Business Valuation Under Pressure

Just like any business, marriages can (and do) fail.

That alone is cause for sadness, but when a marriage also involves one or both of the partners owning a business, it’s vital to also carefully consider the value of that interest and how it can be protected so all parties involved are able to maximize the benefits derived by them. Upon separation, it is important to recognize that there are many emotions involved; which can include sadness, anger and regret. Both parties need to be able to deal with the business issues on a rational, not emotional basis. Since it frequently takes some time to be able to make rational financial and business decisions in a marriage breakdown situation, the family should consider coming up with an immediate interim solution and then plan to wait a reasonable period of time to make a permanent decision. There is little sense in making a quick decision that will be regretted by one party or result in years of messy and expensive litigation.

If possible, the parties involved should work to keep the lines of communication open. If they have to resort to communicating only through lawyers, making decisions that affect either the family or the business will take an inordinate amount of time and be very costly.

All parties with a vested interest in the situation should consult with a lawyer. This doesn’t necessarily just include the separating parties; it may also include business partners or any children or parents. And getting to the right lawyer is crucial — he or she must understand the family dynamics involved and be able to work with the personalities involved rather than “stirring up” the put.

Once the parties have recruited their lawyers, they need to discuss the various legal options available. For example, there are many ways to settle a separation, ranging significantly in terms of level of confrontation, cost, time and effort. Each alternative is appropriate for different scenarios. For example, everyone is aware of full-blown litigation, which is appropriate in situations where one party is not keen on hill disclosure, is not interested in trying to settle a matter, or when there is a genuine legal issue that has not yet been resolved by the courts or in the legislation. But there are many other options available, including mediation, arbitration, mediation/arbitration, collaborative or “kitchen table” settlements.

Shareholder/Partnership Agreements

When it comes to settling issues around a business including determining its value and how to divide it up upon separation or divorce, it really helps if a shareholders’/partners’ agreement has been established in advance. The shareholders need to follow this document regardless of being separated or nor. If properly written, it can be the procedure manual for spouses separating from the business side of their lives. These agreements are well worth the cost even if parties never separate — they provide peace of mind.

Unfortunately, it is quite rare for the parties and their advisers to have had the foresight to draft a shareholders’ agreement, especially when one of the spouses holds shares solely for tax planning purposes. If there is no such agreement in place, the divorcing parties have to determine a way to establish the value of the business for purposes of any buyout transaction.

Determining Value

The Family Law Acts in mast provinces have an equalization system. So, when parties separate, the increase in their total net Family property — assets less liabilities — between marriage date and separation date are “equalized’. In a nutshell, that means the party retaining the higher net family property will make an equalization payment to the party with the lower net family property.

However, there is no requirement that one party buy out the other party’s business interest. This means that if both parties own 50 per cent of a business, there will be no payment from one party to the other and both parties will keep their 50 per cent shareholdings (unless a shareholders’ agreement exists to force a purchase/sale transaction). But, if one party owns 20 per cent of the shares and the other party owns 80 per cent, the party that owns the 80 per cent will have to make an equalization payment equal to 30 per cent of the value of the business at the separation date so that both parties will end up with 50 per cent of the value of the company. And again, both parties will keep their 20 per cent/80 per cent shareholding.

Sounds simple, but problems generally arise because of the very fact that there is a status quo as to the shareholdings. Consider a situation where the wife has even 50 per cent of the shares of the business during a marriage for “income-splitting” purposes and is not involved in the business in any way. Without a shareholders agreement that gives rise to ways for the husband or the company to buy her out or for her to require the husband or company to buy her out, she will be left with 50 per cent of the shares when she may prefer to have the value of the shares in a more liquid form in order to buy a house, invest or make other purchases.

As a shareholder, she is also entitled to realize any future upside in value of the company but will be exposed to the downside as well. She will be entitled to various rights as a shareholder, such as receiving annual financial statements and other financial information and to attend shareholders’ meetings.

It may not be ideal for the husband to have his ex-spouse continue to be involved in his business, particularly if there are other shareholders involved. Consider the situation of a business that is operated by two friends, both of whom hold their shares through a corporation whose shares are owned by the friends and their spouses, The friend of the separated party may not be too excited at the possibility of having a divorce battle played out at the business level.

