M&A and succession planning

Greg: Welcome and good afternoon everyone and welcome to the latest installment of Gowling WLG's M&A series entitled M&A in Uncertain Times. Today's webinar is entitled M&A and Succession Planning. My name is Greg Shannon. I'm a partner in the Calgary Gowling's office practicing in the M&A area and also in the private client service practice group. I'll be your moderator for today's succession planning M&A webinar. Our previous webinars focused on M&A deals where the parties were acting in arms length of each other. On the screen you will see that we started our webinars with the discussion on the disruptive effect of COVID-19. Then on April 21^st we had a webinar, Taking Control in Uncertain Times. April 28^th another COVID-19, Deal Dynamics webinar. May 5^th was Multi-disciplinary M&A. May 12^th was an international M&A update from the UK, EU, Middle East and Asia. We have two upcoming webinars, Spotlight on Private Equity, which should be very interesting, on May 26th and then, finally, on June 2^nd, A Distressed M&A: Preparing for Consolidation, and other issues related thereto. If you missed any of the previous webinars in our series you can log onto the Gowling WLG main website. There's an on demand version section where you can download all past webinars. We encourage you to also enroll for the May 26^th and June 2^nd webinars accordingly. Before we move onto today's session we wanted to highlight a new webinar series launched just last week called Financing in Uncertain Times. In this series we are discussing how companies are accessing capital, whether its for startup business, a mid-cap, or pub-co. We will also discuss equity crowd funding and certain Blockchain developments. If you're interested please go onto our website for full details and please register. Before we get started just want to go over a few housekeeping points. To view the presentation and all speakers please click on speaker view in the upper right hand corner of your screen. For questions throughout the session we would encourage you to use the Q&A button at the bottom of your screen. Towards the end we'll try our very best to answer some of your questions, towards the end, and we ask you to use that Q&A button. The presentation will be recorded and will be posted on our website within a few days afterwards. For those of you who are lawyers this program does count for Continuing Professional Legal Education and Development credits, in applicable jurisdictions, such as Ontario and British Columbia. So check your local CPD requirements of your local law society. Next is our standard legal disclaimer. Today's session will be basically a high level overview. For specific advice please contact your legal counsel or one of the Gowling speakers. As you know the world that we're living in right now is extremely dynamic and it's changing daily. You'll want to look back and partake in the future upcoming webinars. They'll be very informative.

Now, to our esteemed panel. First of all we have Brian Cohen, partner in our Toronto Gowling office and he's co-leader of our private client service team. He's also a recent inductee to the International Fellowship of the American College of Trust and Estate Counsel. Welcome, Brian. Next, we have Garrett Hammel, an M&A and corporate finance associate in our Ottawa office. Welcome, Garrett. Next, we have our fearless leader, Karen Hennessey, she's an M&A partner in our Ottawa office and the leader of our Canadian corporate practice group. Welcome, Karen. And last but not least, David Howell, a partner in our Hamilton office who is involved in a lot of M&A private company transactions and the sales of family businesses. So welcome Gowling's panel of speakers.

Now turning to the agenda for today's session. As you can see we have a pretty full agenda we're going to try to get everything in. Section 5 addressing wealth and estate planning matters we may have to be a little bit quicker on that one, time permitting. But today our panel will look at different issues and we expect that may arise in M&A transactions where the buyer and seller have pre-existing relationships, personal relationships or familial relationships, and the dynamics that are in play amongst them. Our panel will discuss the motivations and objectives to these types of transactions and they will talk about different pre-closing planning items that will be done before any business transition in this manner. We will then provide an overview of the different ways that these types of transactions can be duly structured, followed by a discussion of different deal dynamics including valuations, how to peg the purchase price, how it's structured, types of reps, warranties, covenants and indemnities that we typically see in these type of non-arms length transactions or not third party transactions. We will conclude with some basic wealth and estate planning advice and tips. To help with today's discussion Brian and David will focus their comments on the transition within the family scenario. Karen and Garrett will focus their comments on the sale of businesses to key employees or a management buyout. Of course, as much as possible, we'll want this to be a interactive discussion. We would love for each of you to share your questions with us using the Q&A. Please send them through and we'll do our best to attempt to answer them at the end. This will be a moderated session so we will now take down the slides so that the panelists are more prominent on your screen.

Karen and Garrett, can you please start us off and talk about why business owners may want to sell to a key employee and what are some of the objectives of the parties that may be in these management style, or management buyouts/employee buyouts. Karen.

Karen: Thanks, Greg and welcome everyone. From a management perspective the motivation for this type of sale typically arises from the owner or seller looking to retire or significantly reduce their time spent running the business. So in these situations an owner may look to sell the entire business to an unrelated or unknown third party. However, it's not uncommon when the owner may actually rather give an opportunity for key employees to take part in the future growth of the business. Another objective may be the desire of the selling owner to retain control over the business, as I said because they're looking to slow down, not a full retirement. In a management buyout where the purchase price is not paid in full at closing, the key objective is maintaining that control until the purchase price, or at least a significant portion of it has been paid. Once the owner has made the decision to sell tax becomes a key objective, you know, in minimizing the tax and deferring tax payable out of the sale proceeds. This may include maximizing access to the capital gains exemption which I know we'll talk about in more detail later. As I mentioned, in a management buyout the purchase price is not usually paid in full at the time of closing, so another objective is to defer payment of any taxes until the time that those proceeds are actually received. Garrett, what's your view from the buyer's perspective on a management buyout?

