In our discussions with business owners, not long after we learn about a company’s business model and its most basic financial metrics, the conversation turns to the topic of value. We ask the owner, “How much do you think your business is worth?” Or we ask the broker, “How much does your client want for it?” The answer is frequently a lot more than what we think we could pay for it. Admittedly, we do not always see as much value as the ultimate buyer does, but sometimes the entrepreneur is simply asking for much more than the business is worth.
Why?
Our experience is that there are many reasons for this bid-ask spread. For one, entrepreneurs tend to be more optimistic than most people and place more value on future opportunities than potential buyers do. Also, owners have strong emotional ties to their companies and have trouble putting less-than-extreme values on their “life’s work.” However, a less intuitive phenomenon that we see is what we refer to as “The Interest Rate Paradox.”
In the Interest Rate Paradox, the puzzling effect we see is that, after years of having nearly all their net worth invested in a risky, illiquid and smaller-than-micro-cap company, some entrepreneurs cannot bring themselves to sell their companies until the point that investing 100% of the after-tax proceeds in U.S. Treasury securities would yield enough interest income to fund their lifestyles. This paradoxical trap keeps them tethered to their companies far longer than necessary, with an illogical bias preventing them from selling.
It is true that, after (i) retiring and giving up a salary, (ii) paying off the company’s debt, (iii) paying capital gains taxes to the IRS and (iv) reinvesting the net proceeds in a lower-risk, diversified portfolio, a business owner should have lower expected cash flow. But over time, that cash flow should undoubtedly be more than the yield on Treasury securities.
Financial Planning
We encourage business owners who are considering, or are in the process of, selling their companies to work with a skilled financial planner to map out their future cash flows under several scenarios. Over the years, while we have seen sellers who, once they had done the analysis, realized they needed to keep the business for several more years, we have also seen owners who, once they realized that the proceeds would be more productive than they had anticipated, decided to take their businesses to market.
It’s not clear why some business owners become victims of The Interest Rate Paradox, but we can say that many are able to make much better decisions once they have worked with a financial planner.
Our sense is that it is simply human nature for someone who is facing the prospect of relinquishing control to seek extreme risk reduction. Since selling a company is one of the more emphatic ways to give up control, it stands to reason that, upon a liquidity event, some business owners will seek extreme reductions in the amount of risk they are taking. Said another way, entrepreneurs place incredible value on the control they have over the risks they face in their businesses. When they have to give it up, they sometimes no longer want to take any risk at all.
Bootstrap Capital
Bootstrap Capital’s principals are in tune with the Interest Rate Paradox and many other nuances of transacting in the lower middle market. In situations where a business owner is working through these issues, Bootstrap Capital is, at a minimum, a patient counterparty and, even better, frequently a constructive partner in helping him or her make an informed decision.