If a shareholders agreement does not exist between the spouses, it is a good idea to agree upfront as to whether or not one party will sell their shares to the other party. Both parties may be comfortable with a status quo scenario on the business side. However, if they aren’t, then a second issue needs to be considered — the issue of the valuation date.

The relevant provincial Family Law Acts establish a valuation date for equalization purposes. For example, in Ontario, the valuation date is the separation date. the establishment of which is based on various criteria and has been the subject of many court cases. In Alberta, the valuation date is the date of trial.

So, in Ontario, a discrepancy in valuation dates frequently arises for equalization purposes and for commercial purposes. If, for example, the parties finally agree to a share transaction two years after separation date, the valuations prepared for equalization purposes will need to be updated to the current date.

In cases of a marriage breakdown, other documents to look for are trust documents, gifting agreements and marriage/co-habitation agreements. Any assets that have been gifted will be excluded in the equalization scenario. If a marriage/co-habitation agreement has been properly written and full disclosure provided, the equalization process may be simplified as certain items may be excluded.

Once the parties get to a point of knowing the quantum of either the equalization payment or the share purchase price, the next issues are how to structure them from a tax effective point of-view and how to finance these items and the period of time over which payment can be made. It is important to consult a tax specialist (such as the company’s chartered accountant) because the rules relating to separation and divorce are complex. For example, certain transactions can occur without immediate tax consequences only before parties are divorced, including spousal RRSP transfers and capital property transfers.

Transferring Value

Once the amount of the equalization payment is established, the parties have to decide how that is going to be paid.

If there is a family owned business, it typically comprises the lion’s share of the equalization payment. with the home being the second major asset. As such, the business and/or home will be the primary sources of capital to satisfy said payment.

In most situations, there are three options for drawing capital from a business:

1. Raise debt financing within the business.
2. Sell 100 per cent of the business and use the proceeds for the equalization payments.
3. Sell a portion of the business and bring on a new partner.

It’s usually best to bring in a seasoned corporate financial advisor to help in determining the best course of action by assessing the viability of each option and navigating you through the process.

Raising Debt Financing Within the Business

Debt financing is usually’ the cheapest option and enables a business owner to retain 100 per cent of the equity in the business. It entails using the assets and cash flow in the business to raise capital.

With the credit markets’ nascent recovery there is financing available in the marketplace for small to medium-sized businesses. However, the level of leverage provided is at more conservative levels than what was once available. Accordingly, in many circumstances, the level of capital required to meet the equalization payment may be beyond the finance capabilities of the business.

Even if the business can raise the needed capital, that often pushes the leverage levels to the point that the business is left vulnerable and no longer has the needed capital available for growth.

If the relationship with the spouse allows for him or her to accept a subordinated promissory note from the business, this is an efficient way to meet the capital requirement of the equalization payment while not immediately putting strains on its financial position. However. this means there continues to be a connection between the ex-spouse and the business.

Selling the Business

Sometimes, for a number of reasons, the best or only option available for making the equalization payment is selling 100 per cent of the business.

To maximize the business value and smooth the sale process, the owners and their business advisors must first:

• Ensure the books and records are well organized so information is easily and readily accessible; including all contracts, tax filings and ledgers. This gives the buyer comfort with the validity and accuracy of the information.
• Just as owners “stage” a home before attempting to sell it, the premises should be clean and well organized.
• While tax planning is an important tool to minimize taxes payable, during a sale it’s important to ensure the bookkeeping is accurate and reflects the income and cash flow of the business. Buyers will not pay based on income that they cannot verify. If it is a cash business, there needs to be controls and audit trails to demonstrate the business income.
• Where possible, it’s an asset to have a second tier of management in place ensuring the viability of the business does not rest solely on one person.
• Consider obtaining Review Engagement financial statements versus Notice to Reader, which will provide buyers a higher level of comfort with the historical financial results.

Selling a Portion of the Business

The final option, which falls between one spouse buying out the other or selling the business altogether, is to sell a portion of the business, which often means bringing on a new partner. Depending on the size and type of business, this may or may not be a viable option.

For larger businesses, an option is to bring on a private equity partner with a five-year plan in place for the owner to repurchase the shares sold.

However, smaller businesses will need to look to individuals looking to buy into a business. In that case, employing a corporate finance professional to help find a new partner and structure the transaction can be a big help.