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Posted: June 06, 2011

The great stewards of capital

Where are they when we need them most?

David Tolson

Where have they gone? With our politicians (Republicans and Democrats alike) lacking financial responsibility, we find a group generally unwilling to make difficult decisions that must be made today. Turning to "big business," we find a similar financial turpitude that, to most Americans, is downright frightening. So where are we to look to find the great financial stewards when we need them most?

From my experience in having worked with nearly 500 private business owners over the past decade, I can honestly say that generally speaking, the owner of a small, privately held business has the best sense for where and how to spend or invest dollars. This applies not only to their own business, but to the money that flows through all facets of our economy. They know how to appropriately allocate capital to generate reasonable returns; so we need our state and federal governments, as well as other interest groups, to stand clear and let small business owners do what they do best - create jobs and money to be used in our economy.

One of the common themes we are hearing from President Obama and other members of Congress is that people who make more than $250,000 are wealthy. For the private business owner; however, $250,000 worth of income is hardly worth the effort.

Many businesses these days (small private businesses that is) are what are called "pass through entities," that is to say, they pay no corporate tax. Before getting upset over this concept that the business pays no tax, it is important to note that this does not mean that there is no tax paid at all; it simply means that the business pays no tax and thus, all of the business' income is taxed at the business owner's personal tax rate.

If a business makes $500,000 in pre-tax income and it is a pass through entity, this does not mean that the business owner then puts $500,000 into his or her pocket. At that level of income, the federal and state income tax rates would be close to 40 percent, which means that roughly $300,000 would be income available post tax. (Note: I am using rough estimates to make a point - taxes can vary from individual to individual. In addition, let's assume that he pays himself $100,000 in salary).

The business owner can now take those funds out of the business and do what they want with it. Let's say, however, that the business owner wishes to grow his business by adding employees and a key piece of equipment. As a result of his desire to grow his business, his operating expenses are going to increase and the working capital needs of the business will increase as well, consuming more cash from the company's balance sheet. In addition, let's assume that the business owner also wants to pay some portion (or perhaps most or all) of the new equipment purchase in cash, which is fairly typical. As a result, the business owner will need to leave additional capital in the business to make these things happen.

Everyone agrees that growing small business is a good thing to do. It is good for the business owner, but it is also good for the economy. The hiring of new employees is great, and the purchase of a new piece of equipment provides financial return, which may round trip into more jobs to the manufacturer of that particular piece of equipment. This investment in the business requires additional cash resources, so the business owner elects to leave an additional $100,000 out of his recent earnings in the business.

In effect, the amount that he can truly take out would be $200,000. If you take the amount of money the business owner kept this year (the $60,000 in post tax salary and the $200,000), he would be considered wealthy by the standard being debated.

 It's important to remember that the dollars the business owner makes must not only pay him a salary, but must also provide a return on the business owner's investment. So comparing the income of business owners versus that of non-business owners is unfair. The business owner must receive a return on his investment otherwise, why take the risk? Is it fair to expect a business owner to take the risks of running a business (employee risks, financial / capital risks, litigation risks) for no return? The answer is clearly no.

Most private equity investors look for returns on a pre-tax basis upwards of 25 percent. In essence, given the risk that most business owners take in running their business, they ought to be paid well for their time (salary) and generate a return that is north of 25 percent on a pre-tax basis. We, as the public, must separate these two distinctly, and make sure that we consider the risks in owning a small business and most importantly, provide the business owner an incentive to generate adequate returns for the risks taken.

If we remove the incentive to take risk and innovation in this country, then the United States will quickly slip as the world's most powerful economy. By allowing small, privately held businesses the opportunity to make investment decisions for themselves, and by not handcuffing them with undue regulations and taxes, they will generate more cash to re-invested in the economy. When this happens, everyone wins.

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David Tolson is Managing Director of CapitalValue Advisors, LLC. Since 1992 David has worked in small and middle market based businesses in operations, sales, and marketing, and has extensive experience in appraisals and mergers and acquisition. He is widely regarded as an expert in middle market private company valuation. He has conducted numerous seminars, taught senior level university courses in organizational management, and been featured as a special speaker at the graduate level on strategic planning and acquisition strategies at both Colorado State University and the University of Colorado. Additionally, he is the co-author, along with Chris Younger, of the book Harvest: The Definitive Guide To Selling Your Company.

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