Family Business Articles
Safety Net: How to Protect your own Financial Future
George Vandebeek, Partner
August 2008
Forum Magazine
As a financial advisor, it’s easy to focus so much on helping clients plan their future security that you may neglect to do the same for yourself.
If you have your own practice however, you are likely counting on the value you have accumulated in your business to serve as the foundation for your retirement or other future plans. After all, your firm or book of business accounts for a significant portion of your net worth. When it comes to optimizing that value, it can require several years to plan, implement and reap the reward – which is why you should set up your own financial safety net.
Even if you have no intention of exiting your business for many years, putting a safety net into place today can help you finalize goals and provide direction regarding how to build and protect the value of your firm. Perhaps, for example, you’d like to eventually reduce the amount of time you spend working, but continue to be involved in your business. Or you may wish to maximize your financial returns through a sale and move on to another venture. Possibly, you may wish to preserve the business you have built over decades and pass along your practice to your children.
Every option requires a different strategy – a safety net that reduces risks and also maximizes returns. Moreover, having a safety net in place reassures business partners and family members regarding your future plans. And, it can protect your financial security and that of your family in the event that you can no longer work due to illness, injury, death or other unforeseen circumstances. Finally, having a safety net provides your clients with reassurance regarding your own expertise since you will be able to share with them your personal experiences and suggestions for developing effective safeguards.
Following are some questions and considerations to help you begin the process.
Of course, you have to start with the same questions that you ask your clients: what are your long-term personal financial goals? And what are your goals for your business?
Your personal and business goals need to work together to provide a consistent support system. Where do you visualize your business and yourself in five or 10 or 20 years? Do you want your practice to continue into the distant future? What personal financial returns do you expect? Do you want to retain ownership? Do you want some involvement in the business long into the future? You also need to consider a time horizon. What is your ideal time frame to achieve these goals?
Here are some other considerations as you assemble your safety net.
Determine the current value of your business
If you intend to sell all or a portion of your business at some point, then you need to determine the current value of your firm or book of business. This will serve as a benchmark as you work toward building additional value for a future sale, exit or succession.
The value of professional firms varies widely according to the type of practice – investment, advisory, insurance, etc. While an insurance agent might expect to sell a book of business for two to three times annual commissions for instance, an accounting and advisory practice may yield one to one-and-half times gross revenue. Thus it may be helpful to consult with colleagues in your field who have sold their practices, or know of others who have done so, and are willing to share some insights. As well, while returns can fluctuate widely according to interest rates, demand and other economic influences, you may be able to secure an informal valuation range for your type of practice from your professional body, since some associations track sales and statistics.
Of course a professional valuator will provide a more complete assessment of the value of a practice or book of business. While informal valuations are based on formulas such as multiple of revenues, earnings or book value, they do not take into account as many factors as formal valuations. Valuators can assess a business from a purchaser’s perspective, examining factors such as client relationships, reputation, capital structure, competition, industry trends, etc. Moreover, a professional valuator can also provide important insights regarding the strengths and weaknesses of your business.
Having a valuation completed several years prior to executing a transaction equips you with important advantages. First, if a valuation of your business proves to be in line with what you anticipated, then you know you’re on track to achieve your goals. If, however, the valuation is lower than expected and indicates significant areas of weakness – such as over-reliance on debt, high expenses, or a weak client base -- then you’ll have time to address these issues.
Plan for succession…
Passing along a business legacy to their children is something many financial advisors aspire to do. If this is one of your goals, you’ll need to assess the feasibility of this option. If any of your family members are working in your firm and are interested in succeeding you, do they have the necessary professional qualifications or are they interested in securing these? Would they be capable of running the business without you?
Should you determine that family succession may be a valid option, you will need to develop and execute a plan that defines the role of your successor(s) and establishes a training process and a timeline for the eventual transfer of responsibilities.
It’s also important to keep in mind that if your intention is to pass along rather than sell your practice or book of business to a family member, then you will not be able to take advantage of the $750,000 lifetime capital gains exemption which applies to the sale of shares.
… or prepare the business for sale
This is one of the reasons why selling their business is a common goal of financial advisors. Once you know that you intend to sell the business one day, you also need to consider who may purchase it: partners, employers, family members or an outside party. Each type of potential buyer requires a different strategy in order to optimize sale proceeds and tax results. Also, some of the professions restrict owners and shareholders to those who hold a particular professional designation, therefore this may be a key consideration.
