Business Valuations

The past few years have significantly impacted many businesses, in many cases disrupting even the best laid plans. As society moves towards a semblance of normalcy, many owners are finding themselves at a crossroads in terms of planning a future path for their businesses.

Perhaps that path is investing to sustain operations or spur growth. For those uncertain about whether to stay the course or sell, a valuation to determine your company’s worth in the broader marketplace and potential next steps may be in order. Or you may find you are ready to sell your business.

Each of these scenarios comes with its own complexities, whether it’s determining the optimal financing structure based on the current state of your business, understanding the multiple factors that can impact an accurate valuation, or getting a clear picture of the tax considerations when selling.

Following is a brief overview of considerations that come into play when navigating your future path.

First option: investing in your business

Many business owners find themselves seeking financing options, whether to help the business adjust to current economic conditions (including inflationary pressures, rising interest rates, and increased costs of doing business) or to capitalize on new opportunities that have arisen.

Before determining where you want to go, you must understand where you are now. The first step in determining the financing you need is to examine the current financial health of your business by asking yourself the following questions:

The next step is deciding where financing could be leveraged to support your business moving forward. For example, do you need to invest in automation to address a labour shortage, upgrade your equipment, fund new R&D efforts, increase your inventory, or expand your staffing?

Be fully prepared when approaching lenders so you can present a full story in terms of numbers, relevant anecdotal information, market/competitive conditions, and your plans moving forward.

The first thing they will ask for is a business plan. This should be a living, breathing document based on current goals and aspirations for your business. ‘Must haves’ in that first meeting also include at least three years of financial statements, aged AR, AP, and inventory listings, interim financial statements, and ownership and organizational charts. You should also be prepared to share your financial projections and forecasted cash flows.

‘Nice to haves’ include, management reports or qualitative information that is readily available, including sharing information on top customers and top suppliers, as well as an overview of product sales mix or summary of products/services offered.

Also, be clear on expectations concerning how much you are asking for and where you plan to spend it as well as the timeline in terms of how you are going to use the funds and your repayment plan.

Second option: Valuing your business

A valuation determines the value of your company at a specific point in time and must be fair and conducted at arm’s length.

Valuations are not always an indicator of a selling price, as factors such as market conditions and type of buyer can come into play. For example, a silent partner looking to invest in a company will typically pay based on the valuation. A strategic buyer, such as a competitor, may be willing to pay a premium.

There are three valuation methods for an economically viable company:

1. The income-based method is applied to companies earning a fair return on its capital employed and the buyer wishes to acquire the future cash flows.
   1. Discounted cash flow method: This method is appropriate in circumstances where a business’s cash flows are likely to vary significantly or where past performance is not indicative of future expectations.
   2. Capitalized cash flow method: This method is appropriate in circumstances where a business’ earnings are relatively stable and are not expected to fluctuate significantly in the future.
2. The asset-based method is used when income streams will not be higher than the value of the companies’ assets or where there is no commercial goodwill that is transferrable to a prospective buyer.
3. The market-based method is based on actual transactions involving the subject company shares or the analysis of transactions of comparable companies.

The valuation method of choice very much depends on where you are in your business lifecycle. For example, a company in the growth or expansion stage, expecting a significant increase in cash flows, would likely utilize a discounted cash flow method. Whereas a company in the maturity and exit stage looking to sell may choose the capitalized cash flow method if cash flows are expected to remain stable.

A professional valuator will apply discount rates and multiples during their calculations which are based on assessing risks and returns. This exercise requires an in-depth analysis of where your company stands in the industry, the competitive landscape, potential market opportunities, and your strengths and weaknesses, among other factors.

Valuations also include an assessment of tangible assets (i.e., physical assets that can be sold); intangible assets (assets that lack physical substance and can be identified separately and sold, transferred, licensed, rented, or exchanged); and goodwill (e.g., assets specifically tied to the company such as brand, reputation, location, workforce, etc.).

When working with a professional valuator, the following are the key things you need to do to prepare:

• A business and/or strategic plan
• Historical financial statements, preferably externally prepared
• Three-to-five-year financial forecast, if in growth or expansion phase
• Details of revenue sources (if recurring, attribution rates, contracts or key relationships, concentration risk)
• Details of key inputs which may be variable in nature and have a material effect on margins going forward
• Competitive landscape and industry information

Also, be prepared to have your professional valuator ask the following qualitative questions during the information gathering stage:

• Why would someone want to purchase your company?
• What do you have that your competitors don’t?
• What are your value drivers, and how will they drive growth in the company?
• What are the opportunities and threats in your industry? In your market?
• What do you need to do in the future to achieve your growth plans?
• Who are your key employees? Does your current management structure have the skills/knowledge to help scale your company?

Third option: selling

Once you have gone through the valuation process and have decided it’s time to sell, there are a number of basic tax concepts that need to be considered.

Different sources of income can be taxed quite differently, with the two main ones being capital gains and regular business income. Capital gains receive a preferential tax treatment where only 50 per cent of those gains are taxed, while 100 per cent of regular business income is taxed.

Depending on your type of business and track history, your main options are a share sale or asset sale. If you sell shares, you will generally generate a capital gain, however, this is not necessarily true when it comes to selling assets. For example, selling inventory creates business income, and selling depreciable property such as machinery, generates both business income and capital gain.

One inherent issue with a share sale is the risk of any hidden liabilities for the buyers. Buyers will generally go through a thorough due diligence to identify any “skeletons” that may affect the offer price, such as upcoming CRA audits, ongoing litigation or disputes, or outstanding tax balances.

The lifecycle stage of your business is another deciding factor. For example, a younger, less established company would typically go through an asset sale. A share sale makes more sense for a mature, established company with recurring revenue streams, and strong history of profitability.

Planning is critical whichever option you choose. In the case of a share sale, it is important to review your corporate structure, financial statements, and availability of lifetime capital gains exemption (which allows individuals to sell their shares in a business without triggering significant taxes on capital gains), with your accountant to make sure you qualify to use a capital gain exemption to minimize capital gains tax. Make a note of any passive assets inside the corporation in case you need to move them out of the company prior to the sale.

It is also a good idea to estimate your after-tax proceeds and how you would prefer to receive them before signing a sale and purchase agreement.

Your tax accountant can be an invaluable resource in helping you navigate the complexities of selling a business, from understanding available exemptions to maximizing returns on proceeds. If you are looking for the best path forward for your business, our team of advisors at Fuller Landau have experience in all areas of taxation, accounting, and advisory services. Contact us today.

About the authors:

Rosanna Lamanna CPA, CA, LPA is a Partner in our Audit and Accounting group. She can be reached at 416-645-6502 or rlamanna@fullerllp.com.

Christina Yam, CPA is a Manager in our Tax group. She can be reached at 416-645-6531 or cyam@fullerllp.com.

Eli Plonka, CPA, CA, CBV is a Senior Manager in our Valuations group. He can be reached at 647-417-0373 or eplonka@fullerllp.com.