The decision to sell or retain a business is a question pondered by many business owners. Selling a business is a momentous decision and involves critical analysis and contemplation. Although there are a myriad of factors that influence this decision, most of the pertinent issues fall into two primary categories: Financial and Lifestyle Considerations.
Although the goal in any business sale is to maximize value, most informed professionals agree that selling a privately held, mid-market business is not akin to winning the lottery. In most instances you will receive more money by continuing to own a profitable company forever than selling it today for a single lump sum. Business owners are sometimes initially dismayed when presented with an objective, professional valuation of their companies. Some exclaim, “I wouldn’t sell for that! I could earn that much in the next four years by continuing to own my business.” This is a powerful statement, however this reactive conclusion is typically reached after a rushed analysis that produces an inaccurate result.
An accurate financial analysis must begin with an objective comparison of the net after tax cash flows that would likely be available from your continuing to own the business, compared with the expected net after tax proceeds if you were to sell the business. It is key to consider the tax ramifications of each option since the income remaining after taxes is most relevant.
Selling a business is a big decision – and typically one that entails a reason beyond just money. The piece of mind of not bearing all of the risks by yourself, a lifestyle change, estate planning matters or net worth diversification can be significant motivators. It tends to be more of a lifestyle decision with a financial component than visa versa. Common factors include retirement, burn out, health issues, family matters, capital limitations, risk exposure or a blending of several issues.
You are the owner of Widget Manufacturing, Inc., a Company with $15 million in sales and $2 million in recast EBITDA (Earnings before interest, taxes, depreciation and amortization). You are 62 years old with no children in the business and no succession plan in place. The business requires about 55 hours of your time per week, and you have personally guaranteed both the corporate lease and credit line. The Company has experienced steady annual growth that should continue into the foreseeable future. Business is good.
You receive an unsolicited $9 million offer from a qualified acquirer from within your industry. Your immediate reaction is one of disappointment stating: “Why would I accept that when I could make more by running the Company for another 4 years”. But would you really?
The $9 million purchase price would be taxed at approximately 26% capital gains rate (including Federal and State) that would apply to the amount remaining after subtracting your cost basis in the business. Assuming your basis was $4 million and the balance was taxed at the capital gains rate ($5 million taxed at 26%), your taxes on the transaction would be $1.3 million, leaving net after tax proceeds from the sale of $7.7 million.
Conversely, if you retained the Company, you are paying ordinary income tax rates commonly exceeding 40%. The after tax earnings would be approximately $1.2 million and it is likely that a significant portion of the profits will not be available for distribution since it will have to be reinvested back into the business. This simplified analysis suggests that it would take at least 7 years of continued working involvement to generate the net sale proceeds of $7.7 million. This is considerably longer than the original 4-year assumption.
If you retain ownership your long-term profit may eventually exceed what you would receive in a sale, but as the Company grows so do the working capital requirements. As accounts receivable and inventory balances swell, the drain on cash flow can be substantial. Moreover, capital expenditures to replace aging equipment as well as the new high-speed widget fabricators that will be needed next year in order to keep pace with the competition will cost “a bundle”. It becomes apparent that a substantial portion of your earnings will be needed to fund current and projected operations and cannot actually be taken out of the Company. The profits that are generated, whether or not they are available for distribution, will be taxed at ordinary income rates, which are significantly higher than capital gains rates that would apply to the business sale proceeds.
In evaluating the $9 million offer, more than simple financial analysis is required to determine if it makes sense. If we assume that the net proceeds equate to working an additional 7 years, you will work another 20,000 hours until the age of 70 to net an amount comparable to that of a sale. You will also continue to assume all of the risks and responsibilities of ownership.
The sell option puts a safe and secure $7.7 million in your pocket after taxes. The “keep” option that initially seemed significantly more lucrative actually boils down to having to work about 7 more years to potentially generate a like amount. You might be saying to yourself: “even though it may take 7 years to make what I would of if I had sold, I still continue to own the business if I don’t sell it”. True, and along with that is the full load of intrinsic risks that go along with ownership, combined with your continuing to be consumed with your involvement in the day-to-day operations.
There is a fundamental cost of ownership that entrepreneurs know all too well. Legal exposure, personal guarantees, responsibility for employees and having the bulk of net worth tied up in one place can take a toll on any business owner. If earnings decline for reasons outside of your control or if adverse industry consolidations occur, it could have a major negative impact on the value and marketability of your firm.
Make sure your reasons for exploring the sale of the Company are sound. If the non-monetary motivations don’t stir your soul, now possibly isn’t the right time to divest. If you have all of the capital and strategic resources you need to grow, love the feeling of full ownership, don’t mind the inherent risks and your business isn’t “all consuming”, than perhaps selling is not the prudent decision.
When you are ready to sell, make sure your Company is as well. Too many business owners wait until growth slows and opportunities fade. The healthier the Company and the brighter the growth prospects, the stronger your negotiating position will be. Make sure you get the optimal value for your Company. Seek good counsel, including legal, tax and an experienced intermediary that can orchestrate the M&A process in a way that expands your alternatives, strengthens your position and maximizes your value.