How to evaluate a proposed business acquisition

There's nothing simple about estimating the value of a business you want to acquire. Valuating a business is not a simple exercise, nor is it an exact science. It simply provides a theoretical value that will give you an idea of the fair price to pay for a business.
You mustn't rely only on the judgement of your accountant or of the seller. It is recommended that you have an expert, who specializes in business valuations, produce an independent report. While this is an unregulated field, the Canadian Institute of Chartered Business Valuators (CICBV) does provide guidelines and a code of ethics.

In general, you will rarely be able to compare your potential acquisition with a similar transaction. There is little information available on such transactions and they may not even apply to your specific conditions. Also, the terms may be too closely related to a particular sector to be useful.

3 degrees of assurance
According to the CICBV, there are three types of reports, they vary from the most general to the most detailed:

• Calculation report: provides an approximate valuation for initial planning
• Estimate report: ideal for preliminary negotiations, succession planning, and situations involving important issues that are subject to budgetary constraints
• Comprehensive report: appropriate in situations that involve high risks, important issues, or when there are legal proceedings
• To prepare their reports, evaluators look at the facts and financial data, formulate a conclusion, and the possible impacts on the estimated value. They will also add a disclaimer regarding the scope of the mandate, which varies with the quality of the report provided.

Work required
To produce a calculation report, the valuator reviews and analyzes the financial information and may meet with management.

The estimate report takes the same approach but is more exhaustive.

In the comprehensive report, the valuator provides an opinion. It is a more in depth analysis of the business and it reviews:

• Patents, bylaws, and shareholder agreements
• Business' economic situation and sector
• Market conditions and the competition
• Clientele and any contracts, backlog of orders
• Suppliers contracts and commitments
• Visit to the business
• Financial and forecast data
• Rationale for the choice of discount and capitalization rates using accepted financial models

Basic valuation principles

The first step in the process of establishing a price consists of determining the fair market value of the business. The three main valuation principles are:

• Value is dependent on expectations
• Value is dependent on future cash flows
• Value is dependent on tangible capital assets

Valuation methods and techniques
There are two basic ways of determining the value of a business:
 Asset-based

• Book value: company's net worth, which is equal to assets minus liabilities. What is shown in the financial statements
• Liquidation value: assumes that the business sells all its assets, pays off all its debts, including taxes, and distributes the surplus to its shareholders

Earnings and Cash flow

• Discounted cash flow: value is based on the future cash flows of a business
• Going concern value: assumes that the business will continue operating and compares the current cash flows with future inflows to make projections

Some of the most common techniques used to calculate a business value include:

Capitalization of typical net earnings
A value can be attributed to future earnings resulting from the acquisition. To obtain the going concern value, a capitalization multiple is applied to these earnings and non-operating assets are added.

Capitalization of typical cash flows
The same as above with the exception that cash flows, rather than earnings, are capitalized.

Discounting of expected future cash flows
Consists of determining the most likely future cash flows and discounting them at the valuation date.

Determination of adjusted net assets
Liabilities are subtracted from the determined fair-market value of the assets. It is used for businesses, such as those in the real estate sector, whose value is asset-related rather than operations-related

For more information, consult the Steps to Capital Growth guide included on Canada Business website.

Other rules
In some sectors of the service industry the value of a business is based on a multiple of revenues. For example, an insurance brokerage firm can be worth 1 to 1.5 times the commissions received over a period determined by negotiation.  In the final analysis, purchase conditions and the final price paid will be determined in your negotiations with the vendor

What’s your business worth?

ther you're passing on the company to a family member or selling to outside interests, you will require a business valuation that establishes a realistic and fair price. This value will be an important focal point of your transition plan.

Valuating a business is not a simple task. The number you have in mind may differ from that of your family successors, potential buyers or tax assessors. It's probably best to call in a specialist who can look at your assets, liabilities and goodwill with clear-eyed detachment.

Different methods can be used to arrive at your business valuation, and they can be used alone or in combination.

Asset-based approach
This method totals up all investments made in the business to date. It does not account for the depreciation in the value of machinery that may be several years old, or other assets that have declined in value.