Garrett: Thanks, Karen. From the buyer's perspective one of the common objectives is a desire to be compensated fairly for the hard work that the employee or management has put in to growing the business over the years. Taking an ownership interest in the business allows management to see a more direct financial reward for the work that they've put in, obviously. The management buyout is also an opportunity to invest in themselves. In other words, putting skin in the game for the management. It also presents a less risky form of investment for management given that they're already very familiar and have an intimate knowledge of the business. Another motivating factor for management to move forward with a management buyout is, potentially, the uncertainty that comes with working for a new third party buyer that comes in if the management buyout doesn't occur. A third party buyer may have a much different approach to ownership than the current owner which could result in some material changes to the work environment and the job satisfaction of the key employees. As Karen mentioned, while the ultimate decision is to sell is up to the owners, management can sometimes press the issue of a sale by having a clear understanding of the owner's objectives and motivations, and negotiating from a position of strength in the sense that their absence from the business would create a real issue for other potential buyers. If management thinks that the business is underperforming under current ownership, and they have some ideas for a different strategy to take the business in a different direction that could improve financial results, it may be a good opportunity for management to raise the idea of a management buyout on its own volition. Conversely, management really does need to be ready to change their mindset, from that of employee or management to more of an owner/entrepreneur mindset, in order for this transition to really work. Otherwise it may just be best for them to have a third party buyer come in and they remain as just employees. Again, once the owner has decided to sell, from the management's perspective a primary objective will be structuring the transaction in a way that optimizes cashflow, because there's going to be a need to balance growth and viability of the business going forward on one hand, with their payment obligations to the seller and potentially lenders on the other. Therefore, flexibility in terms of timing of various payment obligations, prepayment rights, etcetera, are often key points in negotiation for management. Lastly, management is also going to want to ensure that they have a clear leader or representative within their group to represent them in negotiations and beyond. As the management by committee approach, more often than not, leads to unwanted results and complications. I guess you could say in other words, there needs to be a clear understanding within the management group itself as to who's going to be captaining the ship, both during the negotiations and in the post-closing phase. Thanks.

Greg:Thanks, Garrett. How about you, Brian and David? What are some of the motivations and objectives in the transfer of the business among family members or Gen 1, Gen 2, Gen 2, Gen 3?

Brian:You're going to find many of the things that the seller, in this case the parents, looking for in a family situation similar to what they'd see in an employee buyout or management buyout, because you will have the former leads of the company taking a step back and maybe the concerns therefore would be the same. But in a family situation where your often looking to do is not to fall into that cliché of going from shirt sleeve to shirt sleeve to three generations. First generation builds. Second generation retains. Third generation loses. That's the world you do not want to fall into. The process may be a little bit different in the family scenario. There may be a gut check that simply occurs at the owner/manager level that the people who built the entity want to enjoy the fruits of their labour, retire, spend more time with the grandchildren and so forth, but at the same time they're not looking to give up all control just yet. They want to show the kids that they still are needed and it'll be a long time before they can see that the kids may be running the business as well as they did during their lifetimes. So there's a little bit of a family dynamic that comes into play there. The other dynamic that's extremely similar to the management situation is where you have many employees, and they're key employees, you can't just bring a child into the ownership scenario and say the company is now yours to run. That will ruffle all the wrong feathers, and you want to be sure that you maintain flow from day 1 to day 2, when the new management team comes in. Obviously beyond the factors of how will the company run, one thing that always is at the back of everyone's mind as a vendor, or just taking a step back, is simply tax, tax and more tax. You're going to hear us refer to the capital gains exemption a few times. There's also tax on split income and timing issues that come into play. What's interesting in this COVID world, you'll have owner/managers that 6 months ago may not have been talking about getting out of the business now say, "You know what? I'm done. Maybe it's time that I pass this off to my kids. I've been away from the business for a few months now and I kind of like this. So let's look at it." That could affect some of the timing. The ideal timing to move into a family scenario handoff could very well be a 2 year scenario, so that you can get multiplication of the capital gains exemption if you have the time to structure properly, and move shares around because for the capital gains exemption to work there has to be a sale of shares. You can't just sell the underlying assets and in many scenarios you need either a 1 year period meeting business assets or 2 year period of holds. So timing becomes very important. So you may need to make sure that you leave enough window that you can have your counsel and the accountants work together to make sure that the tax is minimized over time. The capital gains exemption, as you may or may not be aware, is the sale price that you can receive and not pay tax on in an active business, which qualifies as a qualifying small business corporation, which is a tax term, and is actually $883,000.00 per person. So if you can multiply that you can see that the benefits are quite substantial. The last thing that you have to consider is, something that I see all the time, working the private client sphere I see a lot of planning, tax planning, Wills, trusts and so forth from owner/manager corporation. Unfortunately I also see a lot of litigation. That arises where parents haven't planned ahead as to how the succession will come through and the children are not happy at the end with what mom or dad may have done. Another cliché to look at there is there is not necessarily equal and equal is not necessarily fair. So when you look at which children are going to come in, mom and dad have to consider whether or not they have other assets to equalize the non-business children, and if not, are they going to do something through the sale process to make sure that funds get to the non-business children? Either by way of non-voting shares, promissory notes or otherwise. The last thought to leave you with before I pass it to David as the purchaser or next generation is if there's other stakeholders. Many of these family businesses have siblings in generation 1. What do the other siblings think about your kids coming into the company? Will they get along? Do they want to have that? Is there an early exit possible where you have other family in that situation already? Things to think about as you move forward. With that I think it's a good place to pass it off to David.

