WHEN TO INCORPORATE, AND WHY
Last Friday I attended the Business Excellence Awards Sunshine Coast for two reasons. First, Charthouse Lawyers was an award sponsor and I was exceptionally pleased to present an award to Trail Bay Source for Sports for being the Best Large Business on the Sunshine Coast. Second, Charthouse Lawyers was nominated for Best Medium Business on the Sunshine Coast (we didn’t win, but congratulations to The Clubhouse Restaurant at Pender Harbour!).
As I mingled and spoke with attendees, the number one question I received was:
“When should I incorporate my business?”
Most were coming at the question from a tax perspective; they wanted to know when a business is making enough money for incorporation to provide a tax advantage.
I understand why – incorporation is an added cost (not huge but not nothing) and then there are annual filings to keep track of and a new set of tax returns to file and new bank accounts to manage and corporate documents to draft to show you are running the business like a separate entity from yourself… It can seem daunting and unnecessary.
I had some pat answers. Incorporation protects your personal assets from lawsuit, so if you offer a service that’s dangerous, or have employees who one day may sue you, or produce anything that a person might ingest in their body, strongly consider incorporating. And even when income splitting is not available (though it can be when you and a spouse are both active in the business), incorporation can still act as a valuable tool for holding income at a lower income tax rate on a tax deferred basis once you’re maxing out your Registered Retirement Savings Plan (which is currently $26,500 total and 18% of income, so you gain no RRSP advantage after $147,222.00 of income).
But the real answer is much more basic than this (now I take off my lawyer hat and put on my entrepreneur hat) and it starts with a different question:
“Why do you own a business?”
For some people it’s because that’s how their industry works; many types of trades or professionals don’t have a single employer but many employers and so they must be an independent contractor.
For some other people it’s because they don’t have the ability or disposition to work for another person.
But in both of those cases, these people own a business so they can have a job. What do I mean by a job? Anything where you earn income by trading time for money is a job. And if all you want is a job, there are better, more secure ways to have one than to get it by owning a business if you can manage it.
But a business should be a form of wealth – not money itself but a money-producing asset that functions when you’re not there. If a job trades time for money, a business trades nickels for dollars. Many people are in businesses that mix the two – lawyers are a good example. They have aspects of the business where they trade time for money and aspects where they trade nickels for dollars, but then they blend all their compensation (more on this later).
So, what is the business? It’s the collection of systems you have built into a money-making machine. They are your method of attracting patients, clients and customers, proving to those patients, clients and customers that you have the solution to their problem, delivering on that solution, and being paid for that solution. Underlying that “front-of-house” process is a “back-of-house” process of tracking receipts and expenses, hiring, firing, managing and motivating employees, and ensuring you have the right physical and technological infrastructure to deliver on your solution.
Your business is not you or any specific employee, but the interaction of these processes. And the more that your business relies on you or one specific employee, the less you have a business and the more you have a job and maybe a business too risky for a person to buy.
But if a business works on its own, the number of willing people with the means to buy your business increases and you can sell it at a premium.
This is known as the goodwill of the business – the value that exists over above the inventory and hard assets of the company.
Which brings us back to the question, when should I incorporate my business? And that answer depends on the two ways you can sell your business.
One is an asset sale. This means the person buys the stuff of the business – the equipment, inventory, name, and lease are typical. Sometimes employees are included. Sometimes certain strategic contracts are included (such as equipment leases or important customers or suppliers). But with every added element, you increase the complexity of the sale. Employees need to be willing to stay. Landlords need to be willing to transfer the lease. Suppliers and customers may want to renegotiate terms because you’re a new business to them. The advantage is the buyer does not pick up the risk of any pre-existing debts or bad practices of the owner, but the disadvantage is the opportunity to disrupt the business’s systems, which is what you’re buying.
The other is a share sale. If you have incorporated your business, the business is a separate legal entity and simply continues as-is. There is less interruption of your money-making machine. Perhaps the buyer may be nervous about picking up unidentified debts and liabilities, but the business is intact.
If you either believe you are building something that will be worth selling or believe you have something worth selling and are looking for a future exit, I believe you should seriously consider incorporation, regardless of your tax situation.
This is not just about systems, but also demonstrating value to your potential buyers. Even if the buyer wants an asset purchase, separating your personal and business assets and cleaning up your books will give you a reliable basis for a valuation and sale.
A common area is owner’s compensation. You have probably been blending your compensation for your time and your return on investment in the business. A buyer will want to know what it will cost to replace you and what the normalized profit (i.e. not just last year’s profit but the average of several years) is of the business after your position is paid a market-based salary. If you’re paying yourself too little (or not at all), you’re artificially inflating your profit margin.
On the other side, if you’re paying for your phones and vehicle and who knows what else through the business, you’re deflating your profit margin. Unpaid expenses and largely personal expenses are both added back to the bottom line through the business valuation process. In either case, you want to have realistic expectations about the price you want to sell.
Greg Crabtree, author of the tremendous “Simple Numbers, Straight Talk, Big Profits!”, advocates paying yourself a market-rate. He also advocates having a liquid business, which equals 2-3 months of operating expenses in the bank. A corporation with its own cash assets is much closer to a turn-key operation than one where the buyer may have enough money for the business and then discover they need an extra hundred thousand to manage the transition.
On the legal side, this is also an opportunity to build up a business history that will remove the need for personal guarantees, because this impacts continuity of contracts (at least two years of history are often required by banks and companies to trust a corporation on its own reputation). It is also a good opportunity to go through your contracts with customers, employees and suppliers and revise them so they are clear and reliable. Similarly, it is a good time to identify potential issues that could harm the business and address them so you can assure a buyer they are receiving a clean, compliant, profitable company.
The goal of this is to increase your multiple, which leads to the value of your goodwill. A common method is to multiply your normalized profit by some number between 0 and 5, with that multiple dependent on the effort the buyer must put in to continue the business. A genuinely turn-key business where a person can show up with a cheque and then let the profits flow can command close to a 5x multiple (maybe even more) plus assets and inventory. A job dressed up to look like a business will get a 0x multiple but can still sell assets and inventory.
There are other ways to value businesses – a chartered business valuator will be able to guide you through the process – but the important concept is that it’s a combination of hard assets (equipment, inventory, etc.) and soft assets (goodwill) and when you ignore doing work that can increase goodwill, you’re leaving money on the table. Which brings us back to the beginning: when do you incorporate a business?
It depends on your goals. If you want a job and your business is just the means to use your trade and showcase your skills, wait until you’re solidly making six figures of take-home pay.
But if you want to build a wealth-generating asset that makes you money while you sleep and gives you the time to enjoy your loved ones and hobbies and take care of all life’s other responsibilities, I would strongly consider doing it now rather than later. An extra tax return and a couple hundred bucks a year to stay compliant are nothing in the long run and you gain a solid foundation on which to build your business.
If you are interested in speaking with Spencer about incorporating your business, preparing it for sale, or figuring out a plan for preserving your wealth and protecting the accomplishments of your life’s work, contact Lauren at our office to set up an appointment – email firstname.lastname@example.org or phone 604-885-4151.