Here’s a business fact you might not know. According to Forbes, 80 percent of businesses never sell.

Those that do sell don’t go for the lofty multiples that many of their owners expect. In either case, it may be because the owner was milking the enterprise for income.

Your local colleagues in the area are milking it. How do I know? As an owner of Berkshire Money Management, a financial advisory firm guiding wealthy households with investment selection, increasing income, and avoiding taxes, I’ve tried to acquire competitors but to no avail. Often the deal didn’t work out because the owners thought their companies were worth much more than a reasonable acquirer would.

For example, in 2018, I tried to buy a Berkshire County-based investment company from Daniel, which is not his real name. Our conversation went something like this:

Allen: I’m happy we’re discussing how you can enter retirement by monetizing your business. If you’d like to, please stay on as you wind down your responsibilities. We both reviewed the professional third-party valuation of $881,000. I’m willing to offer a 20 percent premium to close this deal.

Daniel: Wind down? Shoot. I only work 16 hours a week as it is. I write off my golf games and “work” trips to Florida. Why would I want to sell at that price when I can sit back and collect my paycheck?

I couldn’t offer Daniel more money because he doesn’t have a business. He has a glorified job. Since then, assuming nothing changed, Daniel has pulled in $1.5 million of ordinary income compared to my offer of $1 million of capital gains payments. He came out slightly ahead, and all he had to do was work a couple of hours a day and expense his hobbies and vacations. That’s good for him; but unfortunate for the people paying his bills — if those clients even stuck around.

Daniel thought my offer was preposterous, given how easy his life was. However, Daniel’s clients were underserved. I would need to hire an additional financial advisor to do the work he should have been doing. And that made it less valuable to me.

It’s not uncommon for small business owners to not consider their replacement costs. Take, for instance, a local Certified Public Accounting practice I tried to buy in 2023. Tom, the sole owner and tax preparer, is looking to retire. Initially, I was interested in the company as a strategic investment, rather than a financial one. A strategic acquisition consolidates two complementary companies so that the aggregate is more profitable than the two on their own. However, the due diligence showed that it wasn’t a strategic fit. Tom’s clients had less sophisticated needs than what BMM had to offer.

So, I considered it for a financial acquisition. Could I buy the firm as an investment and earn an attractive return? Tom sure thought so. But he didn’t consider that there was a cost to replacing him.

Tom (also not his real name) contended there was $250,000 worth of cash flows from $600,000 of revenue. At an asking price of $585,000, that is attractive. But there was a math problem. Of the alleged $250,000 free cash flow, $170,000 was owner distributions. I’d have to pay another accountant $170,000 to do his job.

In this case, the free cash flow was not $250,000; it was $80,000 ($250,000 minus $170,000). Tom said the firm was priced at 2.34 times cash flow. He was actually valuing the company at a 7.3 multiple. If I were to give Tom 2.34 times $80,000, that would be about as much as his annual income.

Owners often believe their company is worth more than it is. After receiving what they consider a paltry offer, they may be tempted to continue milking it. For Daniel and Tom, the “Just Milk It” strategy appears sound on the surface, but there are some hazards to consider.

You shoulder the risk

The biggest downside of holding on to your business rather than selling it is that you retain all the risk. Uncertainties include labor shortages, growing costs, cybersecurity threats, and unforeseen health issues.

Most entrepreneurs have an optimism bias, but you need only remember how life felt during one of the four recessions in the last few decades to be reminded that economic cycles go in both directions. While business may feel good today, the next five years could be bumpy for many founders trying to pull cash out of the company.

Capital Calls

According to the 2021 Capital Markets Report produced by the Pepperdine Private Capital Markets Project, companies with $2-to $5 million of earnings before interest, taxes, depreciation, and amortization (EBITDA) will sell at a 5.6 multiple. Companies below $1 million of EBITDA are valued at a 4.5 average multiple. These are “real” companies, not milked ones.

Let’s say your business generates $500,000 in EBITDA, and you could sell your company for four times EBITDA or keep it. You could argue it’s better to keep it for four years, pull your profit out as dividends, and capture the same cash you would by selling it. This theory breaks down in capital-intensive businesses where there is usually a big difference between EBITDA and cash in the bank. If you must buy machines, finance your customers, or stock inventory, a lot of your cash will be locked up in feeding your business, and the amount of cash you can pull out of your business each year is a fraction of your EBITDA.

Tax Treatment

You may need to pay yourself $2 of distributions to match every dollar you receive from a business sale because of the favorable tax treatment you may get from transferring ownership. Of course, you only receive preferential tax treatment if you structure the deal properly. A higher net payout from a well-structured deal allows you to invest the proceeds to recreate the cash flow you would have received from milking it.

You’ve probably heard about one of your competitors selling for 6, 8, or even 10 times EBITDA. It’s adorable that they think that’s what they got. There’s a saying in mergers and acquisition,  “you tell me the price, and I’ll tell you the terms.” It’s what a sophisticated buyer says to themselves when dealing with a seller who thinks they are sophisticated. A big chunk of those big payouts is in the form of an asset sale, not a stock sale, triggering a higher tax rate to the seller and preferred tax treatment to the buyer.

You can do better

Finally, you can attract a better offer if you stop milking it. Both Daniel and Tom had been guilty of milking their businesses for income. They were negligent in building a transferable entity. Your business should provide you with a significant income — there’s nothing wrong with that. The irony is that if you only milk it for cash, you’ll stagnate its growth and limit the potential size of your future distributions.

If you build a real, transferable business that doesn’t rely primarily on you — and you don’t milk it dry — you’ll make a better income today and maximize profit at its sale tomorrow.

This article first appeared in the Berkshire Eagle on July 12, 2023.