David:  Thank you very much, Brian. So the children who are acquiring from their parents will have both tax and non-tax objectives. The non-tax objectives are going to be really quite similar to what you'd find in the management buyout arrangement. Namely, they're going to want to have a lower price and they're going to want to have favourable payment terms. They're also going to want to be in a position where they can maximize their decision authority and control free, to the extent possible of parental oversight. But at the same time they're going to recognize the need and the desirability of having the benefit of ongoing advice and assistance from their parents. Tax objectives are also going to be paramount. The first one would be to ensure that the purchase price can be paid with corporate dollars, which have been taxed to the lower tax rates, rather than personal dollars, personal after tax dollars. Second, if they're paying interest they're going to want to ensure the interest is deductible. Third, this is going to be a real opportunity when they set up this transaction to do some tax and estate planning around future ownership for that second generation. And that tax planning could include, one, share ownership by a spouse. Second, share ownership by a discretionary family trust where the discretionary beneficiaries could be the second generation themselves, their spouses and their children, maybe even their grandchildren. Now why would you do all this? Well, the tax objectives of this planning that the second generation would do would be, I would say three things. First, Brian mentioned, there's been a couple of mentions to the capital gains deduction. If you have more than one shareholder, a spouse, a second generation and potentially children and grandchildren, you may be able to multiply access to this $833,000.00 capital gains deduction, so that on a future sale of the business a multiple of that amount could be available tax free to the family members. Second, by having potentially multiple shareholders you might be able to permit future income splitting. In other words paying out dividends to more than one shareholder in lower tax brackets. Now this can be somewhat problematic especially under the new tax on split income rolls. But the opportunity may be available. And third, is to do some estate planning for the second generation by putting yourself in a situation where you can defer capital gains tax on the death of a second generation. This would typically be done by having the shares, or some of the shares, owned by a family trust with discretionary beneficiaries being the children, being G-3, Gen 3, and even farther down the line. So that could defer capital gains tax on death to be an effective estate planning tool.

Greg:Thank you, David. Before we talk about different deal dynamics in these transactions I thought it would be very helpful to show the audience and illustrate the types of transactions that are typically structured. By way of caution these illustrations are oversimplifications of the actual deal diagrams themselves. But let's put up the typical asset sale first. Again, it's a very simplified chart here. Not traditionally used very much in management buyouts or family transition situations. Next, let's move on to the share sale. Typically buyers would incorporate an acquisition co to buy the shares. This is especially true if the buyer requires bank financing, third party financing. Acquisition co is the buyer, and the borrower as well, after closing it's typical that acquisition co is duly amalgamated with op co, which allows third party debt to be paid with company funds as well as a number of other economies of scale. Another option is the next slide, hybrid asset sale and share sale. A little bit of both here where we have maybe real property assets, or eligible capital property, some other types of assets that are depreciable that may be secondary to the business where they can be hived off into a real estate co, sell those assets outright, have the shares of the business sold to either a trust or to the acquisition co. Now we can move on to the next slide which may be a little bit more typical. This is a hybrid with an estate freeze and a redemption. They may also be sale within a freeze. Click through to the next slide. We see this structure more often where you've got an estate freeze using the family trust and the children are beneficiaries of the trust as well as the parents. You've got real estate in the real estate co. You've got the operating business in the op co and you've got maybe retained earnings, investment portfolio accounts and other redundant assets in investment co, to help purify op co for maybe future transitions and future sales. That's more of the typical style. Moving on, next slide is just showing use of a trust to own assets directly. Again, multiplying the capital gains exemption, that $883,000.00 times 5 scenario.

We'll move on now to discuss different deal dynamics including issues relating to valuations, purchase price, typical deal terms like reps, warranties, indemnities, covenants. Turning first to valuations. Garrett, what are the considerations that go into a valuation of a business that is to be transferred to key employees or a management buyout?

Garrett: Well, perhaps even more so than in typical M&A transactions, the issue of valuation is one of the most important things to get right. When it comes to valuation in the management buyout the key is fairness, or the perception of fairness at least. So from the owner's perspective of a seller they're going to want to feel like they're being treated fairly compensated for the considerable time and effort that they put into building the business. Conversely, on the other side, management's going to be looking to ensure that they're not overpaying for the business. Which can be a critical error on management's side. This is particularly true in the context of a leverage management buyout where management leverages third party financing to finance part of the purchase price. Overpaying for the business, in those situations, can often put the business in financial distress after the completion of the buyout, which is a situation that isn't in the best interests of either sides. Given that the two sides will usually be arms length in the management buyout, there not going to be related for income tax purposes, the need for a formal business valuation is less important from a tax perspective. However, obtaining such a formal business valuation can still be a useful tool to promote the fairness and the transparency of the transaction. To the extent that the owner/seller retains a significant role in the in business going forward, the owner may still want to continue receiving benefit of the future growth, commensurate with their reduced but still significant involvement in the business. In those types of situations the parties would need to be careful in consideration to ensure that the valuation and deal structure still reflects this dynamic. David, is there anything different on the family side? David, you want to unmute.

David:  Thank you. Actually, in the family side a valuation is usually one of the first steps that happens when the family starts talking about a transition of a next generation. They want to know what kind of number they're looking at. What are they going to have to do deal with? There's important non-tax reasons and there's important tax reasons. The non-tax reasons, first of all from the parent's perspective, the deal needs to be fair to them. This buyout maybe their retirement income and an important part of their security for their retirement. For the rest of the family too. You need to ensure fairness for them and the perception of fairness to the other children who may not be involved in the future growth of the business. They may not be future shareholders. They may not think it's fair if the purchasing shareholder gets too good of a deal. Also, payments made from the business, from the purchasing shareholders to the parents, may form part of the estate of the parents that may be able to benefit all the children. The entire family. So the price needs to be fair and a valuation provides evidence of fairness. Tax is also important. You need a valuation for tax purposes. The CRA is the third party of this transaction. They've got a financial stake. If the shares are sold to the parents, under the Tax Act the parents will be deemed to have received fair value, regardless of the purchase price stated in the deal. If the fair market value isn't paid double tax can result as the parents will be taxed full on the fair market amount that's finally determined by the CRA. But the children who are purchasing will not receive an increase in the cost base of their shares. Meaning they will pay more tax on any future disposition. It's been mentioned before that often these deals are set up as a freeze where the parent's common shares are converted into preferred shares that have been redeemed out over a period of time. It's important that if the freeze value is below the fair market value of the common shares, and it was pretty simple to think this is intended to be a gift, that could lead to the next generation because they got too good of a deal, then the parents would be taxed on a capital gain equal to the gift amount. So you want to avoid that risk. That capital gain risk. So what do you do? There's two steps. First of all, you obtain a proper valuation and then second, typically in the family context, there's a price adjustment clause included in the deal that would adjust the price to fair market value if the CRA successfully challenges the valuation amount. I'll also mention that if a minority interest is being sold it may be appropriate, at least from a tax perspective, to include a minority discount. Back to you, Greg.

