Five important questions every business owner should answer

Tony Maiorino:

According to the Canadian Federation of Independent Business, 76 percent of owners plan to exit their business in the next 10 years, but only 9 percent have a formal written succession plan, and 46 percent have no plan at all. Whether you started your business two years ago or 20 years ago, every accomplished business owner should have a plan for the future.

Hello, I’m Tony Maiorino and welcome to RBC Wealth Management’s Matters Beyond Wealth. With me today is Prashant Patel, Vice President of High Net Worth and Business Owner Planning at RBC Family Office Services, and Paul Morgan, Managing Director, RBC Mid-Market Mergers and Acquisitions.

Thank you both for joining me today to talk about business owner planning and why this Matters Beyond Wealth.

Prashant Patel:

Thank you, Tony.

Paul Morgan:

Thank you, Tony.

Tony Maiorino:

Prashant, I understand the business owner planning team has come up with the five important questions that every business owner should ask themselves. And I know that you’ve got a really slick acronym for it. Maybe tell us a little bit about those five questions in that acronym.

Prashant Patel:

Yes, so an easy way to remember the five key questions is by using the five-letter word SWORD as an acronym.

So the S in SWORD stands for structure, which is part of the first key question. What is my corporate structure? The W in SWORD is in the second key question. What is my business worth? The O is in the third key question. What are my exit options? The R is in the fourth question – what does my retirement look like? And last but not least, the D is in the final question. What would happen if I died yesterday? Obviously there’s more to business owner planning than just these five questions, but working through these questions with your team of advisors for your specific situation is a great start.

Tony Maiorino:

So that’s a really great acronym and easy to remember. SWORD, why don’t we kick this conversation off by talking about the first one? Why is corporate structure so important to this discussion?

Prashant Patel:

Your corporate structure is important for a number of reasons, such as creditor protection, planning for potential exit options, and minimizing taxes. Now we know when it comes to minimizing taxes, the two largest taxes a business owner may have to pay would be the tax on the sale of their business and taxes at death. So, a common corporate structure option that we discuss with clients to help minimize these two taxes, among other benefits, is something called an estate freeze.

So, what is an estate freeze? Well, typically involves setting up a family trust whereby the future growth of the business accrues to the trust where you, your spouse, your children, and possibly even grandchildren are beneficiaries of the trust. One of the key tax benefits of the family trust is that if the shares of the businesses are sold in the future, each of the beneficiaries of the family trust can utilize their lifetime capital gains exemption, which is now up to $1.25 million per beneficiary and this can save over $300,000 of tax per family member on the sale. Note that the beneficiary of the family trust, whether it be a spouse, children, grandchildren, does not have to work in the business or be an adult to utilize their lifetime capital gains exemption. So, it can be quite flexible.

Now, it is important to note that you cannot set up the family trust at the 11th hour before a sale. Our tax rules generally require the trust to be set up at least two years in advance of a sale and the earlier the better. Also in setting up a family trust, you need to do a reasonable and preferably certified business valuation as it’s only the future growth from this day forward that can accrue to the family trust. So Tony, it’s really important that the business owner have a strong team of advisors when structuring an estate freeze.

Tony Maiorino:

 Yeah, no question Prashant and I hear you talking about valuation there. So Paul, with valuation, is there a formula that specifically leads to what that business is going to be worth and when should an owner really consider getting that valuation?

Paul Morgan:

Generally speaking, like valuation tends to be situation specific. There’s no one size fits all or no one multiple fits all situations. So you really have to carefully look at the business to determine what multiple will be applied to the business. In my work, we do a lot of work on mergers and acquisitions on the M&A side. Virtually all of the businesses that we sell are sold as a multiple of normalized EBITDA.

Now EBITDA is Earnings Before Income, Taxes, Depreciation and Amortization. And it’s normalized for non-recurring-type items that are sitting in the income statement or in the P&L statement. One of the things that business owners typically like to know is, you know, how do I increase the value of my business or how do I create value for myself as a shareholder? Well, generally speaking, if you increase your EBITDA, keep the multiple the same, the value of the business will increase.

One of the other things that we typically look at is how do I improve the multiple that gets used in the particular valuation? And just as an example, you’re trying to improve the quality of the cashflow or the visibility of the cashflow into the future. As an example, you might sit there and say, I’ve got a business that has 10 percent of its revenue with one customer, or I’ve got – same business – got 50 percent of the revenue with one particular customer. One will attract a better multiple. And that’s generally speaking, the business that has 10 percent revenue with one customer. Some of the reasons or some of the uses that you typically will see valuations, it’s for tax planning or estate planning, there’ll be a valuation that will be completed. The other thing that typically we’ll see is if you’re thinking about selling a business or going through an M&A transaction, you probably need some type of benchmarking of value. So you get an idea as to what the value of the business is worth before you start on the process of trying to sell your business.

