Firm for Sale

Robert Walsh works for Provincial Limited, a consulting engineering firm with two offices in Ontario. “We have a succession issue that I wanted to talk about,” Robert explained when he dropped by. “Our company has 52 employees. The founder, John McPhee owns 50% of the company’s shares, and the three members on the senior team, including me, own 21% — 7% each. Then there are 27 other employees of long standing who own the remainder of the shares. They own about 1% each and every year they’re entitled to buy more.”

“Interesting arrangement,” I said.

“It comes out of McPhee’s thinking. He’s over 60 and he’s been working on an exit strategy for the last several years. About 10 years ago, John decided to work at expanding the company. He was good at developing new business and also successful at buying and some small firms.”

“That’s how you met him, isn’t it?”

“Yes. I was in a small partnership. We merged with Provincial and I joined the senior team. Five years ago, we decided to let some of the younger guys participate in ownership. John had hoped that his own partners would buy him out, but it’s slowly become clear that’s not going to happen. The firm has grown. It’s now worth about $3.5 million. John owns half, and the employees really can’t afford to buy the business.”

“How do you know the business is worth $3.5 million?” I asked.

“John has received an offer for his shares from Gigantic Inc., a public company based in B.C. They’ve offered to buy the whole company for $3.5 million — or something less than 100% of the shares for a pro-rated amount. But their offer requires that John gets some people to join him in the sale. He needs to put together a sale package of at least 60%.”

“How do you feel about Gigantic?” I asked.

“We’ve had dealings with them for several years,” Robert replied. “The management is good. The price is fair. It’s an attractive offer, but . . .”

“But?”

“But we’ve run Provincial the way we want. None of us wants to give up what we have,” Robert explained.

“The advantages of the sale could be significant,” I said. “Your shareholders could get a capital gains exemption on the sale. Your investment in Provincial shares would become liquid, which they’re not now. Is Gigantic’s offer an all cash deal or are there shares involved?”

“It’s half cash and half shares. I understand that we won’t pay tax on the exchange of our Provincial shares for Gigantic shares. So, there’s a tax deferral involved. We’d normally be worried about taking someone else’s shares in exchange for our own, but we all feel Gigantic is well run and honest.”

“It sounds like you’ve accepted the idea of the deal,” I said. “Which makes me wonder what you want to talk about today.”

“Once we announce the deal to our employees, it’s pretty well locked in,” said Robert. “I understand that John needs to get money from the business and we have to treat him decently. At the same time there’s not much enthusiasm for the deal among the senior team. I was hoping you might have an idea for a financing arrangement where the employees take over the company.”

“I thought you said an internal buy-out wasn’t likely.”

“Now that we’re facing the risk of losing control of the company, things may be different.”

“Let’s look at your numbers,” I said. “Provincial has $5 million per year in sales. You make 20% of that in profit before tax — about $1 million pre-tax income. Traditionally you’ve paid out bonuses totaling $600,000 to your employee-shareholders. That’s reduced your taxable income to $400,000 per year. After tax, you’ve generally increased retained earnings by about $300,000 per year. So Gigantic is offering to pay you about 12 times earnings. The deal will let John sell his interest in the business for $1.75 million — half in cash and half in Gigantic stock. If the employees came up with, say $900,000, the same cash Gigantic is offering, I wonder if John would sell out to you.”

“But that’s only half the Gigantic offer,” said Robert.

“True. But let’s say he sold only half his shares for the cash and then he could cash in the remainder of his shares over the next few years based on a formula. That would be similar to the Gigantic deal.”

“Where would we get the money?”

“Robert, you have 30 existing shareholders of the business. If everyone were to put up $30,000, you could do this deal. Based on a value of $3.5 million, everyone would need to buy less than 1% of the company. Most people could borrow that much from their bank. Your employees could even purchase their shares using RRSP funds.”

“I didn’t know RRSPs could be used to buy private company shares.”

“Most people invest only in publicly traded shares, but you can invest in private companies, ” I explained. “Look at it this way, the purchase price is about equivalent to a one-and-a-half year bonus. Working something out with John doesn’t seem impossible to me. I suspect that John was hoping a new control group would step up with a proposal, and that never happened.”

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