Entity Structure

Owner-run businesses rarely start as groups of companies, but many become them. A building is bought in a separate company to protect it from the business's risks. Trucks are leased from a family company for tax reasons. A second business set up for a new venture ends up employing half the staff of the first, and years ago an adviser suggested registering the trade name in yet another entity. Each decision made sense at the time. Taken together, they leave the trucks in one company, the name in another and the people in a third, with the operating business's profit depending on payments between them that the owner sets.

A buyer looking at that group cannot tell what it is buying, or what the taxed profit of the operating business really is. Entity Structure draws the boundary of what is being valued. It shows which entities hold the operating assets, contracts, people and licences, how money moves between them, and what is inside the perimeter of a sale, so that the profit and its tax belong to a defined business.

Every entity on one chart

The work begins with a structure chart showing every entity the owner or family controls that deals with the business, with its ownership, its tax classification, and the assets, contracts, employees, licences and intellectual property it holds.

The chart takes two passes. The first, done with counsel, is an inventory of the entities: the formation documents, ownership records and tax classification of each, and one line on why it exists. The second maps holdings to entities. It draws on the asset register, the contract file, payroll, the licence registrations and the trademark records, and assigns each item to the entity that legally holds it.

The map is where the surprises tend to come from. The owner assumed the trade name belonged to the business, and it turns out to be registered in the owner's own name. The licence the business trades under is held by a company that holds other things too, or a vehicle the business depends on belongs to a relative's company. Until the map exists the buyer cannot see what exists or who holds it, and it discounts for that uncertainty.

Every payment between them at arm's length

Next, every payment between the entities, whether for rent, management fees, equipment, staff or the use of a brand, goes under a written agreement at a documented market rate, and the balances between entities reconcile on both sides at every close.

The flows are taken from the ledgers of every entity, three years by type and amount, and the balances between each pair are reconciled. Each flow is then either papered or stopped. Counsel drafts the agreements, at rates from the same benchmarks used to put related-party arrangements at market on the second bridge, and a flow with no business purpose ends.

This matters because a payment between entities controlled by the same owner can be set at any price the owner likes, and the price decides which entity shows the profit. A brand licence fee that rises in good years and falls in bad ones moves profit out of the operating company when it is high and back in when it is low. A buyer cannot value an operating company whose profit is a product of the owner's tax planning, and it will discount the profit's size until the transfer prices are fixed at market and the operating entity's profit comes from what it does.

A perimeter with the business inside it

The last piece is a written perimeter of sale. Every asset, contract, licence, employee and piece of intellectual property the operating business needs is either inside it or available to it under a written, assignable lease or licence at market.

Each holding on the map is tested against the perimeter by asking whether the operating business needs it and whether it is already inside. Counsel and the tax adviser then decide together what to do with each thing the business needs and does not hold. If moving it into the operating entity is cheap and neutral for tax, it moves. If not, a written, assignable lease or licence at market rates gives the operating business a contractual right to use it, and a buyer can inherit that right.

This is the part a buyer most needs before it will pay for the earnings as lasting, because what it values has to be what will actually transfer. In the illustration, trucks worth $60,000 a year to lease have been used for nothing because they sit in a family company. That is a cost of $45,000 a year after tax that the business does not yet carry, and about $375,000 of value at a 12 percent cost of capital. A buyer will deduct it at its own figure. Once a lease is in place at market, the business carries the cost in its own cash flow at its own figure, and the buyer has nothing left to deduct.

Whether to simplify

Defining the perimeter does not require collapsing the group. Some separate entities exist for good reasons, and keeping them is often right. Holding the building in its own company can protect it from the operating business's risks, and lets the owner keep it after the sale and lease it to the buyer. A second venture that is a different business with a different future can reasonably stay separate. All the driver asks is that each entity's reason for existing be written down, and that whatever the operating business needs from it be available on written, assignable, market terms.

Where simplifying does make sense, it has costs. Moving an asset between entities can trigger tax, and transferring employees, contracts and licences takes time and the consent of the other parties. That is why counsel and the tax adviser decide together, and why timing matters. A restructuring carried out years before a sale, with each step recorded and its reason written down, reads as a business tidying its affairs. The same restructuring in the months before a sale costs more, because there is no time to sequence the tax consequences, and it makes a buyer ask what was being rearranged and why. A structure chart kept current from the start of this bridge lets the owner simplify on their own timetable instead of the one a buyer's diligence would set.

What it does to value

Entity Structure ranks fourth on this bridge, because part of what it does changes what the business pays. Each operating asset or contract brought inside the perimeter on market terms, by lease or purchase, becomes a real cost in the cash flow at the business's figure, where it would have been a deduction at the buyer's, and the chance that a buyer finds a gap in the perimeter falls toward nothing. The framework counts both as value.

Restating payments between entities to arm's-length rates is different when the group's total cash does not change. It moves profit from one entity to another and changes what the buyer records, while the group pays the same. The framework records that as a difference in recorded rates, in the price column.

What has to be in place first

The related-party schedule from Separation comes first, because payments between entities are related-party arrangements and the schedule is the list to start from. Counsel and the tax adviser need to be engaged together, since moving an asset between entities has legal and tax consequences that neither should decide alone. And every entity on the chart needs a ledger. An entity whose books are not kept cannot be reconciled, so its bookkeeping goes onto the close calendar before anything else.

Knowing that it works

Three numbers show the work moving: the share of items on the asset register, contract file and licence list that have been mapped to an entity; the share of intercompany flows papered or unwound; and the count of things the operating business needs that sit outside the perimeter with no lease or licence, which should reach zero.

Two tests can be put to the owner. Drawn from memory and compared with the chart, the owner's version of the structure will usually miss an entity or a holding, and each miss confirms that the chart has become the record the business relies on. Asked to say in one paragraph what a buyer would receive, the owner's answer can be read against the written perimeter.

Why it slips, and what holds it

The structure decays as assets and contracts drift outside the perimeter, when new companies are formed for new purposes and new equipment is bought through whichever entity is convenient. Two rules hold it. No new entity or intercompany arrangement is created without counsel and an update to the chart, so the chart is where a structural change starts. And balances between entities are reconciled at every close, so a payment made outside an agreement shows up as an unreconciled balance in the month it happens.