September 1, 2005
by John McMillan & David Harris
Last issue, we provided readers with an overview of the benefits of incorporation, as well as a brief introduction to a few of the potential disadvantages and risks of purchasing shares of a professional corporation instead of assets.1
As share sales may provide substantial tax benefits to practice sellers, they are on the increase and will likely become the norm in practice sales.2 However, they are inherently more complex transactions and there are a number of potential traps to be addressed, with the assistance of professional advisers.3
First Steps – Determining purchase price
In an asset sale, determining the price is fairly straightforward. The value of the tangible assets and goodwill are determined using customary valuation practices and the parties negotiate a price, an allocation of that price between classes of assets (for tax purposes, not be discussed here) and other purchase terms.
Share sales are not so simple. Typically, the price for the equipment, goodwill and leasehold improvements are adjusted to translate the asset price into a price for shares. The following factors are taken into account:
Lost tax shield
In the first article of this two-part series, we discussed the loss of “tax shield” to the Purchaser in some detail. The “present value” of this lost tax shield is normally a reduction of the price.
It is possible that some assets of the corporation are not intended to be sold. These might include cash, real estate (if not part of the sale) investments and artwork. The Vendor should extract these assets prior to the sale date.
Debts of the corporation
Any debts that are intended to be assumed by the purchaser should be deducted from the price.
Discount for risk
All liabilities of the corporation (disclosed or not) will follow the corporation and therefore there is potential risk to the purchaser (discussed below). Normally, part of the price is “held back” for a period to cover these eventualities. In unusual circumstances it may be appropriate to discount the price to cover risks to the purchaser.
Some of the assets of the corporation, such as accounts receivable and dental supplies, and some debts, change daily; therefore it is not possible to determine the exact price until after the closing. The agreement should include an undertaking to adjust certain amounts. Adjustments are normally made against funds held back.
Seek advice first
Given these issues, it is critical to obtain all necessary particulars from the seller (financial statements, material agreements etc.) and to consult with professional advisors before discussing price and other terms with the seller.
As mentioned in the last issue, when you purchase shares, you are buying the corporation “warts and all”. There are risks associated with the purchase of shares. Some of the issues may be found on the corporation’s financial statements; others may be hidden.
All undischarged debts of the corporation will survive the sale, which can be a big surprise if not addressed before the sale.
Amounts that remain outstanding under any rental agreement (premises lease, equipment lease etc.), if entered into by the corporation will also survive the sale. Rental arrears can have serious consequences to the corporation and purchaser, as the landlord will have quick recourse under commercial tenancy legislation.
Any employees who are not properly terminated in accordance with provincial employment laws, and paid appropriate termination pay, will be deemed to be continuously employed by the corporation. Under certain circumstances, employees terminated and then immediately re-hired have also been treated by the Courts as having been continuously employed.
If after the purchase, you decide to terminate a long-time employee, a considerable liability can arise. Depending on the circumstances, there are a myriad of issues that can arise relating to employees of the practice.4
Any taxes unpaid by the corporation will remain payable after the sale. Taxing authorities do not discern between seller and purchaser. As our tax system is audit-based, there is a possibility of a tax obligation relating to the previous owner’s conduct arising after the sale.
While it is clear that dentists are not sheltered from professional liability when they incorporate, an unhappy patient may name the corporation in a malpractice suit, even after the sale.
Look before you leap — Due diligence and assessing potential risks
When making an offer on shares, lawyers typically advise the purchaser to make the offer conditional upon review and verification of certain items. The “due diligence” stage is your opportunity to identify actual or potential risks and the only or one of few opportunities to abandon the purchase.
Technical due diligence
This step involves ensuring that the equipment on which a valuation is based exists and is in good repair, performing a chart audit to verify the number and quality of active patients, interviews with staff, and other matters relating to the operation of the practice. While the dentist may perform some of these tasks, it is often done with the assistance of specialists in dental practice operations.
