Every entrepreneur who has started and nurtured a business must someday relinquish that business if it is going to survive and evolve. For many entrepreneurs, their businesses are their “babies,” and decisions about what to do with them as the founders move into retirement are fraught with emotional and financial complications. The transition can affect family members, shareholders, managers, employees and customers.

“The business may be the client’s largest asset, but it is just one asset. And plans for the business must be co-ordinated with other personal assets, such as the RRSP,” says Rick Claydon, a financial advisor and partner with Stonegate Private Counsel LP in Toronto. “The advisor creates the integrated plan, and this is where we can add a lot of value. As clients get closer to entertaining the sale, you can run the projections and see what their financial situation will look like after selling, and what kind of income can be generated by all their assets.”

Sometimes, business owners are so busy running the daily affairs of their business that succession planning gets put on the back burner until death, disability or the disintegration of the business forces a transition. In such cases, a desperate sale or even bankruptcy of the business can result from the lack of planning. The advisor’s goal to is ensure the business will thrive up until the time of succession, and long afterward.

“Planning leads to successful conclusions,” says Tony Maiorino, vice president of wealth management services with RBC Asset Management Inc. in Toronto. “The more time the client has to structure the business for succession and examine contingencies and alternative routes, the better. The role of the financial advisor is to be an impartial, independent professional who can work with the client to examine all solutions and opportunities.”

The market is ripe for succession-planning advice. Thirty-four per cent of Canadian small-business owners plan to exit their businesses in the next five years, according to a survey by the Canadian Federation of Independent Business. Another 32% plan to exit in six to 10 years. That means more than two-thirds of entrepreneurs hope to relinquish the reins within 10 years. Yet, of those, only 10% have a formal succession plan, 38% have an informal, unwritten plan and the rest have no plan at all.

Financial advisors can provide valuable help in determining the various tasks that need to be done, such as discussions with family, selecting an exit strategy, assessing the business’s value and setting up a timetable of manageable steps.

“A formal plan is important to ensure the future of the business and stability for employees,” says Tina Tehranchian, branch manager for Assante Capital Management Ltd. in Richmond Hill, Ont., whose client base is more than 50% business owners. “A written plan can also generate confidence with bankers and customers, who don’t have to worry about what will happen if the business owner dies or retires. It can also set a timetable to employ strategies that will help with reducing tax liabilities on the transfer of assets, or allow for any training required to groom the next generation of managers or putting the next team in place.”



> Identifying The Options

Business owners face a number of options when it comes to succession planning. The most common include:

> passing the business on to a family member;

> selling the business, possibly to a competitor or an investor;

> taking the business public;

> engineering a management or employee takeover; or

> simply winding down the business and selling off the assets.

Many advisors suggest a plan be put in place two to five years before the transition is to occur, and sometimes even earlier. It’s often helpful to have an eye on succession from the very beginning, as the corporate structure of the business can have implications on future tax strategies.

“We encourage business owners to start planning as much as 10 years before the transfer will take place,” says David Wilton, director of small-business banking with Bank of Nova Scotia and co-author of the Succession Planning Toolkit for Business Owners, available for purchase on the website of the Canadian Institute of Chartered Accountants (www.cica.ca). “But you could make a case that succession plans should be considered from the day the business is started.”

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> Keeping It In The Family

A Royal Bank of Canada survey indicates that 42% of business owners intend to pass the business to a family member, 19% to a third party, 17% to management or employees, and 10% to a partner. Another 8% don’t know and 3% or so will wind down the business.

While most business owners plan to pass the business on to a family member, succession statistics challenge the wisdom of that strategy. Research by the U.S.-based Family Business Institute says only 30% of family businesses survive to the second generation, 12% are still viable into the third generation and only 3% operate into the fourth generation or beyond.

Indeed, the most popular choice, passing the business to a family member, is fraught with emotional repercussions and family dynamics. Many business owners may find it difficult to accept that some children do not have the interest or ability to take over the business. Alternatively, a child of the business owner may find it difficult to communicate that they are not interested. Or a child who does have the potential to succeed the owner may be too young or inexperienced.

