Before Retirement

“I’m thinking about retiring,” Eli Reston told me. Eli founded Reston & Associates Limited 20 years ago. The consulting engineering company has five shareholders. Eli owns 40%. Tim Andrews, who is about the same age as Eli, owns 25%. Four younger men own the remaining 35%.

“My idea is to stop working about three years from now,” Eli continued. “Before I do that, I need to determine what my shares are worth.”

“As I recall, the company has revenues of about $2 million per year,” I said.

“That’s the right ballpark,” Eli agreed. “Our profits before bonuses run at about 20% of sales. We have net assets of $2.1 million. That’s made up of short-term investments of $1.7 million in GICs and term deposits. We also have $400,000 in WIP and receivables.”

“How much of your work is recurring — from existing clients?” I asked.

“We deal with five or six developers and two municipalities,” Eli answered. “They account for about 80%. The remainder comes from new sources.”

“When valuing your company,” I said, “work from recurring sources is very important. If most of your business is like an annuity, the goodwill value is higher. Dentists have great annuity businesses. Their patients come to see them twice a year. The same with income tax specialists. The customers come back every April.”

“Our business really isn’t like that,” said Eli. “We do deal mostly with the same clients, but we compete on most jobs. Developers usually have three or four firms bid on every project. So how would you value our company?” asked Eli.

“You still have a kind of annuity, assuming you win your share of business,” I explained. “Your value is a combination of two numbers. The first reflects the redundant assets you have. The second is the goodwill value. Redundant assets are those not required in the normal course of your business. In addition to the purchase price, I suspect that anyone buying your business would need to invest about $200,000-$300,000 for cash flow to pay rent, salaries and other suppliers before your receivables come in.

“It sounds like you don’t need to access the money that you’ve put into your short term investments,” I continued.

“We haven’t for the last six years,” said Eli. “That’s the period that our investment balance has grown from a small amount to $1.7 million.”

“If your investments are redundant to your business operations, they’d give you a business value of $1.7 million plus whatever your goodwill is worth. Valuing goodwill is complicated. You might get an idea of the business value of your company if you could find out what other firms similar to yours have sold for.”

“That’s not likely,” said Eli. “Those deals are private.”

“In that case you could hire a business valuator, banker or accountant to give you an estimate of company value.”

“I’ve always thought that a $2 million company with our margins would be worth about 0.75 sales, or $1.5 million,” Eli said.

“If the goodwill is worth $1.5 million and the assets of the company are worth $1.7 million, the whole company would be $3.1 million,” I replied. “Your 40% would be worth about $1.2 million. But it would be better if the shares were eligible for the capital gains exemption. If they were, you would pay no tax on the first $500,000 of your capital gain.”

“Are they eligible?”

“Not right now, but they could be,” I said. “There are some important conditions that your shares must fulfil. One crucial test is that the value of the shares must be at least 90% attributable to assets needed by the business when the sale takes place.”

“So my problem is the company has too many redundant assets?”

“Exactly,” I agreed. “But there is a tax efficient way to purify companies of their excess redundant assets. It’s important that we begin work now because in addition to passing tests at the time of sale, there are other tests that the shares must pass for the 24-month period before the sale occurs.”

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto. To receive more information, e-mail Hank at hank@businesslab.ca