Business owners are often looking for opportunities to improve and grow their businesses, or in some cases, refine their exit strategies. If you’re a business owner looking to sell, there are steps you can take to minimize risk and maximize value. In this article, we outline five key things to consider when selling your business, including issues surrounding confidentiality, deal structure, and of course, purchase price.
1. Require a Non-Disclosure Agreement (“NDA”)
A Non-Disclosure Agreement prevents Buyers, the recipients of confidential information, from disclosing this information to third parties or using it to their benefit. It is important, when drafting a NDA, to consider the scope of the information considered to be confidential. This can be achieved by specifying (i) the information that is deemed confidential which may be the same or different for each party, (ii) which exceptions apply to the non-disclosure, if any, (iii) the purpose of the NDA and of the exchange of proprietary information and (iv) the period covered for non-disclosure. NDAs can have a term of up to five years.
2. Assets vs. Shares
Once the parties have signed a NDA, the next step to consider is whether the transaction will be structured as a sale of assets or a sale of shares. There are indeed advantages and disadvantages for the seller in each type of transaction. Nonetheless, the seller will generally prefer to sell shares rather than assets for a number of reasons. First, the sale of shares generally give rise to capital gains, half of which are then taxed resulting in an effective tax rate of one half the rate applicable to ordinary income. A tax exemption on capital gains, known as the lifetime capital gains exemption, may also be available1. It is indexed annually (up to $824,176 for the 2016 calendar year). Furthermore, selling shares also frees the seller of the liabilities disclosed on the balance sheet of the business as well as contingent liabilities, which will be assumed by the purchaser after the sale. On the other hand, in a sale of shares, the entire business passes to the buyer, including the business name or trademark. As such, seller would not be able to continue operating a particular product line or brand or to retain certain assets, unless a particular agreement in this respect is made between the seller and the purchaser.
The tax implications of a sale of assets will depend on the tax position of the corporation prior to the sale, the allocation of the purchase price among the assets being sold and how and when the proceeds of the sale are paid out by the corporation to its shareholders (i.e. whether or not there is an earn‑out clause). If an asset sale has been agreed upon, the seller and the buyer must then agree on how the purchase price is to be allocated among the assets being sold. In such cases, the buyer will prefer to allocate as much of the purchase price as possible to inventory or depreciable property in order to minimize future taxable income. The seller, on the other hand, will want to ensure that the allocation of the purchase price minimizes the recapture of any capital cost allowance previously deducted on depreciable property or a realization of income on the sale of inventory.
Whether the seller opts for a sale of assets or a sale of shares, the tax implications are numerous and should not be overlooked. Thus, proper due diligence in this respect is essential.
3. Good Housekeeping
Once the buyer and the seller have agreed as to whether assets or shares are to be sold, they will enter into a purchase and sale agreement containing the terms and conditions of the transaction. It will also provide for various representations and warranties by the parties. It is therefore essential for the seller to ensure that the corporation is ready to be sold and that representations and warranties regarding corporate existence and compliance with the law and internal regulations are true. Firstly, does the seller possess the original shares of the corporation? Sellers, we recommend that you update your minute books and corporate records at least one year before negotiating a sale of your business. An up-to-date minute book is important to ensure compliance with federal and provincial corporate legislation. In addition, in the context of a sale of shares the minute book may be reviewed by buyer’s counsel as part of the due diligence process. Resolutions passed by shareholders and directors validate corporate actions such as declarations of bonuses and/or dividends.
Secondly, in the context of a sale of a business, it may be important to ensure that the assets being sold are free and clear from third party liens, the buyer has agreed to them. In such a case, the buyer expects the seller to obtain the proper releases from equipment lessors, lenders and landlords etc.
Thirdly, if certain contracts entered into between the seller and third parties contain a consent for a change of control clause, the seller should ensure to obtain such consent before the transaction. Before this can occur, an inventory must be taken of agreements to confirm which have a change of control clause.
Additionally, if the seller believes its intellectual property, both registered and unregistered, is valuable, it must be able to describe the IP in detail.
4. Compliance Questions
Regardless of whether the seller is planning to sell shares or assets, the parties to the transaction will need to comply with any statutory requirements. For instance, the transaction may require that the parties abide by certain provisions of the Investment Canada Act or the Competition Act (Canada). This may also be the case depending on the industry in question in which a regulator may impose certain notification or approval requirements. For example, in insurance, there are requirements relating to the regulator, the Autorité des marchés financiers du Québec.
When selling shares, the seller of shares should be in a position to warrant that the business holds all of the permits and licenses necessary to carry on the business post-closing.
5. Transition to Life after Closing
In the context of a sale of shares, the buyer will inherit all of the seller’s employees. In the context of an asset sale, the buyer may determine that only certain employees will be transferred. Nonetheless, the law protecting employees in Québec may deem that the buyer has “inherited” the employment relationship for all employees of the business, in which case the purchase agreement should be clear on which party bears the cost of termination of those employees not retained by buyer. Responsibility for all obligations relating to the employees post-closing including benefits should also be provided for in the purchase agreement.
The seller should expect to be required to enter into a non-competition and non-solicitation agreement. In the Payette v. Guay Inc2 affair, the Supreme Court of Canada determined that a 5-year period for a non-competition clause was reasonable. In this particular case, the rules for restrictive covenants relating to employment did not apply with the same intensity because the obligations were assumed in the context of a commercial contract where the covenantor benefited from the proceeds of the sale3.
We have saved the best for last: purchase price! The formula setting out the calculation of the purchase price must be described clearly. In some instances, the purchase price will be based on an “earnout” which means that a portion of the purchase price will be paid at closing with the remainder to be paid in the future based on the future performance of the company that is being acquired. Proper documentation evidencing and securing the unpaid portion of the purchase price is essential.