Business succession planning

1. Business succession planningValuation considerationsCarl Chapman, CA.CBVAssurance and Business Advisory PartnerGrant Thornton LLP

2. Business succession planning • More than 70% of Canadian business owners plan to retire in the next 10 years • 47% plan to sell their business to family or a third party • Others will simply down size and ultimately wind down their operations • However, the current economic climate has many re-thinking their exit plans and levels of after-tax dollars required for retirement............

3. Valuation – why is this important? Ensure that: • Owners understand differences between valuation methods • We know what drives value • We understand factors to consider to prepare for a sale to a third party or succession to family or employee(s), why planning now can increase value or $$ received when the actual transaction occurs

4. Valuation methods • Asset based – mostly capital intensive businesses (construction, trucking, real estate) and holding companies. Often preferred by the buyer as they benefit from asset value (tax deductions) and do not worry about corporate liabilities that comes with a share sale. Value is in underlying assets of the business. • Valuation terms are book value, adjusted book value, modified tangible asset backing (MTAB)

5. Valuation methods • Earnings / Cash flow – value of the business is in the cash flows generated which are available to finance capital assets, service debt / taxes and provide a rate of return to the owners. • Consider terms like EBITDA (earnings before taxes, interest and depreciation), earnings multiples, normalization of expenses, redundant assets, industry “rules of thumb” • Often there is a “goodwill” consideration

6. Valuation principles – “Fair Market Value” • Defined as : “highest price available in an open and unrestricted market, between informed and prudent parties, acting at arm’s length, under no compulsion to act, expressed in terms of cash”.......this is what valuators must keep in mind when performing a valuation • At a point in time • Apply professional judgement • Understanding of business, industry • Is “prospective”, historical results a guide only

7. Asset approach to Valuation • Review the balance sheet, line by line, assess value of all assets • Receivables – anything not collectible? • Inventory – obsolete? Cost policy? Pricing? • Fixed assets – appraisals, management assertions, we are looking at FMV not replacement or insured value • Intangibles - goodwill, patents, customer lists

8. Asset approach to valuation • Same assessment for liabilities • Review the costs of selling the assets, disposition costs, tax costs (both corporate and personal) • Book Value = Total assets - liabilities…..or can be viewed as the Shareholders Equity on the balance sheet • Adjusted Book Value = BV + intangibles less notional adjustment for income tax costs

9. Asset approach – example of Adjusted Book Value • Shareholder’s equity $250,000 • Add • Increase in value for tangible assets 50,000 • Goodwill (customer lists, location) 50,000 • Less – tax and selling costs (50,000) • Value of company = $300,000

10. Asset approach - summary • Look at an orderly liquidation, selling assets to satisfy debt in the business and remaining cash gets distributed to the shareholders • Main approach used for holding companies, investment co’s, other companies like construction/trucking /real estate where cash flows may not be the best indicator of value

11. Cash Flow / Earnings based approach • Approach taken where company assumed to be a going-concern, value is in the assets used to continue operations • Goodwill to be determined, must know what the tangible asset backing is to assess reasonability • Multipliers used need to be supported • Risk to be assessed, industry analysis/research required, thorough understanding of the business • Normalization adjustments to be considered

12. Cash flow based approach – process at high level • Start with 5 year historical earnings summary • Meet with management to understand operational variances, how business operates, seasonality? • Research the industry, know what the key success factors are, benchmarks used and how the current economic climate impacts operations • Review the annual capital requirements, what level of sustaining capital spending is required for the business

13. Cash Flow Based approach - considerations • Arrive at historical maintainable earnings levels and through detailed analysis calculate the normalized EBITDA ranges. Must ask “what cash flows can the business reasonably expect to sustain over the long term?”. • Normalization adjustments: management salaries, one-time only expenses, unusually high costs for specific items like advertising, prof fees, bad debts, shut downs, etc.

14. Cash Flow Based approach -considerations • Interest expenses: review the debt structure and financing arrangements to determine if the rates used require adjustment (unusually high/low), analyze debt ratios – assess underlying leverage ratios for the company • Taxation – apply appropriate tax rates to maintainable earning streams

15. Cash Flow Based approach – Multipliers (or Cap rates) used • Professional judgement used • Ranges can be 3-6 times EBITDA, cash flows • Capitalization rates reflect risk for the buyer • Rates used are derived from consideration for: Bank of Canada risk free rates on long term bonds, industry specific risks, private company risks, liquidity, number of years required to pay back the “goodwill”, inflation, other factors • Consider industry rules of thumb

16. Maintainable EBITDA $500,000 Income taxes - 12% (60,000) After-tax cash flow 440,000 Sustaining capital re-investment (80,000) Discretionary after tax cash flow 360,000 Capitalization rate - 20% or 5 times 5X Capitalized value of after tax cash flow 1,800,000 Deduct the interest bearing debt on B/S (450,000) Value of Company 1,350,000 Other factors to consider are tax shield on assets, goodwill testing, look to market for actual transactions

17. Valuation vs. Price • Valuation of a business is a starting point to arriving at a “price” • Negotiation styles can impact how price determined • More than one party interested? Bid up price. • Special Interest Purchaser – pay premium to gain entry into a market, location, access to customers, may be able to increase volume and realize on specific synergies between their operations

18. How to increase value in your operations? • Start by planning now, sale in 1, 3 or 5 years • Clean up balance sheet, collect old AR, inventory – realize on old stock, improve organization • Detailed asset listings to be compared with actual, consider appraisals of real estate, asset count • Maintenance of assets, keep in good repair • Accounting – records & taxes to be up to date, ensure IT system is reliable and secure

19. How to increase value in your operations? • Any redundant assets? If so, move to holding company, potential buyer will not be interested… • Operational efficiencies can improve cash flow, increased cash flow means higher value and more $$ for retirement • Understand your industry and its key benchmarks and success indicators (margin, inventory turns, where are you making money…..)

20. How to increase value in your operations? • Eliminate discretionary / non-business expenses if possible, less to normalize when sale presents itself, just have business related costs as it shows true operating results • Document customer / supplier contracts • Consider long term leases in assets or premises, if it will add value to your business • Remember “sustainable cash flows” and “reduced risk” in your business are valuation drivers…..

21. In Conclusion ….. Planning can help you understand where your company’s value is or where it is “hidden”. Speak to an experienced valuation advisor today to help you assess your business’ worth and how you can realize its potential.

22. For more information ….. Contact: Carl Chapman, CA.CBV Assurance & Business Advisory Partner Grant Thornton LLP (902) 838 – 4121 cchapman @GrantThornton.ca