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MANY people believe that selling their family business is the crowning accomplishment of their career. The sale crystallizes the value that has been created by running the business over a lifetime — or several generations — and it lays the groundwork for a comfortable retirement and maybe generations of family wealth.
To be sure, there are times when selling the family business is the right decision for a variety of reasons:
- Perhaps business logic dictates so — your business’ difficult competitive position is not apparent yet to others, and you can’t fix on your own);
- Exogenous factors such as political uncertainty beyond your control;
- Personal reasons such as unresolvable family tensions;
- Or having all your eggs in one basket, and for many, an illiquid basket at that, is risky.
But people underestimate the risks of selling and overestimate their ability to make money in the financial markets afterwards. I’ve seen it time and again with families that I advise during times of transition and to whom I teach wealth management.
It takes as much energy and skill to maintain wealth as it takes to build it in the first place. This is true whether you continue to own your business, or you sell it and invest the proceeds in the stock market. And business owners often find that trading a business asset for a financial asset simply trades a set of familiar problems with ones that are new but no less challenging.
Usually I work with families after they have sold their businesses and are struggling to manage these unfamiliar problems. It’s too late for them to engage in a detailed exploration of the pros and cons of selling. When our family sold Carnation Company over 30 years ago we didn’t accurately assessed the challenges either. With the benefit of hindsight and experience, here are five reasons why you should think twice before selling.
Reason 1: You will probably make less money.
Wealth creation from business ownership is generated from earnings growth, profitability, and cash flow. Many business owners in Asia expect 15% or higher annual growth from their business. These same people tend to gloss over the fact that since 1971, global stock markets have grown a much lower 8.7% per year (in US dollars) and will likely grow more slowly than that over the next 20 to 30 years.
In fact, after fees, the average private investor in stocks has performed substantially worse than that. Even large, sophisticated family offices are challenged to beat the market indexes. While my crystal ball is as foggy as it’s ever been, there are sound economic reasons to expect this pattern to continue.
Some people who sell their businesses and are dissatisfied with the lower returns from financial markets decide to become “angel investors”, sprinkling their money into new business ideas. They hope to establish an inside track on talent and information, piggybacking on the good ideas and hard work of others as a means of increasing their rate of return.
But, a 2015 study by professors Steven Kaplan, Robert Harris and Tim Jenkinson, published in the Journal Of Wealth Management confirms that the median venture capital fund does worse than the public market, with a lot more risk and variability of outcome.
Furthermore, they showed that a small number of seasoned players generated most of the good returns. Newer entrants have a much tougher time generating decent results. This is not an area for inexperienced players to be taking large bets. I’ve heard too many horror stories about fortunes lost by business owners turned angel investors to advise otherwise.
If your business is strong and resilient, staying in the business may create substantially more value than investing in financial markets. If the business can generate excess cash flow, use it to diversify your wealth away from the core business and to learn about investing in financial markets.
However strong your business is, the future is uncertain and a reserve for tough times could come in handy and it will help you sleep better. You will also be better prepared for the day you do decide to sell.
Reason 2: You relinquish your expertise.
If you trade in your business for cash, you trade your position as the expert — the one who knows more about their asset than anyone else — for a position as an inexperienced client in someone else’s industry.
Your advisor, your investment managers, your banker will know much more about their business and your investment portfolio than you do. They have conflicts of interest that are tough to manage, even with the best of intentions. Furthermore, there are a lot of very smart, highly experienced, ambitious investors who are competing against you to add value.
And, in the investment world, as in most industries, the devil is in the details. You may never have been the “mark” at the poker table, but as a new guy in the investment world, think again.
Reason 3: The leverage is riskier.
Leverage in a business is different than leverage in financial assets. A lender evaluates a business’ assets and its cash flow to determine the size of loan it will offer. Asset values and cash flow goes up and down with the fortunes of the business, but the business’ management has significant control over its health. Furthermore, if the business situation deteriorates you enter into negotiations with your lender. The process is dynamic and you have a lot of influence to enhance your ability to maintain control of the business in tough times.
