Recently, the Canadian Federation of Independent Business ("CFIB") suggested that "some 72% of business owners intend to exit their businesses within the next decade, with over 1.5 trillion dollars' worth of business assets to be transferred to a new generation of business owners"1. This statistic confirms that attention to succession planning will be needed over the next few years. In order for a business transition to be successful, careful and intentional planning is required and the purpose of this brief paper is to summarize a few of the most important considerations.
The three most common transitions involve a transfer to family members, key employees, and a sale to a third party. Sales to a third party are the most popular approach.2 The same survey found that retirement was the most common reason cited for exiting the business (81%).3 The survey also noted that only a small percent of business owners interviewed have developed a written succession plan.4
1. Address Personal Retirement Planning
Given that most business owners are planning to exit into retirement, the first step is to determine how long one needs to work in order to build a sufficient nest egg or, expressed another way, how much money can I expect to have when I retire and what portion of that is tied up in the business? Answering these questions carefully will help answer the basic questions: When can I retire and how much will I need? And, perhaps the most important consideration for many business owners is: "When is enough going to be enough?" Often decisions and planning are delayed because of this basic fear. Am I ready to let go? Yet, delay may prejudice the ultimate outcome. Circumstances may change. An unforeseen health issue may force the issue and hamper the ability to transition on the best terms. Even if one concludes that the time is not yet right, starting the planning process is still a worthwhile and important exercise.
To be successful in this step, one will need to consult with an accounting advisor to get a rough idea of the current value of the business. As well, it will be important to consult with a knowledgeable tax advisor to explore the various baskets of funds from which one will draw retirement income (RRSP's, RRIF's, TFSA's, and non-registered investments and personal real estate that may have been accumulated over one's work life). The greater the value of assets outside the business, the greater the flexibility will be in developing a plan for transition to family members or key employees who may not have sufficient personal financial resources.
2. Identify Likely Successors
As noted, there are three potential outcomes for a transition – a family member or members, key employee(s) or a third-party sale. Dealing firstly with family members, it is very important to honestly consider whether family members are best able to carry on the business. This will be the case even if a family member is already involved in the business. In many situations, the best solution for the family as a whole is for the business to be sold to a third party. However, this will be a difficult decision. It will involve careful reflection and honest conversations with potential affected family members. When considering a sale to key employees, the same questions must be answered. Are they able to carry on this business? Do they have the necessary skill set? If not, can the necessary skills be acquired prior to a transition? What are their personal financial resources? Will they have sufficient resources to enable them to either obtain the financing to purchase the business or to have sufficient skin in the game so that the business owner may provide private financing? If it is determined that the best choice is a sale to third party, it will be a valuable to develop and execute a plan to prepare the business for sale to obtain the highest and best price. My partner, Alec Bildy, will be speaking to you on this topic.
3. Address Estate Planning
Once you have completed the retirement analysis, and identified a likely successor, it will be important to update your estate planning. This will be particularly important if the likely successor is a family member or members. If not all of the family members are involved in the business or are not identified as likely successors, other children will need to be factored into the estate plan to ensure that there is fairness and the appearance of fairness. This will be especially important if the business value represents a significant portion of the estate. It will be necessary to consult accounting and legal advisors to develop a plan that both protects the business and ensures that family members who are not involved in the business share in this portion of the estate. Often, in order to assist in a transition to a family member, an estate freeze is undertaken for the business. This typically involves having the owner exchange his/her current shares for new preferred shares that have a value that is equal to the current fair market value of the business. Once the value is frozen, new growth shares may be subscribed for. This may be the child or children who will ultimately take over the business so future growth will accrue to them. This type of planning can ease the burden for the next generation to take over the business as the business itself will generate the funds to redeem the value of the frozen preferred shares held by the parent. If other children, not involved in the business, are a factor, a discretionary family trust may be a valuable tool so it may subscribe for some or all of the new growth shares.
4. Develop a Clear Emergency Plan
As we know, life is fragile. A business owner must ask how the business will be managed if something happened to him or her unexpectedly – either an untimely death or a permanent disability. Who will manage the business? What impact would this have on lenders and on key customers and suppliers? Is my current senior team able to successfully manage the business until such time as it can be properly transitioned, whether to a family member, to key employees or a third-party purchaser? Will lenders, key suppliers and customers have confidence in the management team so that the business value does not erode? If the answer is no, then steps must be taken to improve the management team and their leadership ability.
5. Preparing the Corporate Structure for Succession
It will also be important to consult with accounting and legal advisors to review the current corporate share structure and to ask whether changes are required in order to properly prepare the business for a transition. This may include undertaking an estate freeze. It may also involve introducing a discretionary family trust. If the plan is to transition the business over a period of time, an appropriate share structure may facilitate an orderly transition of share value to family members and/or key employees.
If the plan is to sell to a third party, it will also be important to consider corporate share structure in the context of tax planning. The capital gains exemption is only available if the shares are sold to a third party. Is the share structure and ownership appropriate to facilitate a sale of shares to a third party? And it will be important to plan early to make sure the shares will qualify for the capital gains exemption. Perhaps there is too much cash, investments or other non-business assets in the business. These assets may need to be stripped out in a tax efficient manner.
6. Prepare a Transition Plan
Once you have completed the retirement piece, identified a potential successor, attended to estate planning and looked at the corporate structure, it will be important to create a transition plan that includes the following:
- Identify all key players in the succession planning process—accounting and tax advisors, legal advisor and financial advisor. To be successful, all parties in the team will need to fully involved and aware of the various issues to be addressed to achieve the desired transition for the business owner. A clear timeline should be developed for various steps to be initiated and completed;
- Identify responsibility for each team member and the business owner in leading various steps in the plan;
- If transition is to family members or key employees, identify timeline, any training/leadership development required and legal, accounting and financing steps to be completed.
- As part of emergency planning, prepare a clear plan for developing future leaders to ensure the business will successfully continue, notwithstanding an untimely death or disability. A succession plan may take several years. And an emergency must still be factored in should an unforeseen event occur. This is also important for a potential third-party buyer, as a strong leadership team is often a key selling feature for a prospective purchaser. This may be especially important for a purchaser from a different jurisdiction that is seeking to establish a foothold in south-western Ontario. All of this is key to attracting the highest and best price for the business.
- Prepare the business for sale:
- Identify redundant assets;
- Identify money losing divisions or product lines;
- Review terms of premises lease to ensure terms and renewal rights will be attractive; perhaps the lease will require re-negotiation;
- Consider issues around owned real estate—is it held by the proper entity? Are there environmental issues or other issues that may detract from the value or lower interest to a purchaser?
1 "Getting the Transition Right: Survey results on small business success planning, Canadian Federation of Independent Business, November, 2018, 3. https://www.cfib-fcei.ca/en/research-economic-analysis/getting-transition-right
3 Ibid, 4.
4 Ibid, 6.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.