You also have to decide what it is you actually want to sell. For example, do you want to sell all of the business or a portion of it? Some professionals prefer to retain certain key accounts and sell the rest. Is this an option for you? Does your business own real estate and if so, do you plan to sell this or to lease it and generate income?
There’s also the question of selling shares or assets. If your practice is incorporated you may prefer to sell shares in order to access the capital gains exemption. And if your company has a number of shareholders who are family members, each may be eligible for the $750,000 capital gains exemption. Of course, certain professional bodies restrict ownership of company shares to those who hold specified designations, so this is another consideration.
If you operate as a sole proprietorship or partnership, you cannot access the capital gains exemption when you sell the business. You may, however, be able to transfer your unincorporated firm into an incorporated entity prior to a sale in order to facilitate a sale of shares and thereby utilize the exemption.
In some cases, an estate freeze may be advantageous to allow future growth in the value of your business to accrue to shares owned by other family members. A discretionary family trust can provide additional flexibility by enabling you, as a retiring shareholder, to maintain control of the business while its future growth accrues to the next generation.
When it comes to external buyers, however, most prefer to buy assets rather than shares in order to reduce liabilities and to generate tax write-offs. It will be important to structure and position your business to address these issues.
Perhaps the most important aspect of positioning a financial advisory practice for sale is your client base. Most prospective buyers are interested in the revenue potential of an acquisition. Will your clients transfer easily to a new owner? Transferability is generally higher for an insurance firm than it is for an advisory firm, for example, because clients tend to be more loyal to the individual because of the personal nature of the service.
Some firms deal with this issue by structuring a sale as equity earn out. This enables a future seller to bring in a business partner who will eventually purchase the company.
The buyer generally contributes a portion of the total purchase price of the business and makes additional payments over an agreed time period. This provides clients with an opportunity to get to know the future owner and facilitates the gradual transfer of the client base.
The quality of your client base is another important aspect of transferability. Potential purchasers will be looking at the length of time clients have been with your firm. They’ll also want to know the average age of your clients. Ideally, purchasers want a growing base of loyal, long-term clients; therefore you may need to spend a few years building the value of your client base.
In fact, planning ahead a number of years to build the value of your business and structure it appropriately will simplify the sale process and maximize after-tax proceeds. For example, you may need to put into place shareholder, partnership, or trust agreements, and possibly buy-sell insurance to facilitate a smooth sale in the future. You may also want to pay out your capital dividend account (the non-taxable portion of capital gains earned within your corporation) prior to a sale so that it does not transfer to a new owner. And you may want to structure a sale to receive the proceeds over a number of years as dividends in order to minimize annual tax bills.
Build additional sources of future financial income
There are a number of other important components of a safety net that provide valuable protection the earlier they are implemented.
Individual Pension Plans (IPPs) are a good example. This defined benefit registered pension plan allows you to make greater tax-deductible contributions than an RRSP. Prior to retirement, you may also be able to “top it up” by depositing a lump sum.
IPPs work particularly well for individuals who are 45 years of age or older, and earn more than $100,000. You can design your retirement benefits to suit your own needs and, like RRSPs, IPPs can hold a wide range of investments.
Retirement Compensation Arrangements (RCAs) are another option if you will be in a lower tax bracket when you retire or if you plan to leave the country and become a non-resident. RCAs are also defined benefit pension plans to which the corporation makes tax-deductible contributions. Benefits are taxable to you only when you receive them in retirement. A tax rate of 50% applies on contributions to the plans and investment income earned in them, which is refunded as benefits are withdrawn. But if you dream of living in the lower tax jurisdiction of the Turks & Caicos, for example, you could pay as little as 15% tax on the income from your RCA.
And of course, insurance is an important component of every safety net. When it comes to building wealth as well as protecting it, universal life insurance policies can be an important consideration. These flexible products enable you to build money for the future. You can make supplemental payments to increase cash value and grow tax-deferred assets. And you can borrow from the policy's accumulated cash value for your own future financial needs.
Of course, your safety net will be as individual as you and your business. But the most effective safety nets are those that are set up early and that integrate financial, tax and legal considerations.
It may sound trite, but it’s always better to be safe than sorry; getting started on your safety net today is as important for you as it is for your clients.
George Vandebeek, MBA, CA, is a partner of BDO Dunwoody LLP (www.bdo.ca), one of Canada’s leading accounting and advisory firms. George, who works in the Markham office, assists entrepreneurs, business leaders and professionals with assurance, accounting and tax support including personal tax planning and estate planning. You can reach George at gvandebeek@bdo.ca or 905 946-2519.
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