transfer at FMV and value arrived at by fair and reasonable method Parties must agree in tax return to have price reviewed by CRA, take necessary steps to settle any resulting excess or shortfall, and file copy of agreement with CRA if and when demanded Excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted Chartered Professional Accountants & Business Advisors

59 PRICE ADJUSTMENT CLAUSES Non-arm s length sales or estate freezes objective is to avoid 69(1) or 85(1)(e.2), 86(2), etc. Retroactive adjustment in price if parties reach settlement with CRA or final appeal Income Tax Folio S4-F3-C1, Price Adjustment Clauses (January 14, 2014): need evidence of bona fide intention to transfer at FMV and to arrive at value using fair and reasonable method Chartered Professional Accountants & Business Advisors

60 INDEPENDENT PROFESSIONAL VALUATION* 1. Would help support fair market value for priceadjustment clauses Independent valuation Qualified valuator 2. Would help avoid exposure to third-party civil penalties by CRA 3. Normally applies generally-accepted valuation methodology * Not required by CRA. Chartered Professional Accountants & Business Advisors

61 IC 01-1 RE FAIR MARKET VALUE 46. The Business Equity Valuation Program is responsible for advising as to the fair market value determinations of private and public securities, partnerships, proprietorships, copyrights, royalties, patents, goodwill, financial instruments and other business equities for tax purposes. It provides expert opinions on technical valuation and related issues, prepared in accordance with current professional standards and ethics, as set out by the Canadian Institute of Chartered Business Valuators. Chartered Professional Accountants & Business Advisors

62 RECONCILING ESTIMATES OF VALUES Businesses use values for variety of business purposes. As a result, values may be identified within types of information corporate, legal, sales, accounting and tax departments assemble and develop. Tax authorities may obtain those valuations and use them as either an offensive or defensive weapon in tax litigation. Chartered Professional Accountants & Business Advisors

63 QUESTIONS? Richard M. Wise FCPA, FCA, CA IFA, FCBV, FASA, MCBA, CVA, TEP Partner, Valuation & Litigation Support Group René-Lévesque Boulevard West 19th Floor Montréal, Québec H3B 2J8 Telephone: Fax: Toll-Free: mnp.ca ACCOUNTING CONSULTING TAX Chartered Professional Accountants & Business Advisors