Greg:Thank you, David. Brian, with the context of the types of transactions on those slides that we put forward, keeping those structures in mind, what do you see as the ideal structure for transition of a family business?

Brian:It's very rare that you'll see a sale of the shares such as you've shown in I believe the first three of those slides. What you're more often going to see is probably that more complicated structure. Where you had the trust and the hold co and op co in place. You may not have real estate and other entities underneath, but it depends on the nature of the business obviously, as to what they'll be. Usually, as David just went through, you would have a freeze and the parents would have some form of preference shares, after those freeze, the freeze was completed. What would occur there is the parents would no longer share in the future growth directly through their shareholdings, but they would likely keep voting control through another class of shares, so that they can keep the company running the way the want to see it go. Given that, they have the bulk of the equity. Gradually that would change. There are a number of ways that that could happen. You can redeem the parent's shares during their lifetime. Future growth can go into a family trust as well and the shares can be transferred and the voting control can be transferred slowly over time, if that is desired. If you do change the control of the company over time, one thing you must be very careful of while looking forward is, where you have a change of control of the company that can have adverse tax consequences. So before you change the controlling shareholders you should be speaking to your counsel or your accountants and so forth. The other thing you'll usually see is a trust in play. Trusts are a very useful tool. It allows you to put off the time that you decide who gets the equity and sometimes the voting control of the company. It allows you to do it with generations. Deal with generation 2, potentially generation 3. One question that's often asked at the frontend is who actually gets to be a beneficiary of that trust? Are the cousins, perhaps of the initial generation, are they allowed to beneficiaries that they can get back into the business? Or once you're out you're out. So if your parent's were a sibling, but G-1 as the parents and they have three children who are G-2, and only one of the children of G-2 is involved in the business, does that mean the children of the other siblings are therefore out of the business forever? Is there a mechanism to get them back in? Somethings like that can be contemplated at the front end. It's rare but it can be dealt with. The other problem that you see with that structure is unfortunate but it what it gets down to is really control of your own destiny. At a certain point G-2 is going to be running the entity and they will hopefully have built it up into something bigger than G-1 left them with. If G-1 retains too much control there can be some unfriendly feelings. You don't want that. The other problem that arises is G-1 often undertakes these transactions for the purpose of stepping away. Hopefully in retiring and enjoying the fruits of their labour, and if they want to get the cash out but generation 2 is saying, "I need that to develop the business in new and great ways." you could have some dynamics that could be difficult to work with and the easiest way to deal with that is at the front end, and you negotiate what the rules for the buyouts and payouts are, so that everyone knows the rules of the road going forward. I'm sure it's a little bit different in the management buyout but maybe, Karen, you can add some thought to that.

Karen: Sure. Thanks, Brian. It's not that different to be honest. I would agree, most of the slides that Greg showed, those are typical M&A transaction structures. A straight asset sale, a straight share sale. Even the first hybrid of an asset and a share sale are more typically used in a straight M&A deal and particularly when the owner is getting paid the majority of their purchase price up front. We would typically see in a management buyout that same hybrid situation that you were talking about where you have the freeze and the redemption. That type of structure allows the owner to get some proceeds up front. Often what we might see is the seller getting enough proceeds that they're using at their capital gains exemption room, at the outset. Then we might do the estate freeze which will be used to crystalize the gain on the unpaid value. The preferred shares and receipt on the freeze can be redeemed over time and those preferred shares also, typically, are voting which means the seller also gets to retain some control. As those shares are redeemed that's when tax is payable. So it meets that objective we talked about early on of deferring tax. Finally, often what we'll see in a management buyout is following the freeze we'll issue new common growth shares, of course to the buyer because that's how they'll be able to accumulate future growth, and allows the buyer to start building equity which then incents the buyer to build the company. However, in a management buyout we typically often see if the seller's going to retain fairly significant operational role, we may also issue new common shares to the seller, or to a family trust or spouse our holding company of the seller, to implement some estate planning features that you've already talked about. Issuing new common shares to the seller, which may be in a lower proportion than it is to the buyer, also incents the seller to continue working towards future growth of the business because the seller will then continue to reap the benefits of that, and also to prevent any seller remorse that they might have sold the business at a price that's too low.

Greg:Okay, thanks, Karen. So the parties have agreed on a value of a business, or perhaps there's even some difference in opinion, Karen, you can now please talk about how the purchase price can be structured based on the valuation given, or any disagreement or uncertainties about the value.

