Archive for the ‘Protecting your equity’ Category

The formula is simple: Know your client + know how to make money = add to your net worth! It seems so simple doesn’t it? The businesses that make money on a year-over-year basis should have an amendment to this simple formula: monetizing your net worth.  This is the hard part.

I had a small business owner lament to me that: “I’ve invested about a hundred thousand dollars into this business and all I’ve done is bought myself a job.” How true!

Small business corporation shareholders receive a salary (and a T4 at year end) but I have seen only a couple receive T5s (investment income – specifically dividends).  Why not? Given that the sum of shareholder loans plus shareholder equity represents a large percentage of the total net worth of  shareholders,  why don’t shareholders integrate their payouts? (salary plus dividends).

It’s a good point. If a shareholder’s remuneration was $75K a year (in salary income) and it was changed to $50K in salary and $25K in dividends, the tax bite would be lower. The $25K is NOT earned income and as such would be excluded from contribution room to an RRSP but, seeing that a small business owner considers their business to be their RRSP,… well .. why not investigate the advantages of this remuneration split?

There must be sufficient equity to pay a dividend of course and no bank loan covenants preventing the declaration of dividends.

There must be billions of dollars tied up in the Shareholder Equity section of small business balance sheets across the country. This is the biggest dilemma facing baby boomers who own CCPCs and are trying to retire.

The old maxim holds: “.. use it or lose it.”

 

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The investment in a corporation is comprised of:

  • Retained earnings
  • Shareholder loans

This can be a large dollar figure. Retained earnings acrete when net profits add to the opening year retained earnings balance in the shareholder equity section of the balance sheet. Shareholder equity is reduced  when a business incurs a loss.

An increasing retained earnings will improve business capitalization and make creditors (like your commercial bank) happy. The main issue that I have with retained earnings is that they are locked in a business. They can be paid to shareholders as a dividend but the business must (a) replace the dividends paid out my future earnings and (b) have the cash flow to pay the dividend.

Canadian households have a lot of net worth tied up in the equity in their homes. Many Canadians downsize – move from their home to a condo or apartment – as they age and the kids leave the nest. They monetize the wealth they accumulated over the previous 25-40 years. A small business corporation is a key line item on a personal balance sheet. The value of business equity can be estimated but the main problem remains: How do you monetize the equity in your business?

Releasing retained earnings should be a major focus for a shareholder of a small business corporation. How can I take a combination of salary and dividends to minimize my tax liability? If the business is not in a cash position to pay dividends, what steps should you take to get the business “dividend ready?”

A financial planner has models to restructure your investment portfolio such that preservation of capital and income (from your investments) goes to the forefront after 50.

Why isn’t this done with retained earnings?

 

 

 

 

The risk a small company carries on its balance sheet isn’t too hard to determine. A publicly traded company has its risk measured by a “beta” calculation. A publicly traded company with a beta of 1.5 means that the market price of the company stock will usually fluctuate at 1.5x the market fluctuation. The beta attributed could be the result of observed fluctuations (ie “technical factors”) as well as possibly the volatility of certain sectors to possible interest rate changes.

The “beta” of  a small privately held company is a “fundamental” factor. My own definition of beta is:   the ratio of outsider capital/insider capital where:

  • Outsider capital is: accounts payable and accruals plus statutory remittances plus term loans and mortgages
  • Insider capital is: shareholder loans plus shareholder equity.

This ratio shouldn’t be more than about 1.3:1; $1.30 in outside capital to $1.00 of inside capital. The higher the ratio (ie. the higher the beta) the greater the risks for the business. There are a number of risks that escalate given a high beta:

  • Business risk – the ability of the business to continue or get interest free funding.
  • Interest rate risk – as interest rates rise, credit limits become strictly enforced and banks tighten up on lending
  • Financial risk – the risk that the business may fail.
  • Foreign exchange risk – the risk to the business of currency fluctuations
  • Market specific risk – being a service industry in a one industry community.

It is easy to see that while outside capital may not change too much over a fiscal year, if the company incurs operating losses, the loss reduces the denominator and increases beta.

Beta is a real indicator of conditions that occur regularly in smaller companies. Any business operating “payroll-to-payroll” and stringing out creditors is over-extended and over-levered. A drop in revenue could cause the business to fail.

Many small businesses are severely under-capitalized.  Simply put – beta is at unacceptably high levels. Lenders look at balance sheets for this ratio. You should know what your “beta” is and have a strategy to reduce risks.

How does your business score in the following key metrics?

  1. Has been profitable for the past 5 years?  ( 1 point for each year).
  2. Your business has a budget and has been on budget for the past 3 years? ( 5 points for each year)
  3. If your business is incorporated, does the business have “key man” insurance? (5 points for yes)
  4. If you employ staff, do you appraise their work annually? (5 points for yes and 0 for no)
  5. Do you have an exit strategy from your business or a contingency plan in the event of your death or debilitating injury? ( 5 points for yes and 0 for no).
  6. For corporate small business owners, do you know what your business is worth? ( 5 points for yes and 0 for no).
  7. If you have a will give yourself 5 points. If it has been updated in the past 5 years give yourself an additional 5 points.

The perfect score is 50 points. All shareholders of small businesses should carefully consider their scores in each of the 7 categories.

What is your course of action to correct the scores in any of the questions where your business falls short?