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Litigation and Business Valuation in a Succession Context – Two MNP Case Studies

24/02/2020


This article was originally published in Droit Inc. and is reproduced in English with permission.

It’s no surprise that planning the succession of a family business can be difficult. A person’s death, while inevitable, is hard to predict. Then, while people are grieving the loss of a loved one or family member, they must also deal with the emotional task of handing the company over to the next generation—a generation who may not be involved in the company at all and may find themselves faced with a number of decisions. Since the family business is often a family’s biggest asset, it’s not uncommon for each heir to have a vested interest in getting their fair share, and the situation can quickly escalate.

MNP’s two service lines, Business Valuation and Forensic Accounting and Investigations, support businesses so they can continue to prosper for future generations. The following two recent cases that MNP has worked on illustrate the business valuation and litigation issues that can plague companies when it comes time for succession.

Case 1 – Business Valuation Issues Related to Succession

When mixing business and family, it’s always best to plan ahead and communicate your intentions through documents like shareholder agreements and wills, in case the unexpected happens. That’s what happened to a small media company owned by Paul, in his fifties, and Julie, in her thirties. They met on a film set and decided to start a company. They worked well together for many years and the company had a number of successful projects, including a Quebec television series. Paul had two children in their twenties who were not involved in the business.

Suddenly, Paul died of a stroke and Julie was left to run the business on her own. After their initial shock, Paul’s two children needed to settle their father’s estate. They wanted to claim the value of their father’s interest in the company. Julie wasn’t sure of the value, so she asked her accountant, who told her he thought the value was minimal. The business was turning a profit, but the owners did not pay themselves salaries, so if someone had to be hired to replace Paul, there would be virtually no profit left for Julie. In addition, the company’s long-term profitability was uncertain because its projects were funded in part by government grants that were subject to annual approval and couldn’t be guaranteed.

The company did not have a shareholders’ agreement that could have included a share buyback mechanism. Paul’s children were convinced that the business was worth a lot because they knew the company had had some commercial success. The estate therefore hired lawyers to assert its rights. Julie, on the other hand, was having difficulty managing the day-to-day operations of the business since Paul was the bank account signatory and all operations had been frozen, which was causing cash flow problems for the company.

Julie hired a business valuation expert to have the business and Paul’s equity interest in it assessed. The expert report corroborated the finding that the shares were of little value. One of the factors considered was how dependent the business was on two key individuals, Julie and Paul (deceased), and the business’s precarious financial situation following Paul’s death. After talks and negotiations, the case was settled out of court, but not before it had caused a great deal of stress for Paul’s children and Julie, who had to work harder in the business in addition to settling the contentious valuation issue with the estate.

Case 2 – Forensic Accounting Perspective on Litigation in an Estate Context

What happened to Paul’s children and Julie is a good example of a situation that could have devolved into a lengthy litigation process. In this situation, as in many other cases we’ve encountered in our forensic accounting practice, what was missing was timely and effective succession planning. MNP’s forensic accounting department has been asked to provide services in several cases involving shareholder and succession disputes. More recently, MNP worked to resolve a dispute between members of a chocolate shop’s estate. This case illustrates common deficiencies in succession planning.

First, it’s important to know if all family members affected by the succession were involved when the plan was put in place. It’s not uncommon for some family members to be active in the business and to have prepared for the transition. However, this doesn’t always make the process as straightforward as it could be. Other family members may have little or no involvement in the business.

In the case of the chocolate shop, the owner decided that, upon her death, her shares would go to her four daughters: Louise, Alice, Jeanne, and Claire. Her daughters had very diverse backgrounds and levels of involvement in the company. Louise, the eldest, had always been a chocolate maker and had never handled the administrative part of the company. Louise’s two children also worked for the company. Alice has a bachelor’s degree in business administration and took care of the management and accounting for the business. Jeanne, the third oldest, was in charge of the company’s sales. Claire, the youngest, was a nurse and never worked for the company. It’s not hard to imagine that each of the girls had a different vision for the company and varying levels of information about the business. Their mother had never communicated her desire to have all four daughters inherit the business, not just the three who worked for the company.

Just like the situation with Julie and Paul’s children, the chocolate shop did not have a shareholder agreement, so the children did not have any pre-established procedure to follow in case there were any problems. When their mother died, the four daughters found themselves without any documentation on which to base certain decisions. For example, Claire had no interest in the business and wanted to sell her shares to her sisters. Having a shareholder agreement with a share buyback clause would have made that process much easier. It would also likely have led to an independent assessment of the fair value of the company, as discussed above. Our forensic accounting services can help in situations like this by assessing the company’s current and past financial data, usually by analyzing financial details from a number of previous years.

If each family member in the business doesn’t have a clearly defined role and salary, it can be difficult to get an accurate picture of the situation. Our forensic accountants help you gain a clear picture by conducting research, analyzing data, and interviewing the people involved. They analyze a number of things at this stage, since remuneration is often at the heart of the conflict. The forensic accountant may review things such as compensation based on involvement in the company, the management of advances to shareholders, benefits granted, bill payment, and personal expenses. Often, the salaries and expenses for several financial periods are also analyzed. In our example, Alice clearly had the most administrative power. What could she do to make sure her sisters Louise and Jeanne didn’t feel like they had been wronged? Our services were able to track Alice’s full compensation, as well as the expenses of each sister who worked for the company.

A company’s internal controls and reliable financial information are also key to maintaining trust when it comes to succession. They should be established as soon as possible and their effectiveness should be demonstrated to the members of the estate. Very few internal or anti-fraud controls were in place at the chocolate shop, which relied heavily on cash. Income information was not readily available, and the MNP team determined that the company’s accountant was a personal acquaintance of Alice.

This lack of controls and reliable financial information led to a rapid decline in confidence following the mother’s death. Louise and Jeanne had no confidence in Alice’s management and the results, so they took legal action against her. Our services identified fraud risks and shortcomings in internal controls. Our team improved the control environment of the chocolate shop for the new generation.

The dispute ruined the sisters’ relationship, but our forensic accounting and litigation support services nonetheless helped improve the estate’s position for the future, determine the fair values for each member of the estate, and establish a clear financial picture of the business.

Lessons Learned

The following lessons can be learned from these examples: It’s always a good idea to make sure your affairs are in order and to have a good idea of the value of your business. It’s important for business owners to regularly communicate their intentions to their heirs and to share certain information with them so that they are prepared, should the unexpected happen. When it comes to succession, it’s important to get an accurate picture of a company’s financial situation and control environment. A forensic accountant can help you with this.

To prevent or resolve disputes, seek out a chartered business valuator or a forensic accountant.

Contact Corey Bloom, Partner and Eastern Canada Leader, Forensics and Investigation, at 514.228.7863 or [email protected] 

Catherine Tremblay, Partner, Valuation and Litigation Support, at 514.861.9446 or [email protected]