Tony Maiorino:

 So you talked about EBITDA there a couple of times and you mentioned normalized EBITDA. Maybe double click on that for our listeners. So what does that mean in terms of that valuation?

Paul Morgan:

Yeah, if you’re looking at it, and maybe a couple of examples, if I look at it, put yourself in the position of the buyer and look at the normalized EBITDA or the EBITDA that the business is generating. A couple of examples might be an outsized management salary being charged through the business. If that management team’s not there, or if that shareholder’s not there, taking that kind of money out of the business, that typically gets added back to the EBITDA or makes the EBITDA bigger.

There could be non-recurring items that typically show up for kind of one-off type things. There’s a number of add backs as it related to things that were done during COVID. And those are just kind of some of the examples that you would typically see that would be, you know, when your EBITDA would be adjusted for.

Tony Maiorino:

Yeah, great. That’s really good to know and the COVID example is a great one. So I’ve got my valuation and now I’m thinking about what my next step is. And as a business owner, what are my exit options? Who are the individuals or entities that I can sell to? Maybe Paul, talk to us a little bit about some of the things that you’ve typically seen there.

Paul Morgan:

Yeah, so most of the work we do is with privately held owner manager, Canadian-based businesses. There’s internal buyers and there’s external buyers. Internal buyers typically will be either management or family. External buyers will typically be strategic buyers, which are companies that are in the same or similar business. And another external buyer would typically be private equity firms.

You know, we typically see internal buyers in many situations where the business is smaller. So think $5 million in value. Maybe it’s getting passed to the management team, getting passed to the family. It’s good because it probably doesn’t have to go through a full due diligence process. It’s not exposed to the market. Whereas you compare it to selling it to a third party or an external party, whether it’s a strategic buyer or a financial buyer, you’re typically going through full due diligence, the business is being exposed to the market, there might be knowledge that gets out in the market that the business is actually up for sale and maybe that impacts the competitive position of the business negatively. The good thing about basically going to the external parties, generally speaking, they will pay more. Generally speaking, you’ll probably get more cash at closing, all things considered.

Tony Maiorino:

Yeah, that’s great. So I’m a business owner and I’ve spent my whole life building this business and I’m going through this process and Prashant, I know we’ve seen this on a number of occasions, but maybe talk a little bit about why it’s important for a business owner to be thinking about… What does retirement look like? I mean, you’ve spent your whole life working in this business or building this business, and now you’re faced with this prospect of retirement and what does that look like? So maybe give us a couple of minutes on how can business owners plan ahead and what does that retirement look like?

Prashant Patel:

Yeah, well, you know, not surprisingly, most business owners have most of their wealth and net worth tied up in one asset, their business. Now, hopefully at some point in the future, they can sell or monetize their business to create a pool of funds that they can access for their retirement income. However, there can be some unknowns here in terms of timing of the sale and the sale price. So what we typically recommend is you start the planning early with maybe a financial projection or financial plan. The financial plan can model your future cash flow to determine if your lifestyle income needs will be met under different assumptions and different sale of business scenarios.

Also, it’s a good idea to start diversifying your retirement income sources by creating different pools of retirement assets rather than relying only on the sale of your business down the road. Now of course there are the common and obvious retirement assets such as RRSPs and TFSAs say, or as a business owner, you have another retirement saving option and that is something called an individual pension plan or IPP. So what is an IPP? Well, it’s a defined benefit pension plan that your company sets up and contributes just for you and possibly your spouse. And it is designed in such a way that if you are over the age of 45, the contributions that your company makes into the IPP are greater than what you can make to an RRSP. So it’s maybe a good idea to have an IPP illustration prepared comparing an IPP strategy versus contributing only to your RRSP to see if it’s right for you.

Tony Maiorino:

Up until now we’ve talking about business owners who are authoring their succession plan. They’re putting the right wheels in place, but the D in SWORD stands for what if I died yesterday? So, Prashant, again, maybe what are some of the things business owners can do to lessen the burden on those who might be making those decisions in the event of that unexpected death?

Prashant Patel:

Yeah, well, you know, we know this is a topic that many do not like talking about and hence many business owners procrastinate when it comes to their estate planning. You know, I’ve boiled it down to three important areas to work on when it comes to the question of what would happen if I died yesterday.