An owner could have more than one child who is equally interested and capable, but feels that selecting one child over another is not worth the risk of disharmony. Or the business owner may have one child who is an ideal candidate to take over but also has other children who are not interested in the business; thus, the business owner needs to find ways to compensate the latter group of children so they are treated equally by the estate.

If other assets are not available, life insurance is often useful for providing an inheritance to any children not taking over the business. It can also be used to pay any capital gains taxes on the growth in value of the business that may be triggered by the death of the business owner.

If the business is involved in different activities, it could be split, with the separate divisions allocated to different children or entities outside the family. Another strategy is to appoint an interim chief executive if the founder believes a child will eventually become a qualified successor. If the founder or family members continue to hold ownership but will not be involved in day-to-day activities, it will be necessary to develop a structure for monitoring the business and participating in important decisions.

The company may also buy out non-working children, but that should be done over time to protect its financial strength. Incentives such as creative remuneration systems and bonuses may be needed for retaining key non-family employees, whether the next generation takes over now or later.

“A business owner needs to consider both the transfer of ownership and the transfer of management, and they don’t necessarily have to happen at the same time,” says Wilton. “There may be management transfer to give children time to acquire skills, and shares may also be transferred over time.

“In some cases, there may be an ownership transfer to a third party,” he continues, “but the skills of the original owner may be retained for a period of time.”

It’s important to realize there is no such thing as “typical,” Wilton says. Some clients see their business as a legacy for their children, while others just want to sell at top dollar.

“The advisor needs to start the conversation,” Wilton says, “and listen carefully to the client’s priorities and goals.”



> Creating A Team Of Advisors

Business succession is a long and complex process, and the most useful role for you to play is quarterback. It is important to work closely with the client’s accountant, who will develop financial statements and assist in strategies for business restructuring and tax planning. Accountants can also help assess business value.

A lawyer with business expertise is essential in drafting any necessary documents, such as shareholders’ agreements and purchase and sale agreements. A lawyer can also advise on the company’s business structure, and whether it makes sense to set up family trusts or holding companies.

Insurance experts may also be required.

In some cases, it makes sense to call in a business valuator to determine the fair market value of the business, and the Canadian Institute of Chartered Business Valuators (https://www.cicbv.ca) may be a good place to find one. A business valuator can provide advice in maximizing value, and provides credibility to the asking price.

Additional support can be obtained from a business broker, who can seek buyers and provide insights on timing and the state of the market. A buyer can often be found among customers, suppliers, the business community or even the competition. Bank managers and accountants can be useful sources for leads.

If family issues are complex, a family business facilitator (often found through banks and accounting firms) can assist in communication strategies such as setting up family meetings, acting as a mediator and clarifying the roles and desires of individuals.



> How Much Is The Business Worth?

A proper business valuation is important for both determining a market price and supporting the fair market value for taxation purposes. A professional valuator will look at a variety of factors, including historical earnings performance, accounts receivable, contracts, assets, patents and trademarks, supplier relationships, company reputations, customer concentration, strength of the management team, industry outlook and market factors.

Many owners overestimate or underestimate their business’s value. It is important to get an accurate valuation, not only to maximize value in the sale but to assess the client’s other financial planning needs.

Financing by the seller often plays a part — particularly when family members take over or there is a management buyout — but the new owners must be able to run the business profitably to ensure repayment of any loans. If the seller expects the business to continue to provide a retirement income in the form of dividends, he or she must be reasonably sure of the viability of the income stream under the new management.



> Tax Minimization

The seller may be able to claim a lifetime capital gains exemption of $750,000 on the sale of shares in the business, providing the business is a qualified small-business corporation. For someone with a marginal personal tax rate of 45%, the exemption translates into actual tax savings of $170,000. That exemption is also available if the shares are transferred to family members or if the company is taken over by way of a share exchange or merger with another company.

To be classified as a QSBC, at least 90% of company assets must have been used to carry on an active business in Canada at the time of disposition, and more than 50% of the assets must have been used in an active business during the previous two years. If only the assets of the business are sold, and not the corporate shares, the seller would not be eligible. Because surplus assets may limit the company’s ability to claim the exemption, the owner may want to transfer non-business assets, such as properties and investments, to a separate holding company, thereby “purifying” the operating company.