Karen: Sure. Thanks, Greg. Structuring the purchase price itself is actually one of the ways that business owners, and their advisors, can really flex their creativity as there's countless different ways you can structure a purchase price in any M&A transaction. In a management buyout I would suggest probably, even a family one, those options are even expanded. So the simplest structure in an M&A deal, of course, is that the buyer has to pay an immediate fixed sum in cash at the time of closing. However, that's rarely, if ever, seen and that's because there's always assumptions on which the fixed price is set. For example, there could be an assumption of a certain working capital amount existing at closing. Or certain amounts of debt existing at closing. This means, that at minimum the purchase price will be subject to some kind of post-closing adjustment, so that those assumptions can be verified once the financial statements for the period up to the closing date are completed. But there also may be disagreement on the value because of unknown factors. For example, a seller may think the purchase price should be higher because they're aware of a large pipeline of work, and this pipeline of work is there because of the seller's elbow grease and hard work they put into it. So they want to see credit for that. On the other hand a buyer may say, "I'm not as optimistic about that pipeline and I definitely don't want to prepay for work that may come in." So, we usually resolve that type of disagreement by using an earnout mechanism. This basically happens where the parties agree the purchase price will be increased, or decreased in a reverse earnout situation, based on whether the company meets certain thresholds after closing. Those thresholds can be based on any number of financial criteria including based on gross revenue, net profits or EBITDA. It's also quite common to structure a purchase price using a combination of these methods. For example, there could be a fixed price subject to a working capital adjustment, and also an earnout based on the company meeting certain revenue thresholds over a period of years after closing. So once you structure the purchase price then the next question that you have to consider is how you pay the purchase price. If the purchase price is fixed it can be paid up front. It can be paid part up front and part over time, what we typically call a VTB, or vendor take back. Or the entire purchase price is often sometimes deferred and paid over time. You may also see a deal different holdbacks which may be amounts paid at closing but they're instead of being paid to the seller, they're paid to an escrow agent. The escrow agent will hold those funds to make sure they're available in case of any required adjustments to the purchase price. Which could be those working capital adjustments that we talked about or indemnity adjustments that we'll get to in a few minutes. In a management buyout situation, the purchase price is rarely, if ever, paid up front. The seller, of course, wants as much of it paid up front to reduce the seller's risk but there's almost always some element of it being paid over time. Earnouts are less used in management buyout situations, especially in a circumstance where the owner has issued those new common shares that I mentioned a few minutes ago, because by issuing those new common shares now that the seller benefit from the future growth by owning those shares. However, as we've talked about in some of the other webinars earlier in our series, we are anticipating there may be more earnouts in typical M&A transactions because of COVID-19. So only time will tell now whether that trend will find its way also into management buyout transactions.

Greg:Thank you, Karen. Brian, what about in the family transition context? Some comments there.

Brian:So this is a little bit simpler as to the purchasers because typically the family will not be receiving the purchase price up front or within a very short period of time. If that's the situation it's probably a sale to a kid, or a family member, which would be very similar to what Karen just said. Rather, what usually happens is, the parent's shares will be redeemed over time and you can control those redemptions, and they'll receive funds out of the company at the time of the redemption. But more often than not what we'll see is there's a large chunk of the purchase price, shall we say, which is the frozen shares remaining at death. You have to figure out, at that point in time, how to get the funds out to benefit the estate and all of the children in the company, and otherwise. The most common one there that you'll see is the use of insurance. If you're using insurance it's very important that the right policy is in the right place, and that there's a discussion before that as to what happens with the capital dividend being created from the insurance, because as people may know, you can get out insurance proceeds, to an extent, tax free from the company using your capital dividend account. That being said, if only child is in the control of the business and they're only the child with common shares, they may want that capital dividend tax free kept in the company for their own use in the future, so it should be negotiated at the front end that the insurance proceeds come out of the company using the capital dividend account, and that money is used to pay tax and make gifts to the other children who may or may not be involved in the company. It's really, on the purchase side for the family succession plan, it's planning ahead as to how you get the liquidity out in the long term, 120 years from now when mom and dad are the original owner/managers are gone. That's really I would probably have to say on that point.

Greg:Okay. So usually no earnouts or holdbacks on that family end. But one other planning tip is the insurance, is a big ticket item here. More often than not the insurance is not dealt with properly at closing, or it's not followed up on, and the unanimous shareholder agreements don't have the insurance in play for the emergency situation when you're going to need the capital dividend account to be funded on a death. Follow through on the insurance matter. It's a very important matter because it's money that you don't have to go finance and get out of the bank if you have the policy in play. We see more often than not that these policies are not followed up on and/or they're not put together properly or they're not enough money. So therefore the buyers are going to have to go to the bank and refinance. So at the outset everybody mentioned taxes, taxes, taxes and it's a matter of how do we look at reducing this or deferring this, with respect to the proceeds. So Brian, what are the strategies for minimizing and/or deferring the amount of taxes payable on the transaction? On a sale of a business.