One, business continuity planning. What would happen to the day-to-day operations of your business if you are no longer around? You want to make sure you have the people and processes in place to ensure your business will continue to be viable for your family if you die prematurely before the sale of your business. If the business will be sold shortly after your death, then you want to plan appropriately for this. Second, ensure your Wills and power of attorney documents are up to date. It is staggering how many Canadians do not have a Will or their Will is decades old. In some provinces like BC and Ontario, it’s common for business owners to have two Wills, one related to their personal assets and one related to their business or corporate assets. And this is done primarily to avoid provincial probate taxes. And finally, review your life insurance needs to ensure there’s adequate life insurance to fund taxes at death rather than you having your family sell other assets at a possibly inopportune time to pay your taxes. Furthermore, many Canadians are using life insurance as another asset class to transfer excess wealth to the next generation on a very tax-effective basis. This becomes pretty attractive if you have surplus wealth in your hold-co, as life insurance in a corporation is the only asset in your corporation that can grow tax-free. The death benefit is then paid into the corporation tax-free and all or most of it can be paid out of the corporation tax-free via something called the capital dividend account. So again, it’s important to work with a strong team of advisors to assist you in these matters to ensure you’ve left no stone unturned.

Tony Maiorino:

Yeah, that’s great advice, Prashant. Paul, you’ve supported many families with the sale of what one might say is their most important asset, something they’ve built up over time. What are some of the issues that you’ve seen when working with business owners as they go down this succession or sale path?

Paul Morgan:

A lot of times business owners get involved in these situations and they tend to have some negotiations and then they essentially go exclusive with a particular buyer. I think some of the problems that we typically experience once we’re exclusive with a buyer is making sure that the business owner is getting good advice. And so that’s either legal or tax planning advice. And certainly as Prashant references, you need good advisors, you need good advisors when you’re going through the M&A process as well.

A lot of times the good advisors can expedite the process. They can educate the business owner and say, well, you might not like this, but this is kind of the way it’s going to work and we’ll get it back some other way. So having good advisors is very important. The process of selling your business is very time-consuming. You’ve got a business to run, you’ve been running your business and now you plan to sell it. Having a management team there and helping you get through the due diligence process is very important.

The number of questions, the volume of questions, the sheer amount of work that goes into selling a business is massive and having a group of qualified members of your management team helping you get through that process is very important. And then I’d say finally, if you have a good management team, you’ve probably been able to talk to the buyer. Everyone’s kind of figured out kind of what the qualitative nature of the business is and why it’s making money, that type of thing.

In the M&A process, a lot of it gets down to the numbers at the end of the day. So having a very good CFO that can create reliable, accurate, relevant financial information that the buyer wants and it’s right and they can do it very quickly is very important. So a CFO is very crucial to these types of processes and they can create a lot of value for the business owner by basically being able to answer the questions correctly the first time in a timely manner.

Tony Maiorino:

Yeah, I think we’ve all seen where a competent CFO has been able to save a lot of time and also can actually help possibly even increase the multiple for that business. So great advice for sure. Now, Prashant, I think as we’ve seen business owners go through these transactions and they receive these large amounts of capital for the sale of their business, tax planning is really important. You know, maybe, you know, just quickly talk about the role that charitable giving plays both in supporting a community, but also from a tax perspective.

Prashant Patel:

Yeah, so we are definitely seeing a greater interest in charitable giving in the year the business is sold, given there’s this large tax bill looming to be paid to the CRA and a larger donation the year of sale can help to minimize those taxes. Now, if a family is philanthropic and planning to make donations annually for the foreseeable future, then what has become popular is setting up and funding a charitable foundation in the year of sale. So the benefit of making a large initial donation into a foundation is that it provides a large donation receipt in the year of sale. But now you can park the money in the foundation and the family has time to decide which registered charities they want to benefit. And parents also like to get their children involved in the foundation and deciding which charities to benefit. Also, it can be more cost effective and simpler to set up a donor advised fund instead of a formal private foundation registered with the CRA.

Basically, a donor-advised fund is a public foundation registered with CRA that you can piggyback off of and set up your sleeve or call it mini foundation account within the larger umbrella public foundation. So this has become very popular with many high-net-worth families and business owners.

Tony Maiorino:

Yeah, it certainly is an area that’s been growing in popularity. Prashant, Paul, thank you both so much for joining me today and exploring this important checklist for business owners and why this Matters Beyond Wealth.

Prashant Patel:

Thank you, Tony.

Paul Morgan:

Thank you, Tony.

Tony Maiorino:

You can find out more about our guests Paul Morgan and Prashant Patel on LinkedIn.

If you enjoyed this episode and you’d like to help support the podcast, please share it with others. Post about it on social media or leave a rating and review. Until next time, I’m Tony Maiorino. Thank you for joining us.

Outro speaker:

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