The everyday assumption is that enterprise owners and managers are completely focused on and devoted to maximization of profit, growth and cash flow from their businesses. This assumption is one of the cornerstones or underpinnings of classical microeconomics. Yet the assumption is deeply flawed. The evidence shows otherwise.
What is the evidence? I have no empirical study, but over the past decades have talked to over a thousand business owners about their businesses and have looked into more detail into hundreds of companies throughout Central Europe. My back-of-the-envelope calculation is that approximately 40 percent of company owners are what you might call profit-growth-value maximizers. The majority – roughly 60 percent – are owners or managers of what might be called “lifestyle” companies, or are “tax minimizers”; often the two go hand in hand. What do I mean by these terms?
A “lifestyle” company may be defined as a business whose primary purpose is to support the lifestyle of the owner and his family. This might mean a generous salary for the owner/CEO, full with perks (company yacht, airplane, fancy car, clubs, travel, etc.) Or it might mean jobs for the kids, with outsized compensation and perks as well. Or it might just mean draining the liquidity and growth potential of a company via dividending all earnings.
“Tax minimizers” are companies that find creative – usually perfectly legal – ways to minimize taxes. It may be via the “lifestyle” methods outlined above, or purchase of tax shelters (which may distort the investment pattern of companies), or even illegal methods or reducing taxes.
So what are the downsides of a company being a tax minimizer or lifestyle company? In my opinion, there are at least three reasons:
- Where liquidity is consistently sucked out of a company, whether via perks or dividends, the company usually becomes incapable of sustaining any kind of investment program, continuous improvements in processes, or investing in sales and marketing. If the competition is making these investments, and a particular company is not, it is only a matter of time before the competition starts stealing market share, or squeezing your margins, or both. The competition grows while those that do not reinvest stagnate. There is an old Russian saying: “that which stops to grow begins to rot.”
- It becomes more difficult to achieve financing. Neither banks nor equity investors like investing in lifestyle companies or tax minimizers. The risk of investing is far higher, and the potential upside far less. In short, the cost/benefit is much worse than investing in a growth and cash-flow maximizing company.
- Corporate value is destroyed. One method of valuing a company is to apply a multiple to its free cash flow, or to its EBITDA (Earnings Before Income Tax and Depreciation). So for every dollar or euro that an owner or manager is cheating the tax department, or spending on his or her own lifestyle, he or she may be diminishing the value of his or company by five, six or seven euros or dollars (whatever is the applicable multiple).
One may have a nice lifestyle as the owner of a “lifestyle” company. But the really big upside occurs when a business owner is in a high growth industry, reinvests earnings to maximize growth as well as efficiency and margins, and then he or she can cash out with an amazing value, based on a very high multiple applied to a very high EBITDA or free cash flow number. There is a compounding effect when two high numbers are multiplied by each other. This is how true entrepreneurs create the really serious wealth.
As a general rule, a higher tax rate reduces a company’s cash flow, hence it reduces the value of a company, and vice versa. However, the effects are not always that simple. Without wishing to enter into the politics of the proposed changes to the Hungarian tax regime, these changes are dramatic, and provide the opportunity for a most interesting case study on how changes in tax regime may affect the valuation of companies.
In a nutshell, the Hungarian government has levied a “Special Tax” on banks and on major companies in the energy and telecommunications sectors, as well as on supermarkets, depriving all of these organizations of a substantial portion of their profits over the next three years. In the meantime, the government intends to reduce the tax rate on individuals to a flat rate of 16 percent (perhaps even lower). The corporate tax rate will also be reduced to 16 percent.
All of those companies facing a tax decrease to the new flat tax would of course see an increase in their valuation. This usually happens according to some kind of multiplier effect- that is to say, a €1 increase in cash flow may create an increase in company value of approximately five or six euros.
Conversely, prima facie, those banks, supermarkets, energy and telecommunication companies facing the “Special Tax” would see fairly dramatic declines in value, with a similar multiplier effect.
However, the situation is not that simple: the increase in consumer purchasing power (thanks to reduced individual tax rates) should help promote additional spending on telecommunications services, gasoline, and groceries, which may fully or partially offset the effect of the Special Tax. Much depends on whether consumers decide to save or spend the tax windfall. Presumably banks may also need to write off fewer bad loans if consumers have additional disposable income. So the long-term effect on valuation is highly uncertain.
Markets abhor uncertainty. For anyone who now wishes to sell or raise financing today for a company affected by the Special Tax, there are major uncertainties ahead, which may make any transaction or financing extremely difficult:
Investors and financiers will also find it very difficult to forecast whether consumers will save or spend the tax windfall, hence it will be difficult to forecast revenues of the companies affected by the Special Tax.
- It will also be impossible to forecast how much of the tax companies will be able to pass on to their customers. (If the entire tax could be passed on, there would arguably be no impact on valuation).
- Investors and financiers may fear that the Special Tax will be extended beyond the three-year period currently intended by the government.
- It is still too early to predict what effects this taxation program will have on investor confidence.
- It is still too early to predict whether the Special Tax will be sufficient to plug the fiscal gap. After all, multinationals have an amazing aptitude for tax planning, in order to find legal ways to avoid taxes. Furthermore, it remains to be seen whether the government announces structural reforms. If the fiscal gap is not plugged, the government may be forced to resort to additional measures.
It is probable only a minority of owners of telecom companies, energy companies, and supermarket chains may be contemplating a transaction over the next few years. For most owners of these companies, the possibility of reduced cash flow will be more significant than a diminished valuation. There may however be a few such owners contemplating exit, who may be tempted to postpone transactions until after the uncertainties have been resolved, as investors will tend to value such companies based on conservative (one might say pessimistic) scenarios.
Overall, however, for the vast majority of companies not affected by the Special Tax, valuations and the environment for transactions is likely to improve.
