Friday, 20 May 2016

The Income Tax Act - When is a Valuation Required?

WARNING:  Dry blog post ahead....

Unless you're an accountant, tax specialist or a business valuator, you should probably stop reading now ;)

The Income Tax Act of Canada requires value to be determined for many different reasons.  The most common reason that value needs to be determined for income tax reasons is for a corporate reorganization (more on that later).

First, below is a laundry list of most instances when the Income Tax Act would require value to be determined.  Some are well known, others less so:

  Section 7 - Employee stock options

  Section 15 - Debts of shareholders and certain persons connected with shareholders

  Sections 38 to 55 - Capital gains & losses

  Section 68 - Purchase price allocation

Equity Value vs. Enterprise Value vs. Company Value... What's the Difference??

There seems to be some confusion some people have regarding the differences between total company value, equity value and enterprise value.  This blog post will attempt to clarify these differences.

The biggest challenge some people have is differentiating between business enterprise value and total company value.  Really simple example... imagine a barbershop business that made $50,000 per year in profit and was valued at $100,000 (not a real valuation but bear with me).  Imagine now that the barbershop business was owned by an Ontario corporation.  Now let's pretend that this Ontario Corporation also had $300,000 in its bank account.  This cash is not used or needed by the barbershop business - it is a redundant asset.   The value of the barbershop business is still only $100,000; however, the total value of the Ontario corporation would be $400,000 ($100,000 for the barbershop business value + $300,000 in redundant cash it has in its account).

Looking at the Graphic below, it illustrates the components of value that are included in Total Company Value, the business Enterprise Value and the Equity Value of a company.

Graphic:


I will attempt to explain, at a high level, the various components of value in the graphic above.

Tip to Valuing a Business - Get the Story Right!

One of the biggest misconceptions out there is that the process of valuing a business is really just a hardcore quantitative exercise that consists of endless excel spreadsheets with complex financial models. Sure, business valuation does have a quantitative slant to it and, yes, there are excel spreadsheets involved. However, the more important point to grasp is that at its heart, a business valuation is all about the future of a business, not its past. And... because the value of a business is about its future then that, therefore, requires a really strong grasp of the 'story' behind the business which is then translated in a quantitative analysis. Too many people, including some professionals, tend to put the cart before the horse and simply jump right into their financial modelling without trying to understand first the story behind the business that should be driving the numbers, not the other way around.

You need to know the story behind the numbers

Buyers of a business care about the future of the business. They care about the future cashflow that the business is expected to generate and they care about the riskiness associated with the future cashflow. As a business valuator, I look to the past results of the business only to the extent that they may help me to understand what the future of the business might look like.