Banks don’t want to own your business.
When you borrow money to finance the purchase of financial assets, the inherent asset value of the underlying businesses, and the cash flow they generate, do not determine the value of your collateral. The lender is only concerned with the mark-to-market value of the security, determined by the marginal buyer and seller of a few shares of stock.
You have no control over stock market pricing. And if prices drop below the level that your lender dictates, and you don’t immediately put up more collateral, they simply seize and sell your assets until their requirements are met. If there is to be any negotiation, that happens after the fact. It’s a different mindset, with different contractual obligations.
Reason 4: You’re a novice investor.
Your training and intuition as a successful entrepreneur or executive have NOT prepared you to be a successful investor. Building businesses creates wealth for the owners, but also for suppliers, employees and often customers too. In contrast, investing is a zero sum game. To outperform in the market you have to take that value added away from someone else.
As a business owner you are used to riding your winners and culling your losers; successful investors often do the opposite.
Success in business is persistent and builds momentum; the returns of financial investments tend to revert to the mean. As a business owner, you are used to taking action when times are tough; successful investors understand the value of riding out the difficult times, often doing very little until the climate improves. (Warren Buffett says he sometimes wishes he spent more time at the movies.) Lots of people see the value of their assets fall and they sell just as the market starts to turn up again.
You have developed information systems and intuition to measure your business’ performance, enabling you to see impending problems early and to respond quickly. It’s hard to get the same quality of management information for your financial assets. Data flow in financial investing is overwhelming and only a tiny fraction of that information is actionable in a way that makes you money.
Furthermore, disorganized data tends to play on emotion and confuse rather than educate. In my investing I try hard to tightly control the quality (and quantity) of information, focusing on that which is most relevant for long-term decision making. It is easier said than done.
Reason 5: You’re risking your family culture.
Selling the business will have a major impact on your family’s culture. A Latin American family I work with speaks of the family’s heart being ripped away when the business was sold.
The business, particularly if it has thrived over several generations, gives definition, a source of pride, and a raison d’etre for your family. Time and again, I have seen examples (including in my own family) in which the sale of the business causes family ties to weaken.
The effort required to counteract that centripetal tendency is enormous, and requires a heavy educational component. Working in a family business, it is relatively easy to “walk the talk” of hard work and the value of success (as opposed to wealth). That changes when the business is sold.
For whatever reason, spending becomes harder to control when your primary occupation changes from running the business to managing your investment portfolio.
So, what can you do with the family business?
The key is to recognise that diversifying and selling are two different things.
If you sell, consider using some of the proceeds to buy and operate new businesses that you understand.
If you haven’t sold, maybe your family business generates excess cash flow that can be redirected, financing expansion into new geographic locations, different products or new types of customers.
Alternatively, you can deploy your family business’s excess cash flow into financial markets. Invest in assets that are not correlated with the success of your primary business. This will give you diversification, greater liquidity, and the opportunity to gain experience managing a small portion of your wealth in financial assets.
Take this opportunity to learn about investing and about the wealth management business, its attractions and pitfalls. Consider going the simple route of broadly diversified, low-cost indexing rather than the alluring but much more challenging world of active management.
In any case, learn how you can structure your financial advisor relationships so that they earn your trust through fact based accountability rather than hope. All of this will considerably lower the risk if and when you do decide to sell your core business.
Hope is a wonderful attribute but a poor substitute for demonstrated expertise when it comes to managing your patrimony.
Stuart E. Lucas is the Chairman of Wealth Strategist Partners, LLC, an outsourced Chief Investment Officer for wealthy individuals and families including his own; author of the acclaimed book Wealth: Grow It and Protect It; and Adjunct Professor of Finance at University of Chicago Booth School of Business and designer and lead faculty member of their Private Wealth Management executive education programme. In addition, he is a fourth generation heir to the Carnation Company fortune.