On the Nature of Long-term Holds - Holding a business for the long-term is lucrative - Yale School of Management
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YALE CASE MAY 28, 2020
On the Nature of Long-term Holds
Holding a business for the long-term is lucrative
“Investing is simply maximizing the rate of compounding for as long as capital
can be employed net of fees and taxes. What strikes us as strange is how little
we hear about compounding with regard to investing.” *
Christopher Begg, CEO, Chief Investment Officer and Co-Founder of East Coast
Asset Management, Inc.
A.J. Wasserstein 1
Mark Agnew 2
Brian O’Connor 3
Aspiring entrepreneurs, whether starting a business from scratch or acquiring a business in a
search fund, often approach us and share their exciting business ideas and plans. It is one of the
great pleasures of being an educator—interacting with and listening to eager students ready to
take on the world and build their dream business—but what perplexes and vexes us is that we
often hear these would-be entrepreneurs craft their story with an exit in mind, typically in about
five years. While it is certainly not our place to direct students and entrepreneurs on how to build
their individual journey, we would like to share a perspective of not focusing on a business exit
and instead building a business for the long term. Speaking from approximately 75 years of
cumulative experience running and investing in companies, we have learned that what creates
value is holding a business, not “flipping” it (a distasteful term that denigrates the robust and
dynamic entities that companies are).
To teach inquisitive students how to build a business while considering holding periods and exits,
we often play a simple game of questions. We start by asking where the student is from. This
game works in most U.S. locations. We then ask who the wealthiest people in that community are.
Everyone can answer the “where are you from?” question correctly, and we hear a wide range of
perfectly livable and wonderful tier 1, tier 2, and tier 3 cities. Most students pause at the second
question, thinking for a few minutes before responding.
When they respond, a clear theme emerges: the wealthy people they recall are all owners of
businesses. The replies typically include the woman who owns a dozen car dealerships in the city,
the gentleman who started a manufacturing business that now employees 600 people, the
entrepreneur who built a regional hospitality services business that now owns ten nationally
branded hotels, the woman who owns the community’s most significant home healthcare services
business, and the married couple who hold a food service franchise with 32 stores in operation.
Anecdotally, these answers reflect a diverse set of somewhat simple companies with no apparent
correlation between wealth creation and the type of business (meaning you can build and
*
All introductory quotes are from: (2016, October 12). Compounding - Quotes from Wanger, Buffett. Retrieved May 28, 2020, from
https://www.valuewalk.com/2016/10/compounding-quotes/
accumulate wealth in a varied set of industries and businesses). This theme (where large wealth holders tend to be business owners) makes sense and is substantiated in the 2017 version of the Federal Reserve’s Evidence from the Survey of Consumer Finances, which indicates that U.S. wealth predominantly resides with entrepreneurs and business owners.4 The top 1% of wealth holders in the United States derive the largest percentage of their wealth from business equity and other financial wealth (as compared to residential equity, retirement assets, and other non-financial wealth). 5 We seldom hear about the wealth of doctors, lawyers, engineers, and (disappointingly) professors. We also do not hear about senior corporate executives who were not the founders of their respective businesses. Professionals are often high-income earners but do not build large personal balance sheets through their paychecks. This is in contrast with entrepreneurs and business owners who frequently do accumulate substantial personal balance sheets, not through their labor, but through their equity ownership interests. 6 The Forbes 400 chronicles the wealth of America’s richest 400 citizens. According to CNBC, 66% of the list consists of individuals who built their own wealth (as compared to an inheritance) through entrepreneurship and business ownership. 7 Once we establish what business these prodigious wealth creators are in, we end the game by asking how long they have been in their businesses. Here, a significant anecdotal correlation appears, as the answer is always decades or generations. We have played this game with hundreds of students, and not once have we discovered someone who accumulated significant wealth in approximately five years despite the propensity for private equity investors, venture capital firms, and MBA programs to think and model in five-year increments. The correlation holds true for most U.S. communities, with wealth being accrued slowly over a long period through consistent ownership. Despite these observations, we keep hearing would-be entrepreneurs planning to engage in a build-and-sell pattern and strategy. This approach is difficult to understand, and we believe it is in any entrepreneur's best interest to hold business assets and enjoy the benefits of a long-term retention strategy while concurrently eschewing the impediments of a short-term sell strategy. Former entrepreneur and venture capitalist Dave Whorton (Stanford Graduate School of Business 1997) recommends an extremely long-term hold strategy. Whorton has a typical Silicon Valley background, having started several technology-centric businesses, including Good Technologies and drugstore.com. He has also invested in and worked with several renowned companies, such as Amazon and Google, as an investor