If a sale to family members is imminent and the value of the business is increasing, an “estate freeze” may allow future capital gains to accrue to other family members, and could possibly multiply the use of the capital gains exemption. By freezing the value of the original owner’s investment, future gains will accrue to the shares held by heirs. No gains will be taxed until shares are sold or there is a deemed disposition upon death.

The most common method of conducting an estate freeze is to exchange the original shares in the company for fixed-value preferred shares equal to the value of the transferred business. The business value for the original owner is capped at the value of the newly received preferred shares.

The heirs, or a family trust established for them, receive new common shares in the company. These would have a nominal value at the time of issue; but as the value of business increases, the growth would accrue to these new common shares. Some business owners may want to take back a special class of low-value voting shares or attach voting rights to the preferred shares. As long as these voting shares carry more votes than the new common shares, they could be useful in maintaining control over the company.

“If something goes wrong with the direction of the company or the next generation isn’t doing what they should do, the voting shares can allow the original owner to take control,” says Grant Walsh, co-founder of KPMG LLP’s Centre for Family Business in Ottawa.

Before deciding on an estate freeze, it is important for the business owner to decide whether the value of the shares at the time of the freeze is sufficient for future financial planning purposes because there will be no access to future growth. If it is not enough, the freeze can be deferred or there can be partial estate freeze by giving up a smaller number of shares of the company. The execution of an estate freeze requires professional advice from a lawyer.

If the children are minors, or the business owner is reluctant to relinquish full ownership for other reasons, a family trust can be used to hold the children’s shares without giving them control. Family trusts are useful, but their drawback is that they are subject to a deemed disposition rule on their assets after 21 years, which could trigger capital gains. It’s best if the shares are transferred directly to the individual children before 21 years, because then the realization of the gain will be deferred until the children dispose of the shares. The children receiving the shares in the business may be able to utilize their own $750,000 capital gains deduction as the shares increase in value.

“The further you plan ahead, the better, if you want to help your clients keep more money in their jeans and minimize the amount that goes to taxes,” says Maiorino. “Strategies at both the corporate and family level, such as transferring ownership to a lower-income spouse and ‘purifying’ a business, must be planned well in advance.”

Claydon recalls working with a client who did an estate freeze in which each of the client’s three children, as well as the client’s spouse, were able to use the capital gains exemption; exemptions for all five family members totalled $37.5 million.

“This is not something you can set up the day before the sale,” Claydon says. “The correct structure must be in place to maximize tax savings.”

Other tax-saving moves include using some of the business-sale proceeds to make a charitable gift, either directly to a registered charity or to the business owner’s own charitable foundation. If the donation is made during the year in which the business is sold, the donation tax credits can help reduce the taxes on the capital gain from the sale of the business.

In some cases, it may make sense to set up an individual pension plan or a retirement compensation agreement prior to the sale of the business, because the company’s contribution to these retirement plans may assist in reducing the corporate taxes and deferring personal taxes. For clients who had worked actively in their business before 1996, there may be an opportunity to pay themselves a “retiring allowance” before the sale, based on the number of years worked up until 1996, and transfer it to an RRSP, irrespective of the contribution room available. The amount is deductible by the company, and is based on $2,000 for every year worked before 1996 and $1,500 for every year before 1989.



> Cementing The Relationship

Succession planning can result in additional business for advisors, from the sale of products such as insurance policies or the management of new investment assets when the owner receives the cash from the business sale. If the business is passed on to family members, the owner may continue to receive an income stream through dividends or share ownership.



> The Caveat

“Some advisors see an opportunity in pursuing business succession planning as a specialty,” Wilton cautions, “but it’s important to seek out partners who can fill the gap in areas where they are not experts.”

Kathryn Del Greco, vice president and senior financial advisor with TD Waterhouse Private Investment Advice in Toronto, is a strong advocate of the chartered professional strategic wealth designation offered by the Canadian Securities Institute. The designation has helped her immensely in dealing with high net-worth clients, she says, giving her the background to determine when advanced strategies such as family trusts and estate freezes are required.

“If the client doesn’t feel the advisor has the depth of knowledge and ability to handle business succession issues and bring in the appropriate professionals when necessary, they may look for another advisor,” says Del Greco. “Clients need someone who can navigate them through the process.” IE