Brian:So on the family side, as I noted earlier on, if you're looking to multiply the capital gains exemption from the start then you need to give yourself enough time to take care of that. So you'll usually need at least a 2 year window if you want to access that deduction. And it's substantial, as I've noted I think three times now, $883,000.00 per potential shareholder. Keep in mind that in many cases that is not savings that you'll see immediately. It's more so savings that, in the case of the original owner/manager, will be not needed to be recognized on death. It is a deduction. It's not in cash you're getting to your hands. Or on an ultimate sale it's funds you won't have to pay tax on. This is something that you're looking to save taxes. It does not work on redemptions because redemptions turn into deemed dividends. So just to be clear on that. Another thing to keep in mind, going back to your insurance and making sure you defer the tax properly, make sure you have enough insurance. One thing to keep in mind, there are a lot of government programs going on right now that are providing a lot of Canadians with much needed liquidity. However, at some point we will have to pay for that liquidity, and that will probably be made up in the form of tax rate changes at some point. So when you buy insurance to satisfy tax liabilities be sure to revisit that down the line. That's not a deferral. That's making sure you have enough to pay for it. The other things are very simple that you can look at. When you're doing redemptions, and getting the original owner/manager bought out of the entity, you stagger those redemptions to keep them in the right graduated tax rate so they don't have everything triggered all at once at a top rate. That's rather straightforward. Similarly you can use trusts to flow income out to beneficiaries, if they qualify, but you have to watch out for the new tax on split income rules which can come back to bite you if the beneficiaries aren't working there or the company doesn't otherwise qualify to get a better dividend rate. Finally, two things that I would tell you to keep in mind is, one, watch out for US owners because you can do great planning on the Canadian side but if you have an American in the mix, and they own shares of a private Canadian company, all sorts of rules can trip you up. There's passive foreign investment rules. There's controlled foreign corporation rules. There's estate tax. Trust rules. Their rules are very different from ours and as soon as you have an American you need to make sure that your planning matches on both sides of the border. People often say I don't have an American. My children aren't American. One of them may have married an American, and they have kids, now but I don't have any Americans because that child has never lived in the US. Well, that's not necessarily true. If one of the two parents was American and they meet certain thresholds, that grandchild in G-3, could be American and you could have some troubles. So you have to watch out for those things. The final thing to keep in mind when you're tax planning, and it's been mentioned a number of times, the shareholder agreements. Get those in place. Set out the rules of the road as to what type of money flows out when. When do you use the capital dividend account? Who does it belong to? How should it be pulled out and who controls the company to make those determinations? That will drive a lot of your tax determinations down the line. The last thing I would talk about is your seeing the phrase capital gains trips floating around. Those are extremely technical tax transactions where you are converting what would otherwise be a dividend into a capital gain. If you're looking at those things on these types of transactions those definitely need a lot of time to plan with your tax advisors, legal and accounting. They are plans that work very well but you should contact your professionals before you do any of those things.

Karen: I just want to add one comment to that, Brian, or maybe two comments. First is I think you can't underestimate, for anybody watching this webinar, one thing you should take out of this is the tax advice is crucial and your tax advisors are going to be your best friend in structuring theses types of transactions to make sure you don't fall into any of those traps. People keep as much money in their own pockets as possible. One very simple example that I thought I would give is on the deferral of tax issue. In an M&A transaction typically a management buyout, as I said, the purchase price isn't always paid up front. Typically we do that freeze and redemption of future proceeds. Of course you could just do a promissory note for those proceeds that aren't paid and sell all the shares, however, from a tax perspective one thing to note is if you receive a promissory note as payment, the seller is going to pay tax on the amount of that note at the closing date even though it hasn't actually received the cash to pay those taxes. If you use the freeze mechanism instead, and convert the unpaid purchase price into fixed value shares, the seller will only pay the tax on the proceeds when they're actually received. These types of structuring issues should always be discussed to make sure you're picking the right structure for your circumstances and deal.

Greg:Great. Thanks, Karen, and just to comment when Brian earlier mentioned if there's an American in the mix. It doesn't necessarily have to be an American in the mix. It could be a Canadian resident who's deemed to be a US resident for US tax purposes to be in the mix. You got to be careful on that. Moving on. Garrett, in these types of transactions we are not dealing with buyers who are independently wealthy or have access to significant credit, so how do you pay the purchase price on those types of transactions when you've got the employees, or the management, and they're not fully flush?

Garrett: Right. Thanks, Greg. That is a good observation. So when it comes to financing the purchase price in the context of a management buyout there's generally three primary sources of funds the buyer can draw from. The first being the buyer's own resources so savings so they're putting their own equity into the deal. The second being the future earnings of the business and the third being some kind of third party financing, whether it be from a bank or some other lending institution. Depending on the size of the purchase price it can be one or more often than not it's a combination of these three sources of funding. From the perspective of the buyer they're going to want to finance as much as the purchase price as possible through the future earnings of the business. As this is going to allow them to maximize their return on investment. Example of how this would work is management would use excess proceeds from the future operations of the business to redeem preferred shares from the owner/seller or paydown principal under a vendor takeback note. From the perspective of the owner or management or the seller, or even the banker or lender if there's one in place, they're going to want management to have some, again, some kind of skin in the game. So they're going to want them to put a sufficient amount of their own equity into the deal so that their interests are aligned as the business continues to grow into the future. But as you've mentioned, often times the buyers aren't going to have enough of their own resources to finance the up front closing payment for these transactions. In those situations buyers are typically going to look for third party financing from a bank or another lending institution to close this gap. Equally, the buyers may not have assets that are sufficient or acceptable enough to the bank to serve as collateral for this long. As such the bank is often going to require the business itself to provide security for the loan. This can create results and duplications of security, in the sense that if you're giving the owner a vendor take back note, often times they're going to ask for security for those obligations against the corporation's assets as well. So when you bring in third party financing, in connection with a third party loan as well, to finance a purchase price the owner is often going to have to subordinate their interests to the bank, provided that in the ordinary course the bank is still going to allow the usual payments under the vendor take back note, provided that the business is not in default of the obligations to the lender. David, how does this compare to the family context?

David:  Pretty similar in a lot of ways. In the family context it's really unlikely that the children will be asked to put in their personal money. They may not have any personal money. The golden goose is the company. So the purchase price is generally paid out of, first of all there may be some redundant assets in the company. There may be a big cash post they built up over the last few years. So that might be a nice source of a down payment. But the real source of payment is going to be from future earnings from the business. As has been mentioned a couple of times, that money will generally flow out of the company and up to the parents through redemption of their shares, directly or through a holding company. We've talked about before, we'll talk about again in a couple of minutes. Now, if the money's coming from the company you have to think about the bank. So you have to make sure that any distributions don't put you offside on the covenants to the bank. In some cases bank consent may be needed. But the funding, in the family context, is generally the company itself and the future prosperity, hopefully, of the company and its ability to pay out the parents. Greg.