with Kleiner Perkins and TPG Ventures. Whorton lived the “get-big-and-exit” narrative that permeates the entrepreneurial zeitgeist. As a former entrepreneur and investor, Whorton now promulgates an alternative approach as the founder and head of the Tugboat Institute® 8, an organization established to serve businesses with long-term horizons. Whorton calls these long-term organizations “evergreen” companies and encourages leaders to set building strategies of 100 years or more, encompassing business transfer and consistent possession. There are companies that have persisted for decades and even centuries by embracing this same mindset. Currently based in Norwell, Massachusetts, The Zildjian Company has continuously manufactured high- performance musical instruments since 1623. That is a true long-term holding period (almost 400 years) and long-term business view.9 Zildjian is considered one of the world’s leading producers of cymbals, drumsticks, and percussion mallets used by amateur musicians and rock stars alike. Founded in Turkey by Avedis Zildjian and relocated to the United States in 1929, the business is now in its 15th generation of family leadership. For an American company, Zildjian is long-term, but in Japan, Zildjian might be considered a startup. Japan claims to have 33,000 companies over a century old, nearly 1,000 companies founded prior to 1700, and eight companies started before 800. The country’s oldest business is a hotel, Nisiyama Onsen Keiunkan, which has operated continuously since 705. 10 These companies, referred to as shinise, embrace a long-term view that 2 ON THE NATURE OF LONG-TERM HOLDS
reflects the relative and context-dependent nature of “long-term.” 11 In venture capital and private equity circles,
long-term can mean five to ten years, while it might imply a few decades in the U.S. and several centuries in
Japan. Directionally, we believe long-term holds serve entrepreneurs well and that, when creating value, long-
term is better. We want to go beyond just long-term existence to explore and examine how companies can grow
and create wealth over extended holding periods. While persisting is admirable, persisting and thriving is
delightful.
For those who are planning to exit a business, the very best economic reason is a material change to the
investment thesis. If an entrepreneur is a fantastic operator, the data and tools that enable the viewing of the
industry horizon will be available. Should the data indicate disruptive industry change, selling might be wise, but
we believe data and strategy should catalyze a threshold exit decision, not just that five years have elapsed.
The purpose of this note is not to show how to select investors for a long-term hold, how to structure a long-
term hold vehicle, or how entrepreneurs get compensated when building a business for decades. Instead, we
will explore the reasons why entrepreneurs should have a long-term view when contemplating building and
growing a business.
We will address the concept that a long-term hold strategy is fundamentally about compounding capital. We
believe that when holding for the long-term, entrepreneurs will create more wealth by avoiding taxes,
transaction fees, idle time, and redeployment risk. Furthermore, long-term entrepreneurs will enjoy the benefits
of financial compounding, continual improvement (we call this non-financial compounding), leveraging start-up
and platform investments, and the emotional rewards of being attached to a business in a community for
decades. We identify the reasons why entrepreneurs choose to exit and whether those reasons are compelling
or not. We highlight the differences between internal rates of return and multiple on invested capital and why
long-term oriented entrepreneurs embrace multiple on invested capital as their key metric. Finally, in Appendix
A, we provide mathematical examples of various investment strategies and performances and illuminate which
creates the most value for the entrepreneur.
Compounding – what long-term holds are all about
“Money makes money. And the money that money makes, makes money.”
Benjamin Franklin on compounding
A long-term hold strategy for an entrepreneur is fundamentally about compounding capital. The phenomenon
of compounding—earning interest on the invested principal as well as the interest already gained—relates
directly to long-term holding schemes and wealth building. Such strategies require patience and persistence
with a focus on performance.
Patience
Compounding capital is a sure-fire way to accumulate wealth. The challenge with this approach is that initially,
interest earned on interest is insignificant, but with time, powerful results manifest. Building wealth in this
manner is a financial version of the concept of delayed gratification, which was famously studied in the Stanford
University marshmallow test in the 1960s. 12 During that psychological experiment, Stanford professor Walter
Mischel tested four- and five-year-old children on their ability to choose between eating one marshmallow
immediately or receiving two marshmallows by waiting fifteen minutes. The second marshmallow represents
interest and compounding—you get appreciably more if you delay gratification.
3 ON THE NATURE OF LONG-TERM HOLDS
Figure 1 illustrates this concept mathematically, depicting the growth of a dollar over 25 years at 15% interest
per year. Initially, barely any interest is paid, but over the 25-year holding period, the initial investment soars to
over $32. The first 15 years, representing 60% of the holding period, show the first dollar growing to $8.10, 24%
of the total capital growth. In the final ten years, the $8.10 more than quadruples to $32.90, and a full 13% of
the total growth occurs in the final year—a marshmallow truly worth waiting for. Financial compounding is a
patience test measured in decades or generations.