Business comparison
This approach determines a company’s market value by comparing it to similar companies in the field and transactions that have occurred in the recent past. For a highly specialized business, it may be difficult to research comparable transactions.

Company's past earnings
This method calculates a company’s value by its past earnings and profits. Those earnings and profits, however, are not a guarantee of future growth.

Doing it yourselfIf you are intent on determining the market value of your company yourself, here are some pointers. First, determine just what it is that will be sold — or passed on — to your successor(s) or buyer(s).

• Do you have significant physical assets, or are you selling goodwill and client lists? How valuable is that client list, and does it include quality clients? Can you charge a premium for your client list, business name or logo?
• If you have equipment, how much equity do you have in it? If it's not leased, consider asking a machinery dealer for an appraisal.
• How about receivables? What state are they in? What percent are at 60, 90 or more days?

Once the assets have been added up, look at your liabilities. These include all outstanding company debts, of course, as well as variables such as unresolved lawsuits.

Some industry groups publish business valuation data based on sales and net cash flow. This data can be used to estimate the value of your business. Research firms that are similar to your own to see how much they sold for. Your company, however, may be a model of efficiency and profitability that outstrips all the rest, so those numbers are not necessarily the best basis of valuation.

Getting professional help
Business valuation requires some legwork and a lot of research. Do you have the time, the proper tools and the inclination to do it? If not, you might consider using a business valuator, who may be an accountant or a lawyer and should be experienced enough to determine the best method or combination of methods for the task at hand.

Your present lawyer or accountant may be able to recommend someone. Be sure to ask for references of similar business valuations that he or she has done.

Improving that number
Whether you’ve done the valuation yourself or had it done by a professional, once you've arrived at a realistic number, it's only reasonable to wonder how that number can be improved. BDC Consulting has the resources to provide you with transition planning and business coaching solutions to make your company more valuable.

• One way of enhancing value is to increase sales — the "top line" — and reduce expenses such as owner perks to improve the "bottom line."
• Do you have variable liabilities such as outstanding lawsuits? If so, these should be settled before you begin the transition process.
• If you are the business — that is, if you are closely identified with the company — consider giving more responsibility to employees. They can make the transition to ownership and thereby render your company more valuable.
• Finally, your business may be more valuable in pieces than as a whole. A buyer may find your real estate holdings more attractive as an asset than as part of a potentially risky business.

There are many ways to estimate and enhance the value of your company prior to your business succession, and it pays to do your research and find a qualified business valuator. A professionally derived valuation will contribute to a smooth transition and continued harmony among family members.

Transition planning: What you need to know

Everyone who operates a company will eventually reach a point when they will have to leave the business because of age or health concerns. This could mean retirement, sale or simply winding up the firm and closing it down.

Collectively these are known as exit strategies, and every business owner should have one. Yet many will exit their companies without a clear plan. This may be largely due to the fact that entrepreneurs are more focused on starting and building their businesses than on leaving them.

The result? When business owners are ready to pass the torch, they may not get the full value of their company if they're selling to outside interests. Or if it's a family transfer, they could end up leaving family members with unmanageable problems instead of the inheritance they had hoped to bestow.

You can always make better business decisions by planning ahead. If you start to think about succession planning early, you can take a more objective look at your future needs and avoid last-minute decisions. Although unique to every business, a succession plan consists of a series of basic steps, such as setting your financial goals, determining legal requirements and establishing your objectives with your family or successor. It is often a complex and sometimes emotional process for a business owner.

"One of the most important steps is first knowing all the options available to you for exiting," says Calvin Hughes, a BDC consultant. "It's important that you feel active and engaged in the process. But at the same time, you have to accept that you're letting go of your business."
Here are some of the most common exit strategies used today.

Family transfer
If transferring your business to a family member is a possibility, it's key to ensure that your family is fully aware that you're planning a succession and to give them clear time parameters. A part of this, says Hughes, is ensuring that family members get a chance to voice their concerns and interest in the business. One of the most obvious advantages of opting for a family transfer as an exit strategy is that your family will benefit from your business legacy. As well, family members who are already involved in your business may require less coaching or involvement.

