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ALTMAVEN'S INSIGHTS SERIES
Should I Stay or Should I Sell?
By: Jason Kirsch
May 21st, 2021
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As financial markets climb to new highs, the astonishing pace at which companies around the globe are being bought and sold parallels this traction. The frenzy of activity finds many founders wondering – "is now the time to sell my business, too?"
As entrepreneurs come to Altmaven with this very question, our first response remains the same - "why do you want to sell?"
A host of reasons have been named, as varying as the individual situations these founders find themselves in. "Valuations are so high," "taxes could increase," "I'm burnt out," and others.
How a founder answers this seemingly simple question offers initial guidance as we work through the discovery process which follows. With a multitude of nuanced factors to be assessed, every situation is unique. There are of course common elements to consider when debating if the timing is ripe for an entrepreneur to sell – right for themselves, their families, employees, and supporters.
Selling your company, the business you've thoughtfully built with determination and endurance is not an easy decision to reach. Logic and emotion both play a role. Hopes, dreams, legacy, aspirations, "what ifs," and "what's next" all come to the forefront. Founders often share that their companies become part of their identities. It can be anything from a rough day in the office ("why am I doing this?") to a surprising amount of investor interest as you raise capital, or perhaps the success story of another company, which gets the wheels turning. It may be that the rapidly changing reality of our world has you considering other opportunities. Regardless of how you've reached this self-inquiry, there are several considerations you can take into account as you pause, step back and reflect.
Take it to the Bank
Valuations of technology startups are at record levels not seen since the dot com era, leaving many to wonder if the right time is now to cash in. Okta paid ~30x sales for Auth0, Salesforce acquired Slack for 25x revenues, Vista Equity Partners purchased Pluralsight for $3.5B (~8x sales), and Wattpad sold for more than $600MM. For comparative purposes, the Nasdaq 100 is trading at a valuation not seen in nearly two decades. Looking at the landscape of private companies, the value of US VC Exits reached $290B in 2020, up an astonishing ~800% from $33B in 2006.
The price tags are getting larger, with more at stake than ever before. As the incumbents look to invest in new growth areas, inbound interest is high for even smaller tech startups. Entrepreneurs are seeing their peers sell for astronomical sums, wondering if they, too, could accomplish the same. As a first step, explore all your options. Don't simply take the first term sheet offered without shopping around. If you were selling your house, chances are you would want multiple bids to evaluate. All too often, we see founders rushing to sign the first term sheet they see. This is an important "pause" moment in the journey. It's imperative to undergo an auction process, generating healthy investor interest with the potential for a higher sale price.
'Cause I'm the Taxman
While valuation is one component in determining what you'll net from a sale, the looming threat of higher corporate and capital gains tax warrants further deliberation. Following a flurry of Canadian and US government spending, the question remains – who will pay for all of this? Rumoured changes to the tax code could include increases to the capital gains tax, directly impacting the amount of money you will net in a sale.
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In Canada, the government currently offers a substantial tax break for owners selling their small businesses.
Each Canadian has a Lifetime Capital Gains Exemption of $892,218 – in other words, when you sell your business, any capital gains up to that amount goes right into your pocket, tax-free. Everything above that exemption, however, is taxed at the capital gains rate of 50%. In the US, the capital gains tax is 20% (or 23.8%, including the surtax on net investment income) at the federal level. However, many are worried that the capital gains rate could increase to 39.6% (or 43.4%, including the surtax) by as early as 2022.
Let's break that down. Imagine you are selling your business for $10.0MM. Net of the 23.8% tax rate, you would take home $7.6MM. Under the new tax proposal, you would have to sell your company for $13.5MM (a selling price 35% higher) to make the same amount of money. How many years of work does that equate to, and is the trade-off worthwhile?
But I Want my Marshmallow Now!
Selling a company can be very satisfying, but what if you waited just a little bit longer? In a 1972 experiment by Stanford professor and psychologist Walter Mischel, children were offered a choice. They could have one marshmallow now or two marshmallows after 15 minutes. Some consumed the marshmallow immediately. Others licked the marshmallow to see if it was real. Many sat content, waiting for their second treat.
Researchers followed up with the children years later, drawing fascinating and surprising conclusions - children who managed self-control, waiting for the second marshmallow, had better life outcomes than those who didn't. They had higher SAT scores, lower levels of substance abuse, lower obesity rates, better responses to stress, and more.
It appears that being able to delay gratification is correlated with better personal and social outcomes. The question is, have you waited long enough?
In another study at the University of Rochester, the researchers split the children into two groups. In the "unreliable experiences" group, children were given a small sticker with the (unfulfilled) promise to be awarded more later. Next, they gave the same group of children a small box of crayons and told them that they would be getting more in a few minutes. The children, left waiting and wanting, were soon to be disappointed. Conversely, in the "reliable experiences" group, children were promised better stickers and more crayons and received them.
