By CoraLee Baerg
When looking at any important life event or business transaction, it is important to first step back and ask these questions: What do I really want here? What are the objectives? What is most important? This idea should certainly apply to the process of selling a business. The business owner needs to step back and assess what it is they desire most out of the sale of their business:
- Maximize proceeds?
- Secure an income stream?
- Ensure the continuity and longevity of the business?
- Ensure that successors are set up for success?
When looking to sell their business, a business owner should consider the relative importance of these questions and also weigh them in relation to who the prospective buyer might be.
Maximum proceeds may be achievable if a large public corporation buys the business, but if the seller is looking to engage a group of key employees to buy in, a secure income stream and the future success of the business might be top of mind.
A collaborative approach between the buyer and seller can help bridge the gap between meeting the needs of the seller and making a transaction even possible from the buyer’s perspective.
We keep hearing the stats about the amount of money that will change hands as the baby boom generation retires and exits the business world, but does the younger generation have the means or borrowing power to assume this large amount of debt? The answer is often no, not without a bit of a helping hand from the exiting generation. A collaborative approach between the buyer and seller can help bridge the gap between meeting the needs of the seller and making a transaction even possible from the buyer’s perspective.
It has been our experience that, at least in part, the seller is really looking to create a secure income stream for retirement and may not need to see all the cash from the sale up front. Most, however, would also like to see the buyer have some “skin in the game” and put some of their own cash on the line to show their commitment to the business and to take some risk off the table for the seller. If the seller can work collaboratively with the buyer to come up with payment terms that work for everyone, the deal can often work out better for both sides, simply by discussing the needs of each party in the transaction.
THE PENSION PLAN OPTION
With a more traditional approach to vendor financing on a business sale, the seller might agree to take proceeds over a period of time after the sale, in essence partially financing the sale for the buyer to make the transaction more feasible. Another option to consider in this scenario would be for the company to set up a pension plan for the seller as part of the sale proceeds. This arrangement can have several benefits for both sides of the transaction.
Setting up a pension requires the seller to have a history of T4 earnings (not just dividend income) in the company to justify providing a pension plan, in accordance with the Income Tax Act. Based on the seller’s years of service and history of earnings, an actuary calculates the maximum pension available to the seller. In many high-earning scenarios, setting up a retirement compensation arrangement (RCA) can be advantageous to the seller.
An RCA offers the following benefits:
- Funds in the RCA are creditor protected.
- Permanent tax is payable upon withdrawal of funds from the RCA.
- No set legislated amount of pension income must be withdrawn at any age, allowing for flexibility in taking future income.
- It is possible for the pensioner to split pension income with their spouse.
- Funds in the RCA Trust fall outside the pensioner’s estate, allowing for intergenerational transfer outside of the will, with no deemed disposition at death.
Contingent beneficiaries of the RCA Trust will be taxed on the income in their hands only upon withdrawal of funds, offering a significant tax deferral opportunity.
So, there can be many benefits to the seller for receiving some of the proceeds via a pension plan, rather than in a more traditional manner as a share or asset sale. An RCA Trust provides a great deal of flexibility for the future and can be a powerful estate planning tool.
BENEFITS FOR THE BUYER
There are benefits for the buyer as well. When the company sets up a pension plan for the seller, the company’s contributions to the RCA are a tax-deductible expense, which reduces the overall cash flow that the buyer needs to commit to fund this portion of the purchase. The buyer can then compare this setup to the overall cost of making payments on a share sale with after-tax dollars. Depending on the company’s tax rate, the fact that the corporate contributions to the RCA are tax-deductible, and could represent a 27% discount on the cash flow required to support the pension-funded portion of the transaction.
The buyer may also enjoy some flexibility for timing of payments into the RCA (subject to the terms of the deal). Funding of the RCA could happen more quickly than planned if cash flow is plentiful, or perhaps be spread over a greater number of years if cash flows in the company are lower than projected.
In any scenario, the implementation of a pension plan is likely to be only a portion of the deal, with the seller likely interested in having some immediate proceeds, coordinated with the lifetime capital gains deduction.
HOW IT WORKS
To bring this example to life, consider Larry, who owns a business worth $20 million. He knows the employee group interested in buying his business won’t be able to come up with enough personal funds or bank loans to complete the purchase on their own, so Larry looks for other ways to make the deal succeed.
70% of the 816,000* private company owners in Canada are planning to sell or pass on their businesses in the next few years. This is a once-in-a-lifetime process for many of them. For most, their future financial security is locked up in the business’s value. How do they extract some capital? Sell? Transition to employees or family?
This short video introduces some outside the box thinking and provides a comprehensive analysis of Larry’s situation and how he was able to implement this exit strategy and achieve these results. Watch Owners’ Exit Strategy: The RCA by Continuity.
* Data sourced from research undertaken for the PwC Family Business Survey (2018) by Statistics Canada.
An actuary determines that based on his years of service and T4 earnings, Larry is eligible for a pension of $565,000 annually in retirement. The company then commits to a pension obligation of $11 million (deductible contributions) to fund the projected $14 million of pension benefits that Larry is expected to enjoy up to his life expectancy. The present value of the pension obligation of $7 million (after-tax cost) reduces the value of the company to $13 million, which the employee group can fund through personal funds and financing. The company will plan to fund the pension obligation over the next 10 years. This significantly reduces the cash flow cost to the employee group up front, and allows Larry to get both cash up front and an income stream for retirement.
Creating opportunities for both sides to benefit from collaborative planning can provide more value to the seller, and at less cost for the buyer.
First published in the September 2019 edition of The Business Advisor.