Greg:Karen, Garrett and David just told us that the buyer doesn't have any money or doesn't have a lot of money, how is the seller protected with respect to any unpaid portion of the purchase price moving forward? What mechanisms can they rely on?

Karen: Thanks, Greg. That's definitely a concern and a conversation that I've had with many clients. As Garrett mentioned there's some risk because the bank, or other lender, is going to have to lend the money and take security over the company's assets. In addition to the things that Garrett raised, I actually had a deal recently where the seller actually had to guarantee the buyer's loan from the bank in order to make the deal go through. So this risk is another reason why I often suggest to clients that they should get new growth shares after that freeze, or after that initial closing, because if the seller's going to take on that additional risk of even getting paid that first purchase price you might as well benefit from the future success. Typical security you would take is security over assets of the corporation. You might take a share pledge from the buyer. But as Garrett mentioned those are both going to be subordinate to your bank or third party lender. In addition to having control by voting shares, new growth shares, so you get to back financially you're going to take voting shares to make sure that you continue to have control over the company, and therefore you have some ability to direct the company to make sure it can pay those loans. I would also advise the seller to get a personal guarantee from the buyer. Potentially even a security interest over the buyer's personal assets, if they have any. Overall I tell clients the right amount of security is going to depend on how that purchase price is structured. What the relationship is between the parties and what assets the buyer might have outside of business.

David:  In the family context you're going to see there's a lot of duplication between what you have in a family context and what you're going to have in an arms length relationship. But let me just go through a couple of things that I've seen in the family context. The first method to get some security for the parents would be to have the parent shares, those redeemable shares we've talked about, held by a holding company. If it's structured properly you may be able to redeem all those shares up front. So you've got the full payment flowing up to the holding company immediately. You want to make sure it's tax deferred so you're not triggering all the tax and then those proceeds could then be loaned back to the operating company and secured. So you'd have a promissory note. You may or may not have interest and you could have security against corporate assets. Obviously it would have to rank behind the bank. Obviously you'd need bank consent. But you'd be in the parents in the situation there where they have security agreement which would have covenants, consent requirements and so on, that you might see in an arms length type of relationship so that funds could be secured in that fashion. In the absence of the loan the parents remain shareholders. So as shareholders they're not creditors. It's difficult to provide security for the value of those shares absence personal guarantees from children. So what do you do to provide some security for the parents as shareholders? Well again, as Karen mentioned, one possibility is you give them a class of voting shares that would have low value, and it might give them voting control over the company so they have some voting control. Second, this has been mentioned before a number of times and you'll hear it again, shareholders agreement. Shareholders agreement between parents and the children taking over the business. The shareholders agreement could do many things but one thing it could do is give the parents representation on the board of directors. It could have majority votes. It could have a minority participation. So they'd be on the board of directors. Second, you'll often see in shareholders agreements there'll be a shopping list of important decisions that would require shareholder consent, including consent of the parents. So they have ongoing control and oversight through the voting shares and through a shareholders agreement. Greg.

Greg:Thanks, David. So that's very important to have those threshold super voting decisions and threshold items clearly enunciated in the shareholders agreement. Let's talk now about other deal terms that are common in traditional M&A deals such as reps, warranties, indemnities, covenants in the family scenario here. So, Garrett, can you describe the purpose of these terms and what they may look like in these types of transactions?

Garrett: Sure, Greg. In a typical M&A transaction the buyer's going to want the seller to provide comprehensive reps and warranties about the business to ensure that they're fully informed about what they're buying. So an exercise of full disclosure. If it turns out any of those reps and warranties are inaccurate the buyer would then have recourse against the seller to recover any loss resulting therefrom. In the context of a management buyout, the scope of these reps and warranties is often a lot more limited, because management already has a very intimate and working knowledge of the business. So one of the benefits of selling to management is actually the due diligence process can actually be a lot more condensed and performed a lot quicker than if there was a third party buyer. Likewise, while the scope of the reps and warranties may be more limited, the buyer is still going to want to see the seller, or the owner, provide certain fundamental reps and warranties. Such as title to the shares and typically with respect to tax issues. Brian, what do you see for reps and warranties on the family deals?

Brian:They are a lot smaller than what you see in the management buyouts. They're nominal in most scenarios and what occurs in most scenarios is actually just, in the section 85 documents and related freeze documents, you may have some basic corporate reps and warranties, but that's really about it.

Garrett: Good. Okay. Then likewise, when you have reps and warranties it often informs the scope of the indemnities as well. In a management buyout context, you're going to also have limited indemnifications from the seller to go along with the limited reps and warranties. But, again, you're going to want to cover off fundamental issues particularly with respect to tax matters. Again, I assume this is the same for family deals, Brian?

Brian:It is the same in family but the reality is, in a family situation if you have to call in an indemnity, that gets very ugly very fast. So usually you'll try to work it out without using the indemnity which would be a court process if it went South.

Greg:Okay. So moving on here. We're running a little bit short on time so we're going to punch through here. So we've discussed a few times now how the seller in these transactions, whether it's a family transition or transition to an employee, remains significantly involved in the business. Brian, what role does the seller typically play in the business post-closing?

Brian:So in the family scenario, what you really have is the owner/manager, and usually the person who built the business being that individual, and they're probably going to be still coming into the office and for a substantial amount of time at the front end. For many reasons. They key being to make sure the business is properly handed off to the next generation and that the business continues. One thing that's very hard to transfer is goodwill. That's what the owner/managers often going to work on the hardest, at getting the next generation to develop so that these huge clients and the key clients stay with the company, and don't get lost when the original contact leaves but rather the next generation builds those even further with the help of the original generation. The only other pieces that you'd typically watch is as people get older they're very concerned about maintaining their health plans and so forth so you want to build that in as well. But the decision making control shifts over time as I mentioned earlier.

