valuation issues for family-owned businesses may2014_valuation... · valuation issues for...

VALUATION ISSUES

FOR FAMILY-OWNED BUSINESSES

Richard M. Wise, FCPA, FCA, CA•IFA, FCBV, FASA, TEP

Partner

TAX-EFFECTIVE SUCCESSION PLANNING FOR THE OWNER-MANAGER

MAY 22 AND 23, 2014 – TORONTO

MNP LLP


MNP LLP

Chartered Professional Accountants & Business Advisors - 1 -

Tax-Effective Succession Planning for the Owner-Manager

May 22 and 23, 2014 — Toronto

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”


MNP LLP




VALUATION APPROACHES

Income-Based

Market-Based

Asset-Based


MNP LLP




WHAT FINANCIAL STATEMENTS OFTEN DO NOT DISCLOSE

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

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

BALANCE SHEET — ASSETS

Personal

Individual


MNP LLP




WHAT FINANCIAL STATEMENTS OFTENDO 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


MNP LLP




WHAT FINANCIAL STATEMENTS OFTENDO 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


MNP LLP




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 post-

financial statement date

Key-person effects

Concentration/dependence on customers, suppliers


MNP LLP




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?


MNP LLP




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?


MNP LLP




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


MNP LLP




THE CLOSELY-HELD, FAMILY-OWNED BUSINESSCAPITALIZATION RATE OR DISCOUNT RATE INCLUDES FOLLOWING COMPONENTS

a. Risk-free rate

b. Equity risk

c. Illiquidity

d. Size

e. Company-specific risk

Risk

Components

DEVELOPING RATE OF RETURN(DISCOUNT RATE OR

CAPITALIZATION RATE)“BUILD-UP METHOD” — EXAMPLE

Risk-Free Rate

Equity Risk Premium

Impact of “Size”

Industry- or Business-Specific Risk

3.1

3.6

7.1

3.8

Market

Rate of

Return

Company-

Specific

Risk

Factors

FACTOR 18.0%

BU

ILD

-UP

Illiquidity Premium 0.4

(After-Tax)


MNP LLP




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

Market

Approach

Guideline

Public Company

Method

Guideline

Transactions

Method

Prior

Transactions

in Shares of

Subject Company

- 13 -

Richard M. Wise, FCA, FCBV, FASA, MCBA, CVA, TEP

MNP LLP

Chartered Accountants & Business Advisors


February 21 and 22, 2012 — Toronto


MNP LLP




IN WHICH MARKET

WILL TRANSACTION OCCUR?

Principal

Market

Most Advantageous

Market

Pool of

Market Participants

Ordinary

Purchasers

Special

Purchasers

1, 2 or more

Greatest Volume

and Level of Activity

Price Maximization

Including

Highest & Best Use

Other

Market Participants


MNP LLP




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.)


MNP LLP




THE MARKET FOR

Control of publicly-traded companies

and

Control of closely-held companies

THE MARKET FOR

vs

Minority interests in publicly-traded companies

and

Minority interests in closely-held companies

EXAMPLES OF MARKETS(CONT’D)


MNP LLP




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


MNP LLP




ASSET-BASED APPROACH

Liquidation

Orderly

Forced

Going-concern


MNP LLP




ASSET-BASED APPROACH

The Asset-Based Approach adopted where:

liquidation contemplated —business not viable as on-

going 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


MNP LLP




VALUATION METHODOLOGY FOR

INTELLECTUAL PROPERTY

Income Approach: Present value of future

benefits

Market Approach: Guideline transactions

Avoided Cost Approach: “Relief-From-

Royalty” Method


MNP LLP




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)

10 35.3 0.0 205.0 143.9

9 37.3 5.9 117.2 56.7

8 39.6 3.7 180.5 127.4

7 41.9 0.0 97.2 15.9

6 G.E. 46.9 12.2 251.1 135.7


MNP LLP




TEN MOST VALUABLE GLOBAL BRANDS — 2013(SOURCES: Interbrand, S&P Capital IQ)

Rank Brand

Estimated

Value($U.S. Billions)

Book Value of

Intangible Assets


Market

Capitalization($CAD Billions)

Book Value of

Shareholders’

Equity


5 Microsoft 59.5 3.2 286.9 83.2

4 78.8 3.6 205.4 18.8

3 Coca-Cola 79.2 15.9 169.2 34.4

2 93.3 6.9 297.1 83.1

1 Apple 98.3 4.6 456.6 129.9


MNP LLP




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


MNP LLP




“SPECIAL PURCHASER” OR “STRATEGIC BUYER”

EFFECT ON VALUE

Stand-Alone Fair Market

Value

Stand-Alone Fair Market

Value

$1.8 Million

Value-Added (Synergies)

