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SUCCESSION PLANNING & VALUE REALIZATION IN THE CONTRACTING INDUSTRY

Canada’s contracting industry has traditionally been dominated by privately-held companies. Indeed, it is fair to say that much of the building stock of this country stands in testimony to the ingenuity and determination of these owner-managed enterprises

Given the nature of succession planning, it is not surprising to find it is an issue that many owner-operators attempt to avoid. As a recipe for acrimony, succession planning has all the necessary ingredients. It is both an individual and family problem where a parent(s) must assess the age, ability, maturity and personality of the children relative to the size and complexity of the business. Where there is more than one child in the business, the problems increase in size and scope. Where there are non-active children, one must attempt to insure that all parties perceive they are being dealt with in a fair manner.

We believe that dealing effectively with the issues of succession requires the owner-operator to view the process as a financial decision, as much as a personal one. To the extent that a succession mirrors an arm’s length transaction, the owner-manager can begin to satisfy the goals which typically are:

  • A reduction of the investment risk by obtaining some measure of liquidity;

  • The transfer of control to the next generation in proportion with the transfer of monetary risk;

  • Availability of funds for retirement and to provide equalization to other siblings;

  • Satisfaction that the business and its culture will survive and be maintained.

Experience indicates that a corporations best interests are served when control of the business is placed in the hands of one individual; where non-active shareholders are precluded from interfering with the management of the business; and, by developing a shareholders agreement that supports family relationships and asset growth.

The Valuation of Contracting Companies

Generally, businesses are valued based on either the market value of their underlying assets, or on their prospective ability to generate income. For the most part, income based approaches tend to be the predominant method used in going concern valuations.

Given the inherent characteristics of the construction industry (highly cyclical; intensely competitive; ease of entry; use of competitive tendering), the income based approach alone is often not appropriate. Unless a company can demonstrate that it has a highly profitable backlog, or a reasonably secure source of contracting revenue and profit, value will tend to gravitate to the company’s net equity value, adjusted to reflect the current market value of the underlying assets and liabilities. As such, the existence of goodwill is the exception, rather than the rule, for construction companies.

For purposes of succession, understanding the treatment of value under the Income Tax Act is critical. Under the Act, any transfer of ownership among non-arm’s length parties must be on the basis of ‘fair market value’. To assist in this process, business valuation consultants are often retained to determine value for purposes of any sale or transfer. In Canada, business valuations are often conducted by individuals with the designation Chartered Business Valuator, or CBV. Such valuations are referred to as ‘notional’ market valuations, as they are conducted in the absence of an arm’s length negotiated sale.

Choosing Your Exit

For any privately-held business, there are a limited number of options to pursue when the decision to exit the business is made. These are as follows:

  • 1. The Internal Sale

In attempting to achieve the ideals of retirement, owner-managers can choose among the following mechanisms for effecting the transition:

  • Gifting or Sale of shares

A gift or sale of shares is deemed to be a disposition at fair market value, thus creating an immediate tax liability. Generally, privately-held contracting businesses will be ‘qualifying small business corporations’, and will qualify for the lifetime capital gains exemption of up to $500,000. In the event of a sale of shares, tax relief may be available through the use of capital gains reserves. Generally, a gifting of shares is most appropriate where wealth exists outside of the business to satisfy the needs of the retiring shareholder and non-active siblings.

  • Estate Freeze

The basic objective of any estate freeze is to crystallize the current fair market value of the business so that the future growth in the value of these assets will accrue to the next generation of family members. An estate freeze offers the same tax advantages as noted above, but generally provides a greater element of flexibility.

The estate freeze mechanism is most useful where there is limited liquidity available to the successor to fund the purchase of the business. While an estate freeze accomplishes a shift of wealth and allows tax liabilities to be determined in advance, it does not shift risk or allow the owner-manager to achieve full liquidity. As such, the estate freeze must be viewed as a tool of succession planning, not a means to an end.

  • Sale to Employees

With respect to a sale to employees, a transition may occur on the basis of a share sale or through the estate freeze process. Virtually the same set of timing, liquidity and tax considerations apply to an employee sale as in a sale to a family member. However, there are other aspects which one should consider before proceeding down this route; including:

  • Who is to be part of the employee owner group?

