Business and Income Tax Issues Involved With Selling a Corporation
When considering the sale of your business or corporation there are so many factors to take into account. Of course, the personal and emotional aspect of letting a business go that you have possibly grown and been involved with from inception is hard enough, but there are many practical considerations to take into account as well.
Let’s take a look at some of the main issues you will need to navigate when considering the sale of your corporation.
Working Capital is a measure of the liquidity of the business and the expectations that come with it can be greatly misunderstood by individuals looking to sell a corporation.
Essentially Working Capital = current assets of the business (cash + creditors + inventory) – debtors / accounts payable.
What a lot of sellers do not take into account is that the purchaser in most cases assumes they will keep all the Working Capital as well as receiving a multiple of the corporation’s earnings as the sale price. The reasoning for this is that the purchaser typically wants enough Working Capital left in the business so that that they will not need to finance it once they have made the initial purchase and contributed whatever cash or line of credit they feel is required upon purchase.
Sellers often have unrealistic hopes when it comes to valuation multiples. In reality, most industries have standard valuation multiples. For most small businesses the multiple is somewhere between 2 and 4 times earnings, with a higher multiple for strategic acquisitions, especially where the purchaser is a public company, since they themselves may have a 15 to 20 multiple.
For many acquisitions, especially those made by public and larger corporations, the multiple is based on Earnings before Interest, Taxes and Amortization (EBITA).
However, in addition to EBITA, there will be adjustments to the upside for management salaries in excess of the salary that would be required to replace the current owner (typically you are adding back bonuses paid to the seller in excess of their monthly wages and any other family wages). Occasionally the adjustment could be to the downside, but that is typically only in cases where the business is a services-oriented corporation, such as an IT company, that is only just starting to see profits or finalize a desired product for market, and the owner’s wages have not yet caught up to market value.
Where a purchase is made by a private company, instead of EBITA, the price may be based on a capitalization of normalized after-tax earnings or discretionary cash flows.
Assets vs. Shares
This is a major negotiation point as both the buyer and seller will have their own obvious preference.
From a seller’s point of view, the sale of shares, in general, will produce a better return for the seller than the sale of assets, especially if the seller has their Qualifying Small Business Corporation capital gains exemption available.
However, the purchaser in most cases will prefer to purchase the assets and goodwill of a business rather than shares. The reasons for this are two-fold.
One, the buyer can depreciate assets and amortize goodwill for income tax purposes, whereas the cost of a share purchase is allocated to the cost base of the shares.
Two, the buyer does not assume any legal liability of the seller when they purchase assets and goodwill, whereas under a share purchase agreement, the buyer becomes liable for any past failings of the acquired corporation.
When the deal is a share purchase, often the existing structure of the corporation is not favorable to utilizing the Qualifying Small Business Corporation capital gains exemption. It is therefore essential to ensure at least some initial income tax planning is done so that if the deal moves forward, proper consideration has been given to the income tax planning and implementation of necessary changes can take place timeously.
Retention and Continued Ownership
In most cases, the buyer will require the seller to stay on for an agreed upon period – normally a year or two to ensure a smooth transition during which the original owner will be entitled to a salary for that period in addition to the sales proceeds.
The retention period often leads to the former owner staying on, as the business is now growing due to additional funds or adjusted management structure and they enjoy continuing to grow the business that they nurtured for so many years without the stress of ownership.
It is also not uncommon for a buyer to want the seller to maintain some ownership in the company so that they still have some personal investment, especially when they will be staying on with the business.
Selling a business at the right time can be a very beneficial move. However, there are a multitude of issues to take into consideration when determining if this is the right move for your corporation. We have touched on some of the major areas to take into account, but it is vital to assemble the proper team of experts (legal, tax consulting and perhaps even a mergers and acquisitions consultant) to help you navigate the sale process and emerge with a fairly negotiated deal.