Management buyout (MBO)
The purchase of a company by its management team has several advantages for entrepreneurs. It can ensure uninterrupted continuity because the new owners already have invaluable experience with the company. For this reason, your company is more likely to keep its existing clients and business partners.

Selling to outside interests
Selling a business to outside interests is the most popular exit strategy because it's typically "more definitive and involves fewer variables than a family succession," says Hughes. Entrepreneurs should appreciate that the price they receive for their company might be more or less than the appraised market value. "While many business owners tend to overestimate the pricing of their businesses, a surprising number may underestimate it. For example, if your company becomes part of a much larger venture, then the value may go up accordingly," he says. A large corporation that is buying out a business, for instance, may be able to do more than you have with your business and therefore willing to pay a higher price.

Getting the full value for your business
Whether you're passing the company to a family member or selling it to outside interests, keep in mind that you will need a business valuation that establishes a realistic and fair dollar figure for your business. "Putting that dollar value on a business takes time, and you need to have a specialist who can look at your assets, liabilities and goodwill with an objective viewpoint," says Hughes, adding that he has seen too many cases of entrepreneurs who got caught at the last minute and weren't able to get the full value they had envisioned.

For entrepreneurs who choose selling as an exit strategy, Hughes feels they should also be aware that buyers are increasingly more sophisticated and demonstrate more business savvy. "Smart buyers will certainly delve more into your business history. So in turn, you have to anticipate this and be sure that you're armed with the right figures and backup material to get the value that you're looking for. You don't want to find yourself in a vulnerable position," he stresses. Company owners should keep in mind that the value of a business is not just based on financial statements. "The number of customers you have, for example, could also be a determining factor," he says.

Planning ahead
"Planning ahead, at least 18 months to 2 years, helps entrepreneurs make better business decisions," he adds. The earlier you start, he believes, the more time you can take an objective look at your company and where it will be down the road. Succession planning takes time, Hughes stresses, because of many complex issues such as business valuations, tax implications, family matters and coaching successors.

One of the first steps in good planning is to get a lawyer involved at least 12 months in advance. Getting legal help as early as possible in the process can help you avoid frustrations down the road such as delays, extra expenses and ultimately a deal that doesn't meet your expectations.

A common exit strategy: The MBO ...

If you're an owner looking to sell your business or an employee thinking of buying the company you work for, you should be familiar with the term management buyout (MBO). In its simplest form, an MBO involves the management team pooling resources to acquire all or part of the business they manage. A Leveraged Management Buyout (LMBO) is similar to a MBO, except that the buyers use company assets as collateral to secure financing.

Most of the time, the management team takes full control and ownership, using their expertise to grow the business. An MBO/LMBO acquisition, which can be sizable, is usually funded by a mix of personal investors, external financiers and the seller.

For a business undergoing a change in ownership, the MBO/LMBO offers advantages to all concerned. Most obviously, it allows for a smooth transition. Since the new owners know the company and its business, there is reduced risk, other employees are less likely to be apprehensive and existing clients and business partners are reassured. Furthermore the internal process and transfer of responsibilities remain confidential and are often handled quickly. Once a business owner has agreed to sell his company to members of his staff, there are usually a series of common steps in the transfer of power:

• Buyer and seller agree on a sale price.
• A valuation of the business confirms the agreed-upon price.
• Managers assess the portion of the shares they could purchase immediately, and then draft the shareholder agreement.
• Financial institutions are approached.
• A transition plan is developed that incorporates tax and succession planning.
• Managers buy out the sellers' interest with financial support.
• Decision-making and ownership powers are transferred to the successors; this can take place gradually over a period of a few months or even a few years.
• Managers pay back the financial institution. This is done at a time and pace that will not unduly slow the growth of the business.

Buyers will need to ensure that the venture is profitable or at least has good potential to be. Keep in mind that the MBO/LMBO requires substantial financing, which will have an impact on company cash flow. To compensate for the repayment, the buyer will need a strategy to increase cash flow through cost-cutting, improved productivity or building revenue.

A thorough financial analysis should reveal cash flow, sales volume, debt capacity and potential for growth. This will provide valuable information on the fair market value of the business and on management's operating flexibility.