  • Do the employees have the skill and financial wherewithal to engineer a purchase?

  • Will the purchase be through future profits or through the employees own capital?

  • Are the employees prepared to provide personal indemnities and assume successor obligations?

It is worth noting that sales to employees has been much more prevalent in the U.S. where tax favourable ESOP (employee share ownership) programs exist. There is no equivalent to this in Canada.

  • 2. The Arm’s Length Sale

The inherent characteristics of the contracting industry discussed earlier ultimately dictate the values observed in actual transactions and in the share prices of publicly traded construction companies.

The so called ‘arm’s length’ market for privately-held contracting companies in Canada is relatively limited. Of the transactions that do occur, there is usually little disclosure of information. With respect to the U.S. situation, our review of transactions in that market indicates that in transactions involving profitable contractors, multiples of between 5 and 7 times cash flow were observed. Stated another way, these same companies generally traded in a range of 1.0 to 1.5 times of the ‘net equity’ or ‘book value’.

One should also consider the investment performance of publicly traded construction company stocks. In a study of the stock prices of publicly traded U.S. construction companies between 1984 and 1994, it was found that these stocks earned an annual return of just over 4%. By comparison, the Dow Jones Industrial Average showed annual returns in excess of 12% during the same period.

In the Canadian marketplace, absent ‘Special Purchaser’ considerations, it has been difficult to achieve values in excess of book value in sales to arm’s length parties, including employees. Illustrative of this was the 1996 purchase by Bird Construction management of a 30% common share interest in the company at a price of book value.

A Succession Planning Scenario

For seasoned owner-managers, the volatility of the contracting industry is an accepted fact of life. As such, appropriate contingencies must be built into the succession plan that will contend with the impact on value this volatility may have.

Consider the following scenario for Dadco Contracting Company:

  • Value for purposes of internal sale: $2 million as at the succession date: January 1, 1995;

  • Dad sells 51% of the common shares to his eldest son, who assumes full operating control of the business. The remaining shares are sold to the non-active sibling;

  • On the succession date, Dad withdraws $1 million from the business by selling assets considered redundant to the contracting operations. As such, they do not impair the companies ability to obtain the requisite banking and bonding facilities;

  • The balance of consideration is taken back via a $1 million promissory note which carries a fixed rate of interest and which is to be redeemed out of earnings over a 5 year period.

All went according to plan until:

  • On January 1, 1997, three senior managers leave the firm. They set up to compete directly with their former employer. In the process, they ‘steal’ away Dadco’s largest clients;

  • By July of 1997, Dadco’s back log has plummeted. Based on the latest financial projections, it is estimated that Dadco will sustain a net operating loss of $250,000 for the year;

  • Both the bank and the bonding companies indicate their concern. Consequently, it is necessary for Dad to return to the company on a ‘temporary’ full time basis.

While the above scenario points to a difficult set of circumstances, Dad did do a few things right:

  1. He passed operational control to one individual. The eldest son has 51% of the common shares and thus his management of the business cant be disrupted by his sibling;

  2. He obtained some liquidity from the business and fully crystallized his maximum life time capital gains exemption while also deferring some of the taxes through the use of capital gains reserves.

Still, there remain some issues that will be problematic:

  • At some point, the inactive brother will wish to liquidate his 49% interest in the business. Minority shareholders generally must recognize from the outset that their investment is relatively illiquid;

  • Dad’s retirement is ‘on hold’ until the business returns to a sound position. Even after his services are no longer necessary, he will still have significant capital at risk in the business. By not retaining any voting control in the business, he will find he is powerless should the controlling shareholder choose not to voluntarily cede control;

  • Because Dad sold 100% of his shares in the business, he will have to recognize the full extent of his capital gain within five years. Although he will not realize his full proceeds, he will nonetheless pay taxes as though the full amount had been received. This situation could have been avoided by using an estate freeze.

Conclusion

The inherent characteristics of the contracting industry make careful, long range planning an absolute essential for preserving and enhancing the value of the family owned business. Given the limited prospects for clean ‘cash’ sales to arm’s length parties, a well executed succession plan is the owner-managers best route to value realization.