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October 11, 2022—Business owners who strive to enhance business value may grapple with how much cash they should reinvest in their companies versus how much to pay themselves. Often, knowing how to strike this delicate balance can influence the future value of the business. In this podcast, National Director of Business Value Strategies Stuart Smith of Wilmington Trust Emerald Family Office & Advisory® discusses the trade-offs business owners make every day, reminding them that “you don’t get it twice.” 

Emerald GEM Formatter

You Don’t Get It Twice – Balancing Business Owner Cashflow and Business Value

Hi, thank you for tuning into today’s Emerald GEM, which stands for Get Educated in Minutes. I’m Stuart Smith, National Director of Business Value Strategies for Wilmington Trust’s Emerald Family Office & Advisory® and your host for today’s podcast. In today’s GEM I’m going to answer the question:  Why shouldn’t a business owner maximize distributions?

In March 1538, Thomas Howard, 3rd Duke of Norfolk, became a “proverbial” superstar when the highly influential nobleman wrote a letter to King Henry VIII’s chief minister. The contents of that dispatch were historically mundane, except that it contained the first known writing of the popular truism: “You can’t have your cake and eat it too.” *

For generations that have followed, the duke’s turn of phrase has perfectly crystallized a fundamental economic concept of the trade-off. We understand the phrase because we regularly make trade-offs. Sometimes, though, we miss their deeper ramifications.

Each day, life presents us with choices—some are unquestionably significant, others can be downright immaterial. Most of us think long and hard about big financial choices. Want a bigger apartment on your current income? You’ll likely need to cut other budget items to afford the higher rent. Would you love to buy a fully loaded car? You may do the math and opt for a more basic model.

Those trade-offs principally hinge on monetary cost, but other considerations can play into our choices. Suppose you’re stopping by your favorite convenience store for a fountain soda on the way home. There are plenty of identically priced options, so cost differential isn’t a factor. You’d really like to treat yourself to the regular cola, but you’re watching your weight. Do you buy the tastier sugary drink or go with the diet version? You have a trade-off decision to make.    

For business owners, trade-offs are often an inescapable, constant reality. A given day’s choices might include approving a capital outlay, charting strategic direction, or setting corporate policies and procedures. Some choices won’t have clear monetary costs, but the vast number could influence business value. That leads to the ultimate trade-off: reinvestment or distribution of the cash that the company has generated.

As an advisor to entrepreneurs for many years, I can confidently say that too many missed the subtleties of this trade-off. Of course, while they all generally reinvested in their businesses, most tended to prioritize cash distributions over reinvestment. To be clear, there may be nothing wrong with that. It’s perhaps the primary benefit of ownership, but it comes with a catch. All things being equal, the reinvestment-minded owner is likely to garner a higher exit valuation for their business because their consistent discipline has made the enterprise more transferable, more predictable, and more sustainable. Buyers generally pay up for those key attributes, so it’s important to bear some key lessons in mind:

  • The transferability lesson: Too many entrepreneurs try to do it all. They make all the decisions. They limit hiring (particularly at senior levels). They fail to emphasize robust systems and procedures. In the near term, those choices may yield more distributable cash, but there is usually a downside. Failure to invest in people and processes may make the owner indispensable—if the owner leaves, business value may suffer. That outcome could be avoided by building and engaging a multi-disciplined team, delegating authority, implementing good systems, and developing repeatable processes. These investments may slowly reduce the current owner’s importance to the operation and make the business more easily transferable to a future owner. This sort of “turn-key” operation is generally far better positioned to maximize business value than an owner-dependent one.
  • The predictability lesson: Predictable cash flow is often a cornerstone of value maximization. Think of software companies. They typically trade for higher price/earnings ratios than most other sectors because their license-based revenue models and high switching costs “lock in” highly predictable future cash streams from a broad base of customers. I’ve also seen the flip side in a highly profitable contract manufacturing business. Significant distributions supported a great lifestyle for the shareholders, but purchase offers were disappointing when they sought to retire. The problem: over 60% of sales were to one customer who could easily switch to other providers. Consequently, the owners enjoyed current cashflow, but buyers couldn’t depend on future cashflows. Opting for lower distributions and directing cash toward new customer development could have diversified the company’s revenue stream, boosted cash flow predictability, and spurred investors to more appealing valuation levels.
  • The sustainability lesson: Many years ago, I advised a transportation company on a potential sale. A clearly articulated niche strategy and peer group-leading profitability attracted many potential buyers, but passions cooled when they figured out that the company’s fleet was meaningfully older than the industry average. The reason: The seller valued cash distributions over fleet reinvestment. The result: The business didn’t fetch the top-of-the-market valuation the seller coveted. Buyers estimated the cash outlays to update the fleet and reduced their valuations accordingly. If she had lowered distributions to fund more regular fleet investment, the owner could have enhanced the sustainability of the company and perhaps achieved a higher valuation.

So, where do these lessons leave us? Early in my mergers and acquisitions career, I worked with a senior banker whose mantra to entrepreneurs was, “you don’t get it twice.” This simple yet profound advice was rooted in a bedrock truth—growing business value is often an investing activity. When owners pick their spots on the spectrum between distributing cash or reinvesting in their business, the truly wise ones take care that they are not diminishing future business value as they reward themselves today. They intuitively hear the Duke of Norfolk—and they may be the richer for it.

Thanks again for joining us today. Please contact your Wilmington Trust advisor if you have any questions about the choice between taking cash distributions and reinvesting in your business. We would be glad to help you. See you next time!

* Source: IDIOMS: YOU CAN’T HAVE YOUR CAKE AND EAT IT | Speakup Blog (speakuponline.it)

Wilmington Trust Emerald Family Office & Advisory™ is a registered trademark and refers to wealth planning, family office and advisory services provided by Wilmington Trust, N.A., a member of the M&T family. Wilmington Family Office is a service mark for an offering of family office and advisory services provided by Wilmington Trust, N.A.

The information provided herein is for informational purposes only and is not intended as a recommendation or determination that any tax, estate planning, or investment strategy is suitable for a specific investor. Note that tax, estate planning, investing, and financial strategies require consideration for suitability of the individual, business, or investor, and there is no assurance that any strategy will be successful.  

Wilmington Trust is not authorized to and does not provide legal, accounting, or tax advice. Our advice and recommendations provided to you are illustrative only and subject to the opinions and advice of your own attorney, tax advisor, or other professional advisor.

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