Financial due diligence
During the conditional period after the offer is made, your financial advisor should be provided with access to all of the books and records of the corporation and the practice to verify revenues, expenses, assets and debts and to conduct other various analyses. Originals of all previous years’ tax returns and assessments of the Corporation should also be reviewed.
Legal due diligence
Your lawyer will conduct preliminary searches against the corporation to verify that the corporation is in good standing, is not bankrupt, has no Judgments against it and that there are no registered security interests against the assets of the corporation that have not been disclosed and accounted for.5
It will also be important to conduct many of the same searches against the individual dentist (and other shareholders, if any), as any claims against them may expose the shares to claims.
Your lawyer should also conduct a review of all material agreements entered into by the corporation, so you may be fully advised as to what obligations will survive the sale.
The sequencing of the various due diligence procedures needs to be carefully coordinated to identify potential problems at the earliest opportunity and to minimize costs if a purchase is abandoned.
When purchasing shares, there are several lines of defence.
First, wherever possible, the corporation should be required to satisfy, before the sale, all obligations that you did not agree to assume. This may require a re-direction of a portion of the price to third parties to be certain that the obligations are satisfied.
Second, where it is not possible to satisfy obligations prior to the sale, the purchaser can seek security to ensure that the obligations of the corporation are fulfilled. The previously discussed holdback (held in the trust account of the solicitor for the seller or purchaser), with a written undertaking of the seller’s solicitor to ensure satisfaction of such obligations is the most common security.
Representations, warranties and covenants of the seller
It is customary for the
seller to make certain representations and to give certain warranties regarding the corporation and the practice. There are many examples (speak to your lawyer) and they are made and given by the seller in the body of the Offer and then often confirmed in writing on the sale date.
You will also wish for the seller and the corporation to give certain covenants to do certain things before, at or after the sale date. Examples include covenants to terminate certain employees (and pay all statutory entitlements), pay corporate taxes, not to compete or solicit and so on. These covenants are often repeated again, in writing, at the time of sale.
If the seller is later in breach of representations, warranties or covenants, you as purchaser will have recourse, which might include rescission (cancellation) of the sale, damages or specific performance of certain obligations by the seller.
Your lawyer will also likely advise you to obtain further comfort by requesting undertakings from the seller and, wherever possible, from the seller’s solicitor, to perform certain acts such as paying debt obligations and obtaining discharges.
As a further protection, you will wish to obtain written indemnities from the seller relating to liabilities of or claims against the practice or the corporation up to and including the sale date, as well as all associated costs of such liabilities or claims.
With respect to the corporation, you should also require a written opinion from the corporation’s solicitor relating to various material facts to be provided to your lawyer.
Obtain proper documentation
From a documentation perspective, share sales are complicated and require the assistance of an experienced solicitor. In addition to the above items, there are a myriad of documents that will be required (from the seller and from and relating to the corporation) in order to maximize your protection in a share sale.
While share sales are clearly more involved than asset sales, the magnitude of the tax saving to the seller provides an extra benefit not available in an asset sale. Provided the various concerns are addressed, this provides an opportunity for benefit to both parties.
1.Transacting an Incorporated Dental Practice – Part 1, Dental Practice Management, Summer 2005, pg 33.
2.See discussion of “Lifetime Capital Gains Exemption” in Part 1.
3.This article is not to be construed as comprehensive treatment of all issues that may arise. The reader is advised to seek competent professional advice when contemplating a purchase or sale
4.Speak to your lawyer about the risks associated with successor employer obligations under employment legislation in your jurisdiction.
5.This step is for early detection purposes and is not a substitute for a written opinion from the solicitor for the seller’s corporation, which should be obtained.
John McMillan is a Toronto business lawyer serving dental professionals. He may be reached at 416 364 4771 or johnmcmillan@ bellnet.ca
David Harris, MBA, CMA, TEP, is President of Harris Beattie MecLennan & Company, a Halifax-based dental advisory firm. He may be reached at 902-421-1533 or email@example.com