What's perhaps not surprising is what came next, as the same marshmallow test followed. In the unreliable group, the children ate the first marshmallow without plans to wait for the second. Children in the reliable group waited patiently and were rewarded. Our past experiences will often dictate our expectations.
Is a Bird in the Hand Worth MORE than Two in the Bush?
Children aren't born with self-control, and neither are we. Experiences and the environment have an impact on one's ability to show restraint. Our past is more likely to portray a history of unreliable experiences, giving rise to questions about whether it is worthwhile to wait.
Theories supporting the benefits of both delayed gratification and self-control in business come up often. As an entrepreneur with thoughts of selling your business, the marshmallow sits in front of you today. Several factors bear an impact on how many marshmallows (ahem, money, other benefits) you receive – so many factors, in fact, that you may never be sure you have all of the information. Understanding that there are "unknown unknowns," however, will leave you well-positioned to make aptly informed decisions.
The Headline Number is Never as it Appears
The sale price of private companies reported in newspaper headlines can often be misleading. Deals can include shares, a vendor take-back (when a seller offers a loan to the buyer, paid back over time with interest), or a portion of the deal could be cash (with the balance based upon performance incentives, also known as earn-outs).
When Patrick Mahomes signed with the Kansas City Chiefs, the headlines shouted, "10 years, $503MM." Quite the payday! Digging deeper, we know that only approximately 30% of his pay, ~$140MM, was guaranteed.
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In football, as in business, the guaranteed number always matters most. When you sell, the acquirer may want you to stay on board for a year or more to maintain a smooth transition. They may even expect you to achieve challenging financial targets. Ask yourself, if I would do it for them, why not just do it for myself?
Second Time's a Charm
Maybe you believe that you can do it all again. The knowledge accumulated, wisdom earned, and fresh perspectives could make "the next go" at a startup much more manageable. Consider, however, the findings of a 2013 study, "Practice Makes Perfect: Entrepreneurial-Experience Curves and Venture Performance." Second-time founders do not consistently achieve financial performance on their next company, particularly when the area of focus changes. Don't assume that you can repeat with the same success. Remember how long you worked, the difficulties you had along the way, and even the lucky occurrences that led you to where you are. If one thing is true, it's that nothing is for certain.
What Are You Trying to Accomplish?
It's important to come back to the basics. Why did you start this company? What problems were you trying to solve, and have you solved them? Was your intention to build the company and sell it after reaching a certain milestone?
It's important to know what you want to do and why you're doing it. Defining your purpose acts as an anchor, helping to guide this critical decision-making process.
Conjure up the Olympian's mindset - every decision you make should have a precise goal in mind and results benchmarked against your objective. What should I eat? How much sleep should I get? How should I train? Every decision is made with one goal in mind. The same is true for your business - your North Star acts as a single, clear, definable purpose based upon which all decisions are made.
Divestiture Aversion
As a child, playing Pogs was a fascination. While my friends and I also liked trading Pogs, I struggled to give one up to acquire a new one. In my hands, the Pog had a higher value to me than if someone else had the same or similar Pog. The simple fact that I owned a Pog made it more valuable to me. What I didn't know then fascinates me now – I was emotionally biased by the aptly named endowment effect.
Nobel-prize-winning Behavioural Economists Richard Thaler and Daniel Kahneman argue that humans are inherently loss-averse. In other words, we prefer to avoid losing as opposed to gain an equivalent amount. In their experiment, Thaler and Kahneman split participating undergrads into two groups. Half were given coffee mugs. When both groups were asked to estimate the buying price of coffee mugs, the group without mugs was willing to pay $2.75, whereas the students with the mugs were ready to sell for no less than $5.25. The study examined fascinating human behaviour whereby the possession of the mug inherently changed its perceived value.
In negotiations, the consequences of this coffee mug bias will cost you more than a cup of joe. The ability to rationally step back and reflect on the value of your business to the market rather than to oneself is an essential step in contemplating an exit. The good news is that when a sale is prepared correctly, everyone wins. As the owner, you will get a fair price for your business, and investors in turn own an asset which will yield a return in exchange for the risk they are taking. It's not a zero-sum game.
Know Who You Are Dealing With - Your Counterpart
An underestimated aspect of the sales process is knowing whom you are selling to. Buyers undertake extensive due diligence in understanding your business, and a founder would be remiss not to do the same. Who else have they worked with? Speak to as many references as you can - even names that they didn't give you. Examine their past deals. Ideally, speak with their investors and employees, past and present. Hand over the castle keys to worthy hands. When acquisitions go well, everyone is happy. But should things go awry, you want to know in advance who your partner could become.
This is the End
Your business is meaningful to you, as well as to the people who rely on your company for their livelihood. Family, money, relationships, health, and passion will all impact your decision. Armed with an astute awareness of all the factors: the market environment, your financial situation, your biases, and who you are doing business with, plus more will clear the muddy waters. A systematic and documented approach will lead you to a deliberate, well-thought-out decision. As you continue to write the story of your business and your life as an entrepreneur, what does this chapter or the next entail – and how many marshmallows?
