Business Owner: Are You Buying Your Job?

Balaji’s Food For Thought - Aug 2, 2016

Author:
Balaji Krishnamurthy
Subject:
Strategy

First off, let me warn you that if you are a business owner, this article might hit too close to home. But please understand, no offense is intended. Just like with my previous articles, I’m simply attempting to provoke thought. Here’s a preview of what I’m going to say: Many small private companies do not provide an adequate return for the owner to financially justify owning the company. They would be better off selling the company. So why don’t they do it? The owner is too emotionally attached and their life is too intertwined with the company. With that preview, let’s build the argument from the ground up.

Owners of small to medium-sized businesses tend to view their business’ success based on the profitability of the company. How profitable should your company be? For some, “profitable” might be a reasonable answer, while others might demand it be “very profitable.” How profitable is profitable enough? More financially savvy owners might seek a return on assets or a return on equity. There too you have to determine a rate of return on that underlying investment. What rate of return makes sense? I argue that you should seek a return on market capitalization.

First ask yourself, how much can you get if you were to sell your company? To keep our calculations simple and our numbers relevant, let’s say you could sell your company for $10M. So, on January 1, you could have sold your company and pocketed the $10M. Assume you did just that. (If you’re a persnickety reader, please try to ignore the tax implications.) Being the entrepreneur that you are, you immediately invest that $10M into a company that you buy — your own company! However, being prudent, you pocket $2M for diversification and borrow $2M at an attractive 5% interest rate to make up the full $10M. So, now you have $10M invested in this company, $8M of your own money and $2M of borrowed money. Clearly, you should seek a return on that investment commensurate with the risk that this investment entails. What rate of return should you seek?

To illustrate how risk and return are related, we use a half-baked idea courtesy of my colleague, Think Shift CEO David Baker. Suppose I decide to start a new business wherein I bake cookies, but I only bake them halfway. Every morning I deliver these half-baked cookies to all the convenience stores, who then bake them the rest of the way. People who come to the convenience stores for their coffee in the morning will be tempted by the wonderful smell of the baking cookies, and my business will flourish. I ask you, “Would you invest in my company? And, if so, what rate of return would you demand?” Naturally, you have much concern about my half-baked idea. Even if you are interested, you would expect a high rate of return. While you would have settled for a 10-15% return on a mutual fund investment in the S&P 500 index, you would be demanding a return of 50% or more in any contemplated investment in my venture. Your expected return represents the collective risk you estimate in this investment. The risk is not just the market viability of the half-baked idea. It also includes my ability to execute and the risk of building the infrastructure for execution. The risk further includes the fact that I am a small company, that I will be susceptible to the swings of a local market and not a global market, that it is an illiquid investment, that it is an equity investment and not a debenture, so on and so forth.

So, what kind of a return should you expect in the business you just bought for $10M? Wall Street calls it WACC – Weighted Average Cost of Capital. Most small businesses are financed by a combination of debt and equity. WACC is the weighted average of the cost of the debt and the cost of the equity. The cost of the debt is usually pretty clear — in our case, $2M at 5%. But what is the cost of our equity? In other words, akin to the half-baked investment, what return should you expect for your $8M investment in your company? The going rate of return on risk-free investment, often known as the prime rate, is about 3%. This simply represents time value of money and is usually indexed to inflation. Equity investment in blue-chip, large, publicly traded companies should yield an additional 10% or so. When you move away from blue-chip companies to other large, but not “shiny” companies, your risk goes up, and you might expect an additional 5% or so. When you move away from publicly traded companies to privately-held companies, even if they are large, the illiquidity adds additional risk that might cause you to demand an additional 5%. On top of that, if the company is small, that adds another 5% for the additional risk. Add it all up and it would be reasonable for the cost of equity for any small private company to be in the range of 25-30%. For private companies in the tens of millions of dollars, 30% might be a good number to use for cost of equity. So, your WACC is computed by averaging $8M of equity at its cost of 30% and $2M of debt at its cost of 5%, arriving at a figure of 25%.

Does your company provide a return to the shareholders at a rate of 25%? That would be $2.5M! How does a company provide a return to shareholders? In three ways: distributed dividends, retained earnings and appreciation of equity. (If your company is not a US C-Corp or a similar structure, you might need to adjust some of the considerations here.) The sum of those three parts must add up to $2.5M or more. Otherwise, you would have been better off to have sold the company for $10M at the beginning of the year. And, if you do deliver the $2.5M of value, now the valuation of your company has gone up from $10M to (say) $12M. Assuming you have paid down $500K of your debt, the company’s $12M valuation is being funded by you and the bank — $10.5M by you and $1.5M by the bank. The WACC then becomes 26.875% on a valuation of $12M, requiring you to return $3.225M the next year. In other words, the better you perform, the more valuable your company gets, the larger your portion of equity funding the company, the higher the WACC and the more you have to return.

It is very tempting to argue, and many owners do, that even though you have not delivered that value, your company is poised to do that and better in future years. If that is really true, then your ending valuation of the company should reflect that, and your equity would have appreciated commensurately.

Do all small private companies provide that kind of return? After running public companies in corporate America for 25 years, I’ve spent the past decade focusing on helping CEOs of private companies. I have spoken with about 5000 CEOs in the last ten years and have worked closely with a few hundred of them. I am surprised to find that many would not pass the above test. They do not provide a WACC rate of return.

So, why do they continue to run the company? Reminding you that I tend to be provocative, here is my analysis of why they continue to hold on to their company.

The owner, who is often the founder/inheritor of the company, is, typically, also the CEO. The owner’s identity is inextricably linked to the company. The owner likes the lifestyle. If they sell the company, will the owner be able to find something else to do that is more lucrative? And would it be as much fun and secure as their current job? Would they have to work for somebody else? Can the owner work for anybody else? Does he or she want to? Besides, as the CEO of the current company, the owner gets a lot of perks. Your vacations can be planned to your liking. You charge many of your meals and expenses to the company, not to mention the thousands of dollars of value in the airline miles you get from all of the company expenses being charged to your credit card. And, the list goes on.

Do all these perks add up to the deficiency in the rate of return? Usually not. But there is the emotional satisfaction. In other words, the owner has bought himself or herself a convenient job in exchange for a lower return. If so, the owner needs to be intentional. The owner must acknowledge how much he or she is paying for that job.

So what should you, the owner, do? Here are some ideas:

  1. Compute your WACC. Assume your cost of equity is 30%. Blend it with the cost of debt and compute the weighted average.
  2. Estimate the enterprise value and the market value of your company. If you need help, reach out to your banker, your financial consultant or reach out to us. Although we are not a financial consulting company, we will help you think through it.
  3. Determine if your current performance delivers full WACC return. If so, familiarize yourself with what that does to the valuation of your company in the next year and the kind of return you should expect then. This will give you a good feel for the financial health and prosperity of your company.
  4. If not, you should do the following two steps:
    1. Compute the difference between what your company is delivering now and what the WACC rate of return requires you to deliver. That is what you are paying to have your job.
    2. Compute a valuation for your company at which the current performance of the company would represent a WACC rate of return. That valuation should be the threshold you use when considering any offer made for your company.

We all do things for the love of life rather than the love of money. There is nothing wrong with that. But you should be intentional about why you have chosen to do so and how much it is costing you. Awaken to the power of intentionality.