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.
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