Succession Planning: the Value of Preferred Shares

This article was originally published in Droit Inc. in French and has been reproduced with permission.

There are a number of factors to consider when deciding how to use and value a private company’s preferred shares.

In privately-owned companies, preferred shares are often used in tax or succession planning. With the help of legal and financial advisors, customized characteristics can be assigned to these shares based on the client’s objectives.

In a family business, for instance, parents often transfer most of the common, voting and participating shares to their children so they can benefit from the company’s future growth, after the parents retire. Under the tax rules, parents must receive consideration equivalent to the fair market value of the common shares at the time of the transfer. Since the company may not have the liquidity to redeem the value of the parents’ holdings in cash, the consideration is often paid in the form of preferred shares. The characteristics of these shares could include the following:

• Voting rights
• Dividend rights, at a fixed or variable rate or as declared by the directors
• Right to convert to another class of shares
• Redeemable at the option of the shareholder and/or the company
• Priority over other share classes for dividends or other distributions

The valuation of a private company’s preferred shares must take all these characteristics into account as well as the respective rights of all other share classes, as defined in the company’s articles of incorporation. For example, if there is a shareholders’ agreement, the provisions of that agreement need to be analyzed to understand the respective rights of each class of shares in order to determine their value.

As a result, it’s imperative that the characteristics of the preferred shares be clearly defined in order to achieve the tax planning objectives. One of the most important aspects is the right of redemption at the shareholder’s option. This means the shareholder can require the company to buy back their preferred shares at their redemption value as defined in the articles of incorporation.

In the case of succession planning, when preferred shares are issued in exchange for common shares, the tax rules require that they be redeemable at the shareholder’s option (i.e., retractable) so they retain their full redemption value. These rules are in place to avoid a benefit being conferred on the next generation when a company is transferred. The parents’ taxation is deferred until the preferred shares are redeemed, or in other words, until they are cashed in.

Some preferred shares are issued with significant voting rights, sometimes even control of the company. The goal of this kind of plan is for the parents to retain control if they feel their successors are not fully ready to assume that kind of responsibility.

This way, the parents protect their preferred share investment by avoiding potentially detrimental financial and operating decisions. Preferred shares that include enough voting rights may have a higher value than their redemption value when they confer company control. However, an in-depth analysis of the characteristics of these shares, and of the other classes of shares issued, is needed to determine their fair market value.

A business valuation expert can help you determine the value of all your company’s share capital and the value of the various classes of shares, both at the planning stage and in the future for tax, transactional or shareholder litigation purposes.