It remains a hotly debated topic among business owners and investment bankers whether holding a business can be better than selling a business. Macro trends and personal desires can greatly impact a question framed in such broad strokes, but the question often holds a great deal of weight. It may be helpful for owners to understand more precisely and analytically the implications of their “hold vs. sell” decision. So bear with me as I dig a little deeper than usual so you can more accurately assess the risks and rewards of owning a business compared to the alternative of selling and investing the sale proceeds. We all know that business ownership is not a risk free proposition. There is a lot of risk associated with owning a small or mid-sized business that owners don’t like to think about, but the old saying of not keeping all your eggs in one basket applies to business ownership, as many owners discovered during the most recent “Great Recession”. Owners should be clear-eyed and realistic in determining the right time to take risk off the table and convert the business value they’ve created into a more diverse and therefore inherently less risky set of investments. The decision to sell the business or hold on longer should be a conscious risk management decision that incorporates the realistic rewards to the owner from continued ownership. This is particularly true for older owners who may not have sufficient time to recover from a business setback, should one occur before age-related events force the issue.
I occasionally talk to a client prospect or a client who is facing the “Hold or Sell” decision. Sometimes it’s a client who is contemplating a proposal from a buyer in the form of a term sheet or a letter of intent. These business owners are wrestling with one aspect of the question: “Is this the right time to sell?” The owner looks at the offer or the potential of an offer and says to me, “With the purchase price of let’s say 5 x EBITDA (earnings before interest, income tax, depreciation and amortization), I can just stick around for 5 more years, put the same amount of money in my pocket, and still have a company to sell.” Effectively, this owner is thinking “Double the money for me if I just hold on for another 5 years.” Of course that’s not really true, and the firm may be worth more or less when the owner finally decides to sell, but the key thing is that in most cases the owner is not going to come close to putting that amount of money into his or her pocket simply by holding on for another 5 years. In fact, unless the company is expected to grow by a goodly amount, the owner may need to hold the company for over a decade to achieve the contemplated benefit of continued ownership. Here are the things the owner is not considering:
o EBITDA must be adjusted for changes in working capital (up or down) – An example would be a growing company that needs more working capital to support expanded operations, taking away from the amount of operating income that the owner keeps.
Free Cash Flow is the important statistic, and there are 2 kinds of free cash flow.
I hate to get too deep into the weeds here, because EBITDA is such a handy little tool to compare one company to another, but the problem is that owners and even some brokers have come to believe that all they need to know is the EBITDA and a common multiple and they know the company’s value. Even worse is the owner who comes to believe that EBITDA is money he or she can take home each year. Those concepts are incorrect. FCFF is what really matters in valuation, and FCFE is the benefit the owner gains (although some of that benefit is likely not extractable and must remain on the firm’s balance sheet). To get even a little more deeply into it we have the concept from the Business Brokerage industry of Seller’s Discretionary Earnings (SDE) or sometimes “Owner’s Benefit” that includes the owner’s salary and certain perquisites like the company car or the annual “seminar” in the Bahamas. Altogether that’s the owner’s benefit of ownership.
Let’s look at an example and I’ll do the math for you.
Our example company is a C-corporation that has earnings before interest and taxes (EBIT) of $3 million, and EBITDA of $3.1 million. It has a combined state and federal income tax rate of 42% (the actual tax rate will vary among the states). It has Depreciation and Amortization of $100K per year, and Capital Expenditures of $150K per year. Interest expense is $60K per year. Working capital increased by $20K over the past year.
Now I can calculate Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity FCFE.
FCFF = EBIT x (1- tax rate) + Depreciation and Amortization – Capital Expenditures +/- change in Working Capital.
Let’s pay the owner $200,000 in salary and perks so his actual annual benefit from ownership is $1,810,000 or 58.4% of EBITDA. Not too bad except for all those taxes.
So how long does the owner have to own the business to get the same benefit as selling today for 5 x EBITDA? The simple (but incomplete) before tax answer is 8.56 years to generate the same $15.5 million that a sale would produce.
If the owner holds for 5 years his or her benefit before paying personal income taxes is 5 x $1,810,000 = $9,050,000. The sale price would be $15,500,000 before paying personal taxes, so the owner comes up short by $6.45 million, and needs to hold for another 3.56 years to achieve the desired result. Thus, the simple answer is 8.56 years.