Greg:Great. Karen, anything to add?

Karen: No. I think those are exactly the same in the management buyout situation. Thanks, Brian.

Greg:Okay. So if the seller remains involved in the business, and continues to hold shares, it is critical that a shareholder agreement be put in place. We've heard that over and over. So, Garrett, maybe just go in a little bit deeper and say why it's critically important.

Garrett: Right. I'm just going to touch on this at a high level. The shareholders agreement is important because it's going to set out the relationship between the owner or the seller on one hand, and the new management buyer on the other, in terms of their respective investments in the business post-closing. It's just there to cover a number of critical aspects of the relationship such as who's going to be on the board, or rather who has rights to appoint the board members, how decisions are going to be made going forward. Typically you're going to see a drag along provisions in the event that the business is sold to a third party sometime down the road. And what happens in the event of death or disability. It's also important to note that we're talking about shareholder agreements being important in the context of the seller or owner staying on. The shareholders agreement is also a really critical document to have in place, even if the management buyout is a complete buyout, in the sense that the management is going to have that document to govern their relationship going forward as well.

Greg:David, anything to add?

David:  On the same points I want to make just three small points. These are the buy/sell provisions that would apply on death of the parents or the children. On the death of the parents, as I think Brian mentioned before, there's usually an obligation to redeem their remaining shares often fund with corporate life insurance. So this is very important because it ends the parents connection and provides funding to the parents estate which benefits the entire family. That's a very important piece. Second, often you'll find buy/sell if the child purchasing dies prematurely. Their shares can be bought back which provides funding to their estate and then the ownership would effectively go back to the parents. Again, corporate insurance could be used for that purpose. I guess the final point is this, sometimes there's more than one sibling or child who's taking over ownership, and so in those circumstances I often find the shareholders agreement is going to have two stages. The first stage is going to be the rules that apply while the parents are alive, maybe with decision making control for them, second, when they die their shares are redeemed. Now you've got an agreement among the siblings, and so there needs to be a new set of rules dealing with decision making among the surviving siblings, and buy/sell as between them if they don't get along or if one of them dies, retires or becomes disabled. Greg.

Greg:Okay. So we are running out of time here and the next bullet point on the agenda dealing with wealth and estate and succession planning items. We're going to leave those for the on demand PowerPoint that you can download the slides on those matters and we're going to now move to the question and answer period as it's 12:02 and we've got about 10 minutes max to go through questions. We've got a question here and I'm going to maybe direct it Brian. In trending transactions where much of the purpose price is paid in the future do you normally see voting rights deferred until proceeds are paid, ie: the shares are in escrow or some other mechanism until proceeds are paid and then votes are allowed to be cast.

Brian:In the family context the original owner/manager will almost always maintain control going forward. You'll see them either having voting control shares just by themselves, or you'll often see them not only that but they'll double up, and also if there's a share trust holding the new common shares there'll be a controlling trustee in that trust somehow. So there's always a level of control at the shareholder level, which gives them the ability to appoint the directors, which gives them some comfort as to how their preference shares are going to be dealt with. In the key employee or other buyout scenario, there'll be control ... perhaps it's better if Karen speaks to that because I think she was speaking to a little bit earlier to make that clear.

Karen: Yeah. The only thing I'll add to that and I agree. I think in the management buyout situation, whether or not the person keeps voting control will depend a bit on the deal dynamics and how much involvement the seller continues to have. One point I wanted to make that we didn't talk about though, is there's other ways that you can still exert control over the business without owning shares and one of those is we may, in the deal agreement or in the terms under which there's a promissory note as we're having, or in a shareholder agreement, if there's pref shares, is control just still over decision making. Even if you don't have voting control perhaps all you're saying is you can't take on debt without my consent. Or there may be some covenants that you put into place, even if you don't actually maintain enough voting or operation decisions, you may still get a contractual veto or a contractual power over certain fundamental decisions of the business.

Greg:Thank you, Brian and Karen. I don't see any other questions popping up on the Q&A right now. I just wanted to make one little side note on the wealth and estate succession planning team members slide that you'll see later on. It's very important that the CPA's, the lawyers, the life insurance portfolio managers, external advisors to the board, family advisors, business coaches consultants, real estate advisors if there's major real estate involved in the family business, that these members work as a team. Meet regularly, have a regular agenda, have minutes and follow up and make sure that, thanks Bob, and make sure that the team is regularly evaluated and that everybody's in sync. Because if people are not in sync on this it will be a hodgepodge for the estate planning to be successful and there'll be gaps. Those gaps could cost lots of money to the sellers in these transactions, and/or to the buyers, so we highly recommend that the planning team members meet regularly, self-evaluate the team as well and work with the family and/or the second gen or the employees or the management team, post-closing. So those are my final comments. Karen, do you have anything to add?

Karen: I don't. I just see there's one other question that I'm going to address only because I think it's a good segue to next week. Somebody asked us if there's any different advice of a third party equity funder gets involved such as a private equity investor. The answer to that, very simply, is yes. Next week we are actually having an entire webinar on those considerations and there'll be a spotlight specifically on issues that arise in private equity back deals. So, stay tuned for that one which will answer all of your questions on private equity transactions.

Greg:Great. I want to thank the Gowling panelists and thank all the attendees for attending today. As I said this would be recorded and placed up on the Gowling website within a few days. So please download the slides from there and please partake in the private equity seminar coming up. So, I guess we'll sign off from Gowlings. Thank you everybody.