How to finance an MBO/LMBO
The buyer(s) will need to develop a strong business plan to prepare for the acquisition. The forecast should be credible and realistically attainable. Personal and business contacts and referrals can also help a successor secure confidence from bankers. A small buyout usually involves only one institution. In larger transactions, several institutions may handle the financing.
In an LMBO, business assets are evaluated to determine the equity available for financing. The lender will use the assets as collateral. The financial institution will adjust interest rates according to the risks associated with the transaction.

The financer may ask the seller to finance a portion of the sale as a form of commitment to the venture, and as a sign of confidence in the management team. Be sure to shop around for the best terms.

Any of these types of basic financing may be combined to achieve a successful transition.
Personal funds can help secure confidence from a financial institution, add equity to the transaction and share risk. Buyers often need to invest a significant amount of personal money — which may involve refinancing personal assets — to demonstrate their commitment. Loan or credit notes from banks are often used to purchase owner shares in the business. This type of financing is attractive because of its simplicity—assets are used as collateral—and because interest rates are lower.
Seller/owner financing can extend payments over a number of years. This form of financing is tied directly to the seller and may include credit notes, loans or preferred shares. This may reduce cash outflow at time of transaction and make the transition easier.

Similarly, an installment purchase of stock allows the seller to maintain a level of control until he or she is completely paid off.

Selling stock to employees can be used in conjunction with an MBO/LMBO to finance the remaining portion. The Employee Share Ownership Plan Association explains how this type of financing enables other employees to purchase stock options in the business. This can give incentive to existing employees while the management team retains control of the business.

Subordinate financing can complement a management team's equity investment by bringing together some features of debt financing and equity financing without diluting ownership. If a profitable business maximizes the financing on its assets, and the management team's personal funds are insufficient, then subordinate financing may take on a higher risk to participate in the venture. Repayment terms are established at time of transaction.

For more information: http://www.bdc.ca/EN/advice_centre/sell_your_business/Pages/RelatedArticles.aspx?PATH=/EN/advice_centre/articles/Pages/succession_mbo.aspx

Examples of typical special/preferred share provisions

Examples of typical special/preferred share provisions are as follows:

Non-voting:

• The shares may be non-voting (except in certain situations provided for in the governing legislation). In the "Income splitting" example, above, the shares given to Taxpayer "B" and the children are likely to be non-voting special shares so that Taxpayer "A" does not lose control of XYZ Company Inc.
• In the "Estate freeze" example, above, Taxpayer "A" will likely receive voting special shares so as to retain control of XYZ Company Inc.

Redeemable:

• Redeemable shares are shares that can be reacquired by the corporation from the shareholder at the corporation's option usually at any time (in effect, a "call" provision). In the "Income splitting" example, above, the shares given to Taxpayer "B" and the children are likely to be redeemable special shares so that Taxpayer "A" can eliminate Taxpayer "B" and or any or all of the children as shareholders in the event of a matrimonial or family dispute.
• In the "Income splitting" example, above, the special shares would typically be redeemable at the nominal consideration originally paid by the shareholder to acquire the shares so that the redemption by XYZ Company Inc., in effect, costs the corporation nothing. In the "Estate freeze" example, above, however, the special shares would be redeemable at the value of the shares on the date of the freeze (in the example, $500,000).

Retractable:

• Retractable shares are shares that give the shareholder the right to require the corporation to buy back the shares from the shareholder at the shareholder's option usually at any time (in effect, a "put" provision—the mirror opposite of a redemption provision). In the "Estate freeze example, above, the special shares would be retractable at the value of the shares on the date of the freeze (in the example, $500,000). This gives Taxpayer "A" considerable indirect control over XYZ Company Inc. whether or not the special shares received by Taxpayer "A" on the freeze are voting or non-voting.