But the simple answer still isn’t the whole picture, because the owner who sells [and who is smart enough to have moved to a no-income-tax state like mine – Washington] has traded his equity ownership in the business for $11.67 million in proceeds after taxes (23.8% federal capital gains tax) and fees (assumed 4% legal and transaction fees) – proceeds which in all probability won’t be stuffed under his or her mattress. That $11.67 million can also generate a return for the owner, just as the business generated an annual return for the owner – sometimes higher and sometimes lower than average. How much of a return you can expect from an alternative investment depends on the type of investment. Low risk investments provide low levels of return, but higher risk investments can provide higher returns. You would have many choices for investing a sum of that magnitude including publicly traded “private” equity groups or “business development companies” that invest in portfolio companies of similar size to this one and shoot for total returns in the low 20% range, or maybe an S&P 500 index fund with a long term ~10% rate of return, or maybe a bond fund with a long term rate of return in the ~5% range, or any other type of investment, all with varying risk and return profiles.
Here’s a table of expected % return vs. the equivalent pre-tax dollar return on the $11.67 million you can now invest after a sale.
If you choose an investment with an expected 5% return and achieve it, the incremental average annual pre-tax benefit to business ownership compared to the pre-tax benefit of owning the investment would be $1,226,500 and you would actually need to hold the business for ~12.6 years to achieve the same pre-tax benefit as selling today. So you hold on to the business for 12.6 years and that produces an incremental benefit of ownership of $15.5 million compared to a conservative investment, and then if nothing goes wrong in those dozen years you sell the company for its presumed value of $15.5 million at that time and sure enough you’ve achieved the $31 million benefit some owners have told me they could achieve with a five year hold time, but no-one says “If I just hold on for another dozen years I’ll put the same amount of money in my pocket and still have a company to sell.” If you choose an investment with an expected 10% return for comparison (a more reasonable comparison in my mind), the incremental average annual pre-tax benefit of holding the business instead of the investment would be $643K and you’d need to hold the business for ~24.1 years to achieve the same pre-tax benefit as selling today. That’s a career for some folks, and I have yet to have an owner tell me “If I just hold on for another 24 years I can put the same amount of money in my pocket and still have a company to sell.” If you choose an investment for your sale proceeds with an expected 15% return, there is only a $60,000 incremental average annual pre-tax benefit of business ownership compared to holding the investment, so that you’d need to hold the business for over three average lifetimes to achieve the same pre-tax benefit as selling today. Even though investments with expected returns of 15% are most comparable to the risk profiles of well-run small and mid-sized businesses, no-one says “If I just hold on for another 258 years I can put the same amount of money in my pocket and still have a company to sell.”
If you’d like to be more precise in these comparisons you’d look at after tax returns compared to pre-tax returns but since most of the return will likely be in the form of capital gains and dividends in either case, and those federal tax rates are essentially the same, I didn’t go any further. S-corporations, partnerships and LLCs would be different than C-corporation results. Varying deal structures can also change the results. Companies in states with no state income tax might have higher or lower answers depending on the way those states extract money from the business and its owner. If the owner lives in a no-income tax state, regardless of where the business is located, he or she will likely do much better than an owner in an income tax state, subject to various deal structure considerations. There are lots of details to consider and the above is just one example. Nevertheless, there is a big picture lesson to be learned for business owners who decide to hold on a while longer before selling:
Because EBITDA is not cash flow to the owner, and because sale proceeds can be invested to produce a return for the owner just like the business produced a return for the owner, the hold time to create a return comparable to the return from selling the business may be a lot longer than you might otherwise think.
If you’re prepared to hold your company for another decade or two to try to double your money, that’s great, and you do have a chance to double your return in exchange for a considerable amount of your time. At some point, however, it does make sense for most owners to compare the hold time needed to achieve the expected return from the business to their own remaining life expectancy, or even better the remaining duration of their desired working life.
There’s also one other little point to be made when the owner who’s contemplating holding on tells me that he’ll “still have a company to sell”. That’s true but if the proceeds from sale of the company are converted into an alternative investment, the owner will “still have an investment to sell”. That is, the owner can always sell part or all of the investment to create cash and if the investment is publicly traded the sale is very likely to be done in a single day compared to 6 months or a year for a business sale. The ability to sell quickly for a market price and thereby create cash is a very valuable attribute that simply doesn’t exist in privately held businesses, and that “lack of liquidity” is one of the risk factors that attends ownership of a privately held business.
The decision to hold on is a much better decision if there actually is a realistic plan to grow the business and increase the bottom line for the reason that the growth can increase the incremental benefit of business ownership compared to alternative investments. If there is not such a plan then the owner should take a realistic look at single company ownership risk compared to the alternative of selling and diversifying the sale proceeds into other types of investments. What’s the risk and what’s the reward? Specifically what’s the incremental benefit of continuing to take the substantial risk of single company ownership? Is there enough incremental benefit to convince you to continue taking that risk? I hope this article helps owners to more carefully consider their alternatives.