Understanding Return on Equity for Privately Owned Businesses
Calculating the return on equity for a privately owned business and understanding the implications of not achieving market-driven cost of capital.
I am a big fan of Robert Slee, an investment banker, author, and investor in the middle market. His most well-known book is Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests, and his teachings are centered around the following key fundamentals issues plaguing the lower middle market:
- Value creation occurs when returns on equity are greater than the cost of equity;
- 70% or so of private business owners are not increasing the market value of their firms; and
- Most business owners are not generating returns on equity investment greater than their company’s cost of equity capital.
This article is intended to explore these issues and their implication for mid-market business owners.
What Is Cost of Equity for a Mid-Market Business?
In general terms, the cost of equity is the compensation that the market demands in exchange for owning and bearing the risk of ownership in the equity of a company. Shannon Pratt, a well-known authority in the field of business valuation, provides the following definition:
"Cost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment. In economic terms, the cost of capital for a particular investment is an opportunity cost - the cost of foregoing the next best alternative investment. In this sense, it relates to the economic principle of substitution — that is, an investor will not invest in a particular asset if there is a more attractive substitute."
Based on historical empirical evidence, the cost of equity for businesses at various sizes and stages of the business life cycle can be summarized as follows:
- Blue-chip public companies: 8%–15%
- Well-established large companies: 16%–24%
- Mid-market business: 25%–34%
- Main street business: 35%–45%
- Start-ups: 45%+
So what does this mean for a private business owner? As Robert Slee states, "private mid-market business owners must generate returns on equity of anywhere between the range of 20-40% each year (beyond reasonable shareholder compensation) just to cover the risk of ownership. When a company does not generate returns greater than its cost of equity, the company loses value in the eyes of the market. If it goes enough years without generating such returns on investment, the value gap grows. Given enough under-performing years, the business will fail."
Calculating Return on Equity for Private Businesses
Let's walk through some illustrative examples of how a mid-market business owner can calculate their actual return on equity and compare these returns to the acceptable cost of equity levels.
Illustrative Example #1
A shareholder makes an initial investment in their business of $200,000 on January 1, 2000 with subsequent investments of $300,000 and $400,000 on January 1, 2005 and January 1, 2010, respectively. The company is sold on January 1, 2015, and the shareholder receives after-tax proceeds of $8,000,000. The return on equity is calculated as follows:
Illustrative Example #2
A shareholder makes an initial investment in their business of $200,000 on January 1, 2000. They are able to issue a dividend of $500,000 on January 1, 2005 but are required to reinvest $400,000 on January 1, 2010. The company is sold on January 1, 2015, and the shareholder receives after-tax proceeds of $5,000,000. The return on equity is calculated as follows:
[NOTE: Return on equity can be calculated using the XIRR function in excel.]
Learnings from the Above Example
The above examples are very simplistic but can provide the following important takeaways:
- Earning a return on equity that is commensurate with the expected cost of equity for mid-market businesses is not an easy task. How many business owners can take a $200,000 investment and turn it into $5–$8 million in after-tax proceeds? In example #1, the required cost of equity for a mid-market business in excess of 25% is not even met.
- Return on equity is greatly improved when a shareholder is able to extract money from the business earlier. This is illustrated in example #2 through the issuance of a dividend. Business owners should understand and consider the practice of dividend recapitalization to improve their return on equity.
- As stated above, reasonable shareholder compensation should not be considered in the calculation of return on equity.
Why Don't Entrepreneurs Care About Return on Equity?
This is an extremely important issue for mid-market business owners, given the potential value gap that is created by not exceeding a business' cost of capital. From my experience, business owners are not overly concerned with this. But why? I believe that there are few different reasons.
Determining return on equity is a difficult and arduous calculation that is performed over multiple years, usually at the end of the investment period when the businesses is sold. Also, the periodic value of a private business' equity is not as easy to obtain as the equity value of a publicly traded entity. A regular (annual) valuation assessment of privately held companies would provide the necessary information to calculate return on equity.
Business owners who sell the equity of their business for after-tax proceeds of $5 or $8 million, as in our examples, are more concerned with the absolute value rather than a return on equity percentage. Regardless of whether you have $5 million in the bank or $8 million, you're still doing relatively well. The percentage return on equity earned doesn't mean as much at that point.
Perks of Ownership
Entrepreneurs start businesses for more than a return. Freedom, lifestyle, fulfillment, and shareholder compensation/perks are all factors taken into consideration when determining a successful business venture. In many instances, business owners are building lifestyle businesses where the end goal of flexibility is more important than a return on investment.
Adopting a "Return on Equity" Focus
To obtain a premium valuation upon exit, a business owner must be able to exceed the return on equity demanded by the market. To do this, a return on equity focus must be a adopted. Regular valuations, use of leverage and dividend recapitalization are all tools needed to determine whether or not you are on track. Alternatively, if market-driven cost of capital levels are not achieved, a business will have to settle for lower valuations on exit. For some, this might be acceptable because of the added perks that business ownership provides. The question is, will it be acceptable for you?