Purchase for cancellation:

• Redemption and retraction provisions give the corporation or the shareholder the right to trigger a purchase/sale of the shares at a share price specified in the provision. In certain circumstances, it may be desirable for the corporation to repurchase the shares at a share price that is different from the redemption or the retraction price; for example, the corporation is in financial difficulty and the shares are worth less than the redemption or retraction price.
• The legislation gives the corporation the power (but not the unilateral right) to repurchase its issued shares (see OBCA, s. 30; CBCA, s. 34). Where a corporation purchases its issued shares, the shares must be cancelled or, if the corporation's articles limit the number of authorized shares, the repurchased shares may be restored to the status of authorized but unissued shares (see OBCA, s. 35(6); CBCA, s. 39(6)).
• Strictly speaking, it is not necessary to include a provision in the articles for purchase for cancellation. Nevertheless, some articles do include such a provision either to expand on the statutory provisions or simply to highlight the prospect.

Dividends:

• Dividends may be fixed or variable:
  • A fixed dividend will require or permit the corporation to pay a dividend on the shares typically calculated as a percentage of the amount originally paid for the shares (i.e., the stated capital). Fixed dividends can be "cumulative" or "non-cumulative." Cumulative dividends accrue annually; if the corporation fails to pay the dividend in any year, the dividend becomes a debt due from the corporation to the shareholder. Non-cumulative dividends do not accrue annually and are only payable in the years in which the directors declare such a dividend to be payable. Where a non-cumulative dividend is not paid in any given year, no obligation to pay the dividend is carried forward into subsequent years.
  • A variable dividend allows the corporation to pay a dividend at a time and in an amount that is in the directors' discretion.
  
  
• One of the advantages of using different classes of shares is that a dividend may be declared and paid on one or more classes to the exclusion of the other classes. In the "Income splitting" example, above, and assuming Taxpayer "A" and Taxpayer "B" have two children, Taxpayer "A" could have caused XYZ Company Inc. to issue Class A shares to Taxpayer "B," Class B shares to child #1 and Class C shares to child #2 (with Taxpayer "A" holding the common shares). If subsequently child #1 requires money to fund, for example, university tuition, a dividend can be declared on the Class B shares without having to pay a like dividend to the holders of the other classes of shares.

Liquidation, dissolution or winding-up:

• This provision will determine the extent to which each shareholder will share in the corporation's equity. In the "Income Splitting" example above, if Taxpayer "A" wants to split income but does not want to otherwise share the value of XYZ Company Inc. with Taxpayer "B" and/or the children, then Taxpayer "B" and the children will receive special shares that can be redeemed for nominal consideration and therefore never have a value that exceeds such nominal consideration.
• In the "Capital gains exemption" example, on the other hand, Taxpayer "B" and the children would receive special shares that participate equally with the common shares in the equity of XYZ Company Inc. By way of illustration, if Taxpayer "A" holds one common share, Taxpayer "B" and each of two children each hold one participating special share and the equity value of the corporation is $1,000,000, then the value of each shareholder's share is $250,000. This value would apply on the liquidation, dissolution, winding up or sale of shares to a third-party.
• Finally, in the "Estate freeze" example, Taxpayer "A"'s shares are fixed (frozen) at $500,000. If the equity value of the corporation is $1,000,000, then on the liquidation, dissolution, winding up or sale of the shares to a third-party, Taxpayer "A" will receive $500,000 and, assuming two children, each child would receive $250,000.

Price Adjustment:

• In an estate freeze or similar tax-planned transaction, the determination of the fair market value ("FMV") of the shares on the date of the freeze is critical to the success of the structure. For that reason, a formal valuation of the shares as at the date of the freeze is usually obtained to support the freeze value in the event that CRA contests the value.
• Estate freezes are non-arms' length transactions. Section 69 of the ITA deems non-arms' length transactions to take place at FMV. In the "Estate freeze" example, above, Taxpayer "A"'s share value is frozen at $500,000. If CRA subsequently determines that the FMV of Taxpayer "A"'s shares on the date of the freeze was $600,000, then Taxpayer "A" will have a taxable capital gain of $100,000. To deal with this contingency, it is normal to include a "price adjustment clause" in the share provisions of the "freeze shares" (in the "Estate freeze” example, the special shares received by Taxpayer "A" in exchange for her common shares). The price adjustment clause provides that if the FMV of Taxpayer "A"'s share value is assessed by CRA (or any other taxing authority) to be other than the amount provided for in the freeze transaction, then Taxpayer "A"'s shares are deemed to have an FMV as determined by CRA (as at the date of the freeze).