Monday, March 09, 2009

Sell or Keep Your Business - The Numbers May Surprise You

Many business owners simply are too emotionally tied to their businesses to analyze it the way they would another investment. This post provides a framework that a business owner can use to dispassionately examine the cost / benefit of owning his business.

In our Merger and Acquisition practice we watch as business buyers go through an exhaustive analysis to determine if it is financially prudent to make a particular company acquisition. Some use EBITDA multiples or free cash flow multiples. Others use the classic discounted cash flow approach while another group might look at a payback period analysis or debt coverage ratios. They all have one thing in common, however. They do a financial analysis as the primary determinant in making a decision to buy or not to buy.

It occurred to me that a business owner, not necessarily a business seller, should do his own financial analysis to determine if he is better off owning the business or selling it. In other words, will a business owner make more money by selling the business and replacing his business salary and dividends with the investment income he would earn by investing the business sale proceeds?

Owner A Owner B Owner C
Owner Comp $137,500 $578,490 $800,000
Sale Price($000) $4,400 $17,600 $26,000
Tax & Fees($000) ($1,100) ($4,400) ($6,500)
Net Proceeds($000) $3,300 $13,200 $19,500
Investment Income $214,500 $858,000 $1,267,500
Gain (Loss)*** $77,000 $279,510 $467,500

*Representative examples for Illustration purposes
**Proceeds invested @ 6.5%
***Calculated as Income from Investments less Income from Compensation

When you look at it using this analytical discipline, it puts things into a whole new perspective. Now let's add another factor to make the analysis even more interesting. When a business valuation firm performs a discounted cash flow analysis to value a business, they typically take the projected cash flows for ten years and discount those cash flows to today's value using a risk adjusted discount factor.

They are attempting to calculate a terminal value which is the value of ten years of cash flow discounted to present value. For a small privately held company those discount factors typically are in the 20% to 25% range. The effective discount rate used in this terminal value calculation is the 20%-25% rate less the company's growth rate.

So for example, if the company growth rate was 5% and you used the 20% risk adjusted rate, your discount rate would be 20% minus 5% or 15%. This says that $1 of cash flow received after 1 year = 87 cents today. That $1 received after 2 years is worth 76 cents, and so on.
This is the same principal used in pricing corporate bonds. AT&T might carry a rate on their 30 year bond of 5% as a triple A credit. Acme Electric, a BBB rated credit, might carry a rate of 16%. This adjusts the rate of return based on the risk of possible default and compensates an investor for taking additional risk.

Back to our privately held company and the risk adjusted discount rate. What this 20% - 25% rate is telling us from a strictly unemotional, analytical standpoint is that future cash flows from a small business are considered quite a risky proposition.

Please refer back to the chart and look at Company C as an example. The owner is taking $800,000 per year out of the business. Why would anyone in their right mind sell this company and walk away from this golden goose? Similar companies in his industry with similar financial performance are selling for $26 million. When this company is sold, the owner will pay a total of $6.5 million in taxes and professional fees. His net cash proceeds are $19.5 million. Investing $19.5 million in a balanced portfolio returning 6.5% annually will provide the former owner $1,267,500 in investment income.

Compare this to the $800,000 that the owner takes home from his business annually and it shows that the owner is actually paying $467,500 for the privilege of running his company.
Of course the owner receives a great deal of satisfaction and psychic benefit from running this very successful business. One can not overlook the pride of ownership and accomplishment, prestige in the community, and the purpose and meaning in his life that business ownership provides. It is very difficult to try to attach a dollar value to that.

With an extra $467,500 of annual cash flow and an extra 50 hours per week many owners could find other equally rewarding activities like philanthropy and charity work, travel, family and friends, or pursuing the career they would want if money were not a concern. Owning a business has many rewards and it is often difficult for an owner to objectively step back and look at his ownership in a totally analytical way. With the number of businesses that we have represented for sale after a significant negative event, however, this kind of thinking would have been quite useful when they were still on top.

Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist

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