Summary – Holding on to your business for an extended period of time will usually not give you the same financial reward as selling. This article addresses the fallacy that holding a business for the number of years equal to a multiple of EBTIDA will net a business owner the same amount of cash after taxes. The numbers don’t lie and the truth is that the risks associated with holding on typically outweigh the reward of selling. This article addresses in detail a typical scenario and the potential financial benefit of taking “A Bird in the Hand.”
Let’s assess the risks and rewards of holding on to 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 are a lot of risks associated with owning a business that business owners do not like to think about. Those include but are not limited to the following:
- Economic Downturn
- New Competition
- Unexpected Capital Expenditures
- Loss of Key Staff
- Lack of Immediate Liquidity
- Disasters
- Taxes
- Health and Personal Issues
Business owners should be clear-eyed and realistic in determining the right time to take risk off the table, monetize their life’s work and convert the business value they have 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 versus the risks to 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.
We talk to many business owners facing the “Hold or Sell” decision. These business owners are wrestling with one aspect of the question: “Is this the right time to sell?” The business owner looks at the market value of their business or the potential of an offer and says to us, “With the purchase price of 5 times EBITDA, 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 business 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 significant amount, the business owner may need to hold the company for over a decade to achieve the contemplated benefit of continued ownership. Here are the things the business owner is not considering:
EBITDA is not free cash flow to the business owner. The following must be subtracted:
- Cost of capital expenditures
- Cost of interest paid
- Cost of federal, state and local income taxes
- EBITDA must be adjusted for changes in working capital (up or down)
Free Cash Flow is the important statistic, and there are 2 kinds of free cash flow.
- Free Cash Flow to the Firm (FCFF)
- Free Cash Flow to Equity (FCFE) – the Free Cash Flow that accrues to the business owner
While EBITDA is such a handy little tool to compare one company to another, the problem is that business owners 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 business owner who comes to believe that EBITDA is money he or she can take home each year. This thinking is 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 and other perks. Altogether that’s the owner’s benefit of ownership.
Let’s look at a sample company.
- S-Corporation
- EBIT of $3 Million
- EBITDA of $3.1 Million
- Depreciation & Amortization of $100,000 annually
- Capital Expenditures of $150,000 annually
- Interest Expense of $60,000
- Working Capital increase of $20,000 annually
Now we can calculate FCFF and FCFE.
FCFF after taxes is $1,699,400, but EBITDA = $3,100,000. Actual free cash flow to the firm is only 54.8% of EBITDA.
FCFE is $1,664,600. Actual free cash flow to equity is 53.7% of EBITDA.
Assume the business owner receives $200,000 in salary and perks after taxes so the actual annual benefit from ownership is $1,864,600 or 60.1% of EBITDA.
So how long does the owner have to own the business to get the same benefit as selling today for 5 times EBITDA? The simple (but incomplete) before capital gains tax answer is 8.31 years to generate the same $15.5 Million that a sale would produce.
If the owner holds for 5 years their benefit before paying personal income taxes is 5 times $1,864,600 or $9,323,000. The sale price would be $15,500,000 before paying capital gains taxes, so the owner comes up short by $6.45 million, and needs to hold for another 3.31 years to achieve the desired result.
But this is still not the entire picture, because the business owner who sells 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 can be invested. That $11.67 million can also generate a return for the business owner, just as the business generated an annual return for the business owner – sometimes higher and sometimes lower than average. A business owner would have many choices for investing a sum of that magnitude.
If you choose a low risk 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 approximately 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 12 plus 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 us they could achieve with a five year hold time, but no-one says “If I just hold on for another 12 plus years I’ll put the same amount of money in my pocket and still have a company to sell.”
To be more precise in these comparisons you would 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. S-corporations, partnerships and LLCs would be different than C-corporation results. Varying deal structures can also change the results. 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 business owner, and because sale proceeds can be invested to produce a return for the business 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. Hence the bird in the hand.
If you are prepared to hold your company for another decade or more 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 business 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 is also one other little point to be made when the business owner who’s contemplating holding on tells us that he will “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 business 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 to 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 does not 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? We hope this article helps business owners to more carefully consider their alternatives.
If you’d like to talk about your business and your personal situation please call us at 314-330-9966 or 314-452-6576.