SITTING PRETTY:  Sell The Firm Or Sit Tight?  A Formula To Help You Decide Where You Sit On This Issue

Leader's Edge, July/August 2004
Author:  Robert J. Lieblein

To be, or not to be: that is the million dollar question. Whether ‘tis nobler in the mind to continue managing the firm and suffer the slings and arrows of outrageous business fortune, or to take up golf, tennis and fishing and depart your involvement altogether.

To sit: perchance to dream: ay, there’s the rub.

With apologies to William Shakespeare’s angst-ridden alter ego Hamlet, of course, but the question remains: Are you better off to be selling or to be continuing to own the firm? Just where do you sit on this issue?

Today’s acquisitive marketplace has put the option of sales and mergers in front of many a broker. But if you’re making a good income and annual growth is in double digits, you might think selling now would be killing the cash cow. Not necessarily.

When you perform a detailed financial analysis, a concept we call “Monetize to Maximize,” you might determine the cash cow is not to be, but instead is producing skim milk. How can you answer the question?

For many owners the decision to sell or continue running the firm is made without fully understanding and contemplating the long-term cash flow after tax impact to the owners under either scenario. Most closely held businesses make decisions based upon short-term analysis rather than long-term financial planning.

The importance of determining a firm’s capacity to provide future earnings and cash flow to shareholders is a critical analysis that must be performed to weigh the benefits of continued operations versus a potential sale.

The accurate financial analysis of a potential sale compares projected growth and tax ramifications to an investment portfolio created from sale proceeds after taxes. Factors that could tip the scale toward selling include the tax differential on capital gains versus ordinary income, the present value of invested funds and the uncertainty of future market conditions, known as the “business risk.”

You must candidly project your brokerage’s growth rate over the next 5-10 years. Have you considered the financial impact of a softening or soft market and the possibility that your firm’s growth rate could flatten? Essentially, you would then be working harder while earning less.

Many owners closely track their growth rate and resolve to sell at the time it is cresting. Ask anyone on Wall Street how risky a game it is to attempt such timing in the markets. When you delay a decision to explore the sale of your brokerage, you bet the future on uncontrollable factors.

Taxing Issue
One of  the biggest factor in the sell-versus-own equation is the impact of varying tax rates. In 2003, the government presented brokerage owners considering sale with a 25% reduction in the tax liability when it reduced the capital gains tax. The new 15% tax rate on long-term capital gains can have a significant financial impact, especially when compared to the effective ordinary income tax rate for a high-earning individual—which can approach 40%.  Simply put, for every $100 dollars received you net $85 from a sale versus $60 dollars from operations. That difference adds up over time.

Many times, too, the acquiring company will desire, or insist, that the selling shareholders continue working for the business. Far from being a drawback, this offers great benefits. You can continue to earn income and stipends, and the sale has substantially reduced your personal financial risk by increasing liquidity and diversification.

If owners have most of their personal worth tied to their businesses, the timing of a sale may be even more crucial. In today’s competitive landscape, consolidation may be the only way to remain viable, especially in the middle and larger markets where competition is fierce. Also, alignment with a larger organization provides professional opportunities for a leadership role within a larger organization. The greatest benefit is minimization or removal of personal risk to the owner by achieving liquidity and diversification by selling the brokerage.

Currently, the leverage of the supply versus the demand curve favors the seller, but that dynamic constantly changes. As banks and brokers build distribution networks, the acquisition pace will inevitably level off as supply outpaces demand and leverage will switch from seller to buyer. In several years the price premium paid by banks compared to public brokers will likely disappear. The impending market stabilization of product rates (dare we say “soft market”) will result in very modest, incremental revenue growth, or even revenue declines, if you exclude new clients. Flattening revenues will result in elevated direct expenses and earnings deterioration. Because the valuation of a business is based upon historical and projected revenue and earnings trends, such leveling or decline will mean lower valuations for firm owners. This would be further exacerbated by shrinking demand among leading acquirers.

Finally, there is no guarantee that today’s low capital gains rate will continue. There is already speculation it will be quickly abolished if a Democrat unseats President Bush in November.

Monetizing
To weigh the options, brokerage owners must understand the concept of monetizing their agency versus continued operations. We refer to this a the “Steady State” analysis.

