profits to any offer he or she might consider. This article suggests such a simple comparison is not accurate. It is important to consider additional factors.
Let’s say you are the proud owner of Allstate Corp., a company with $25 million in sales and $4 million in earnings before interest, taxes, depreciation & amortization (“EBITDA”). Your business has enjoyed steady growth over recent years and you anticipate double-digit growth for the foreseeable future. Business is good. You receive an offer for $16 million and immediately say to yourself as you shake your head in disgust, “I could run the company for another 4 years and make more than that.” But would you really? That $16 million offered to you would be taxed primarily at the 20% capital gains rate, and even that tax would only apply to the portion above your basis. If your basis was $6 million and the rest was taxed at 20%, your after tax proceeds would be $14 million.
You say, “If I simply keep the company my projected profit figures should far exceed that.” But consider that as the company grows so do your working capital requirements. As Accounts Receivable and Inventory balances swell, the drain on cash flows can be surprisingly large. Moreover, capital expenditures to replace aging equipment as well as that new high-speed widget fabricator you’ll need next year will cost a bundle. You quickly realize that easily half, if not more, of the profits you were expecting cannot actually be taken out of the company. Instead, those profits are needed to fund current and projected operations.
Capital expenditures, new R&D to stay competitive, and increased working capital requirements in the aggregate can easily consume over half of your company’s projected earnings. Every company is different but each one has one thing in common – they all need capital to grow. As you apply this comparison to your own or some other particular circumstance, you’ll need to adjust it accordingly. But be careful not to underestimate future capital and operating cash requirements.
In keeping the business you visualize a future profit stream of $4 million growing at 10% per year for 4 years. That should total over $18.5 million, but with at least half of that going back into the company, there’s only $9.25 million left to distribute to shareholders. And here’s where it gets even uglier. Those profits along the way are going to be taxed at ordinary income rates. Whether Allstate is an S-Corp taxed on the full profit amount or a C-Corp forcing you to take an even more painful double tax hit, it’s safe to say you’ll lose about half of that $9.25 million to the IRS if not more.
Suddenly, that stream of future profits based on your initial comparison dropped from $9.25 million down to about $4.6 million over 4 years. And you haven’t even discounted it back to the present to account for the time value of money.
Consider this alternative, your option to accept a sale now puts a safe and secure $14 million in your pocket after making your contribution to the Federal budget. Your option to keep the business, which seemed so much more lucrative by initial comparison, eventually boils down to only $4.6 million in total cash that actually trickles its way into your wallet.
You might be saying to yourself, “Even though $4.6 million is a lot less then $14 million, I still have the business if I don’t sell it.” True, and along with that you have the full load of the business’ intrinsic risks in the future. There is a fundamental cost of ownership that entrepreneurs know all too well. Fundamental costs include, and are not limited to, legal exposure, personal guarantees, and having the bulk, if not all, of your net worth tied up in one wonderful yet vulnerable asset. The economy, terrorism, wayward employees, acts of God, and other potentially catastrophic events beyond even good management’s control can affect that one asset. The concentration of financial assets in one or a few investments can take a toll on the strongest of stomachs.
But there should be a reason to sell beyond the money. The reason may be your piece of mind for not bearing all the risks by yourself, a lifestyle change, estate planning, and/or net worth diversification. Whatever the reason, there should be something other than dollars to motivate you to explore a sale.
Make sure your reasons for exploring a sale of the company are sound. If these non-monetary motivations don’t stir your soul, then perhaps now is not the right time. If you have all the capital and strategic resources you need to grow or you simply love the feeling of full ownership and don’t mind the risks so long as you can reap all the rewards, then don’t sell. Wait until you are ready.
May I suggest that when you are ready, make sure your company is also groomed for its sale. It is smart to begin the grooming process at least one year in advance. Proper grooming with C.V. Lemmon & Co., Inc. allows you to negotiate from a position of strength and maximize your after-tax value.
Charles V. Lemmon is President of C.V. Lemmon & Co., Inc., a private M& A advisory firm in Dallas, Texas. Charles Lemmon can be contacted by telephone @ (214) 207-9694 or by e-mail at firstname.lastname@example.org.