How to Sell a Business in Ontario
There are two ways to sell a business in Ontario:
(1) Selling the underlying assets of the business; or
(2) Selling the shares of the corporation that owns the assets and operates the business.
Usually it is preferable for the seller to sell their shares as opposed to the assets of the business since the gain from selling shares will be treated as a capital gain for income tax purposes. Perhaps more importantly, the buyer of the shares, subject to the terms of the purchase agreement, will assume all liabilities associated with the company. The essential component of the transaction is a share purchase agreement which will form the basis of negotiations.
The Share Purchase Agreement
Generally the lawyer acting for the buyer drafts the first version of the share purchase agreement. The agreement addresses, among other things, the following key items:
- The purchase price (either fixed or based on some form of calculation such as net book value), which may include “earn-out” provisions;
- The procedure for closing the transaction; interim investigations/due diligence and confidentiality of the negotiations and the information disclosed;
- Representations and warranties about the business;
- Third party contracts approvals or consents; and
- Non-competition clauses.
Representations & Warranties
Usually, one of the most important items in share purchase agreement is the list of representations and warranties the seller is willing to make about the business. There is often a direct relationship between the number and scope of the representations made and the burden or ease with which the buyer conducts their due diligence. That is, the more representations and warranties the seller is willing to make often lends to a less onerous due diligence process.
Common representations and warranties found in share purchase agreements include representations on:
- The accuracy of financial statements (particularly the earnings reports);
- A statement about the authorised, issued and outstanding shares in the corporation, and any options or similar rights that have been granted to acquire shares;
- The existence of employee and independent contractor agreements;
- Current inventory levels;
- The value of accounts receivable;
- The amount of salaries and other perks;
- tax accounts with the relevant tax authorities (CRA etc.);
- All deferred compensation agreements, group life policies, pension plans and service agreements;
- All employee benefit plans, pension commitments etc. being fully funded;
- The status of any existing or anticipated law suits or proceedings;
The existence of representations and warranties can significantly effect the price a prospective purchaser is willing to make. Consider the infamous Tim Ferriss’ comments on his blog:
Several chess moves into price negotiation, after the suitor and I had arrived within 10% of each other, I offered to reduce the asking price 20% in exchange for the elimination of most “reps and warranties.” This would give me a clean break, financially and emotionally, and it would dramatically speed up the sales process. I don’t regret that apparent “concession” and would make the same decision in a heartbeat.
Third Party Consents
Often a business contract with third parties requires the third party’s consent to any change in control. In these cases, the approval of the necessary third parties must be obtained if the corporation is to retain the benefit of the contract. More importantly, if the business is a regulated one, the applicable legislation may also provide that upon a change of control, the approval of the regulatory authority must be obtained.
In a share purchase agreement, the purchaser’s lawyer usually includes a non-competition clause in favour of both the purchaser and the corporation. Without a non-compete there are no guarantees the purchaser is not, in effect, financing the vendor as a new competitor.
Step one of the any business purchase and sale transaction is often obtaining tax advice. We work with tax accountants to ensure your agreement is structured in the most tax efficient way possible.
Generally speaking, a vendor will realize a capital gain on the sale of shares, one-half of which is included in the vendor’s income as a taxable capital gain. If you are selling your shares as an individual some or all of the capital gain may qualify for exemption (i.e., may be non-taxable) under the lifetime cumulative capital gains exemption.
However, where the purchase price is fixed in relation to future earnings of the corporation (i.e. an earn-out provision), the sale proceeds earned in the future from the “earn-out” may be taxed as income as opposed to capital gains unless the agreement is structured according to the CRA’s guidelines on “Shares Sold Subject to an Earnout Agreement”.
The Canada Revenue Agency also sets out some of the key tax considerations for selling your business online here.