The analysis provides the brokerage owner with a comparison of the present value of the free cash flow after tax that can be earned by the agency’s shareholders over a specific time period by continuing current operations and selling the agency at the end of the specified time period versus selling the agency today at an estimated fair market value and reinvesting the sale proceeds. We refer to the continued operations of the agency using the term “As Is” model. We refer to the sale of the agency today using the term “Sale” model.

Critical to both analyses, are various assumptions:

• Projected growth rates over the next five years.

• Cash compensation, including salary, commissions, and bonuses, to be received by the shareholders over the next five or 10 years under both the As Is and Sale model.

• Determination of adjusted or normalized EBITDA (earnings before interest, taxes, depreciation and amortization).

• The appropriate market multiple to determine the estimated sales price of the agency both now and at the end of a selected time period (e.g., five years).

• Projected reinvestment requirement.

• The appropriate ordinary income and long-term capital gains tax rates.

• Calculation of an appropriate discount rate on future cash flows.

• Investment income (rate of return) on proceeds received from the sale of the company.

To effectively evaluate the assumptions, several scenarios should be modeled. For instance, assume growth rates of 5%, 10% and 15%. Although some firms show double-digit growth rates going back a number of years, it is not wise to assume those healthy rates will continue forever. Finally, it is best to model several possible sale dispositions, such as the agency selling for 7.5, 8 or 8.5 multiples of EBITDA. These variables will balance the overall impact of market conditions, and thus provide parity in the overall comparison.

In the end, each model will calculate the present value of the total cash flow after tax that can be earned by the shareholders.  The comparison of the present value of the total cash flow under both models provides the shareholders with a “benchmark” as to the financial benefits of continuing operations versus selling today. The last critical step is to further analyze both models to determine the growth rates that are necessary to calculate “breakeven points” of free cash flow between the Sale and As Is model.  

Pulling It All Together
While the Steady State analysis is subjective to the many assumptions that must be considered, we have found that over the years, owners have found this to be an invaluable tool in providing them with the financial insight necessary to make the right decision.  Based on our experience, many analyses show the wisdom of selling the agency, while some might show the opposite. Every analysis provides different results. Many times, the shareholders are better served by continuing operations. There is one guarantee that we can make and that is, the Steady State analysis is bound to open eyes and raise many questions about existing strategies and the long-term risk and rewards of selling the business versus continued operations. The lesson before embarking on either path is to make sure that you truly understand the financial impact of either scenario and that decisions you make must consider long-term financial planning versus short-term gratification. Only then can a sound decision be reached: milk that cash cow, or put it out to pasture. Even Hamlet would feel at ease sitting through this exercise.

Monetize to Maximize: The Steady State Analysis
The Answer: Evaluate “As Is” v. “Sale”

To show a simplified calculation of the Steady State analysis, we have used a real life scenario to illustrate the model.

Background Information
ABC Brokerage has been a growing, profitable agency and currently generates EBITDA of $6.6 million. There are three shareholders with an age range of  42 to 60. Due to the age differences and financial objectives of the shareholders, there was a disagreement about what to do with the business, so they performed a Steady State analysis to evaluate succession planning.

As-Is Model
In our baseline scenario, management expects a growth rate of 10% and a market multiple of 6.75 times EBITDA after five years. Other relevant factors are reinvestment in growth initiatives at 20% of earnings, and a discount rate of 18%. The net present value of all future cash flows was $42.5 million if the business remains As Is.

Sale Model
For the Sale Model, we assume the same market multiple of eight times EBITDA, which resulted in a total purchase price of $52.8 million. We assume two more key elements: the principals stay with the business for five years after the sale (at an initial compensation of $400,000 that grows 10% annually), and the investment rate for the proceeds from the agency’s sale is 5.10% (pre-tax). The result of this model shows the present value of all cash flows to the principals—through sales proceeds, investment portfolio income, and net compensation—to be $57.4 million.

Conclusions
In this situation, the net benefit of selling versus continuing is $15 million. In fact, in this case it would take a sustained 18% annual growth rate for the numbers to tip in favor of continuing operations rather than selling (the break even point).

What really happened? The younger shareholders concluded they would prefer the life style issues associated with owning and operating the business instead of reaping the rewards of a sale. They bought out the older shareholder. The right answer? Financially, no. However, it depends on the emotional and personal decisions that accompany selling your firm.