Business A Business B Combined Business AB

$1.0 Million

$1.8 Million

$3.5 Million

$1.0 Million


MNP LLP




RELATIVE LEVELS OF VALUE

Non–Marketable Minority Value

Strategic Control Value

Marketable Minority Value

Financial Control Value

Discount for Lack of Marketability

Financial-Control

PremiumMinority Discount

Strategic-Control

PremiumEnterprise

Level

Shareholder

Level


MNP LLP




“FAIR MARKET VALUE” OF SHARES

LEVELS OF VALUE — EXAMPLE

Synergistic (Strategic) value $24.00

Strategic–Acquisition Premium (say, 20%) (4.00)

FMV of control shares (financial buyer) 20.00

Minority Discount (say, 25%) (5.00)

“As-if-publicly-traded equivalent” minorityshare value 15.00

Discount for Lack of Marketability (say, 30%) (4.50)

FMV of minority shares $10.50

PER SHARE


MNP LLP




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% controlpremium

$15/share

30% marketability discount

$10.50/share

ControlPremium{

{Discount for

Lack of Marketability

MinorityDiscount

Value of financial-

control shares

{Value of

non-marketable

minority shares

Value of minority

shares as if

freely-traded

(N.B.: Discount percentages are for illustration only — each case varies.)


MNP LLP




LEVELS OF CONTROL

1. 100%

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”


MNP LLP




VALUATION ISSUESSHAREHOLDER 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%


MNP LLP




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?


MNP LLP




CRA POSITION ON MINORITY DISCOUNTS

“It is a rebuttable presumption thata family group has acted in concertto control a corporation.”

“In a situation where the existenceof 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”.

FAMILY AND GROUP CONTROL

(Information Circular 89–3)


MNP LLP




FRACTIONAL INTERESTS INREAL 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


MNP LLP




FRACTIONAL INTERESTS INREAL 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


MNP LLP




VALUATION OF FRACTIONAL INTERESTS IN REAL PROPERTYNEW 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 one-

third interest is worth less than one-

third of the entire value, the lesser

valuation should be adopted.”

Article 35, New York Transfer-Tax Regulations, 1937.


MNP LLP




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


MNP LLP




KEY-PERSON DISCOUNTSLES 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].


MNP LLP




VALUATION OF RETRACTABLE PREFERRED SHARESMINIMUM 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;


MNP LLP




VALUATION OF RETRACTABLE PREFERRED SHARESMINIMUM 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.


MNP LLP




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 newly-

incorporated shell, having no assets other

than Opco shares

Redemption by Holdco of preferred shares

may subject shareholder to personal income

tax on deemed dividend


MNP LLP





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 holderbecause of missed dividends

If shares voting under allcircumstances


MNP LLP





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


MNP LLP




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)

RETRACTABLE PREFERRED SHARESITAK INTERNATIONAL CORP. v. CPI PLASTICS GROUP LTD.2006 CanLII 22117 (ON SC)


MNP LLP




BUY-SELL AGREEMENT TRIGGERING

EVENTS

Death

Mental or physical disability

Bankruptcy

Voluntary cessation of employment

(retirement)

Involuntary cessation of employment

(dismissal)


MNP LLP




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


MNP LLP




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


MNP LLP




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


MNP LLP




BUY-SELL PRICE: WHAT “VALUE”?

Adjusted book value?

Fair market value?

Fair value?

Value to owner?

Formula price?


MNP LLP





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)?


MNP LLP




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


MNP LLP




SUGGESTIONS FOR MINORITYSHAREHOLDERS

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).


MNP LLP




SHOTGUN PROVISION

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 buyingout offeror at that low price

“You cut the pie in two, and I will choose my slice!”


MNP LLP




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


MNP LLP




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.


MNP LLP




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


MNP LLP




COVENANT NOT TO COMPETE(CONT’D)

Projected sales with non-compete covenant in

place

Costs of implementing appropriate counter-

measures (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


MNP LLP




LAROCHELLE v. THE QUEEN2005 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.


MNP LLP




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


MNP LLP




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


MNP LLP




INDEPENDENT PROFESSIONAL VALUATION*

1. Would help support fair market value for price-adjustment 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.


MNP LLP




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.”


MNP LLP




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.


MNP LLP




QUESTIONS?

Richard M. WiseFCPA, FCA, CA•IFA, FCBV, FASA, MCBA,

CVA, TEP

Partner,

Valuation & Litigation Support Group

1155. René-Lévesque Boulevard West

19th Floor

Montréal, Québec H3B 2J8

Telephone: 514.861.9724

Fax: 514.861.9446

Toll-Free: 1.888.861.9724

E-mail: [email protected]

mnp.ca

ACCOUNTING › CONSULTING › TAX

valuation issues for family-owned businesses may2014_valuation... · valuation issues for...

Documents