Figure 1: Growth of a dollar over 25 years—where nominal dollars occur
Source: Created by the case writers
Persistence
A long-term hold strategy built on compounding is also about persistence, which can be measured by keeping
capital working in a system instead of withdrawing it. Consider an entrepreneur who operates a business with
$1 million in EBITDA *. The entrepreneur enjoys a comfortable salary of $250,000 per year, reflected in the net
EBITDA. At the end of the year, the entrepreneur can withdraw any amount from the business up to $1 million
or persist and let the $1 million stay in the business to compound at 15% per year. Assume that the
entrepreneur dreams of additional homes, multiple luxurious car leases, and frequent exotic travel—all of which
can be paid for by withdrawing the available $1 million. Calculating the future value of a fixed annuity at 15%
over 25 years reveals that, by not persisting and withdrawing $1 million per year, the entrepreneur will forgo
$212 million† in favor of $25 million. We encourage entrepreneurs interested in building wealth to persist,
keeping their capital in their businesses to work this alchemy while resisting the temptation to withdraw
excessive amounts of capital for personal consumption. While 15% returns are not always tenable or
guaranteed, if cash remains in the business it is available for opportunistic acquisitions, prudent CapEx‡
investments, and building infrastructure for future growth. If cash is withdrawn and consumed, it is no longer
available for future returns.
Performance
Performance is all about the rate of compounding. We think it is possible for small businesses to create mid-teen
equity returns over long periods in simple, enduring companies. For example, Joe Smith is the CEO of Smith
*
Earnings Before Interest Taxes Depreciation and Amortization
† FV= PMT * (((1+i)n )-1) /I = FV = $1,000,000 * (((1+.15)25 )-1)/ .15 = $212,793,017.
‡
Capital Expenditures
4 ON THE NATURE OF LONG-TERM HOLDS
Brothers, a Connecticut-based insurance brokerage with $40 million in annual revenue. Smith has guided the
company with a 14% compound annual revenue growth since 2000. 13
The key to thinking about performance is to think about moving forward steadily. Some years will be more
profitable than others, but avoiding devastating setbacks is crucial for permitting compounding to do its magic.
Private operating companies, like public equity markets, will have years of expansion and contraction. It is the
effect of these years over the long term that determines performance.
Mild performance differences matter considerably over longer periods. Figure 2 shows that even a 1% increase
in performance over a 25-year period can result in significantly more nominal dollars, which makes it worth
fighting for an incremental 100 bps in returns. As shown in Figure 2, the value of an additional 100 bps from 16%
to 17% over a 25-year period is worth an additional $10 million on an initial equity base of $1 million.
Figure 2: The impact of increased performance over time
Source: Created by the case writers
The friction associated with selling a business (reasons not to sell)
“The power of compounding is so great that our first job as investors is to avoid anything
that might short circuit it.”
Ira Rothberg, Portfolio Manager and Managing Member of Broad Run Investment
Management
Some entrepreneurs think it is glamorous to talk about building and selling a business, conjuring images of cash
windfalls and newspaper headlines. We agree; it does sound glamorous, but we encourage would-be sellers to
also consider the impediments and friction associated with exiting a business. There are many, and they all
nibble away at the opportunity to accumulate wealth.
We are not advocating for holding onto businesses blindly. A business that is flagging and not creating value for
any constituent (customers, employees, and shareholders) should be jettisoned. A company with an investment
thesis that is no longer tenable should be put to market. A business that has slogged through five to ten years of
trying to get off the ground with no results to show should be liquidated or exited. However, a healthy business
with a tenable investment thesis and strategy and a proven and improving record should not be sold just
because 60 months have elapsed. Such a wonderful business should be held onto because fantastic enterprises
are hard to come by. We would define such a business as one that is capable of generating mid-teens returns on
5 ON THE NATURE OF LONG-TERM HOLDS
equity for at least a decade with a path forward for equally desirable returns. This is not easily achievable and would put the entrepreneur in an elite group of performers. Taxes One of the factors having the most deleterious impact on wealth accumulation when exiting a business is taxes. Federal, state, and local governments do many excellent things that make our society run smoothly and allow entrepreneurs to thrive, requiring the dutiful payment of taxes. We know of only one legal way to avoid taxes, and that is not to transact. Businesses pay income taxes annually, but do not pay capital gains taxes unless they transact. Currently, U.S. federal capital gains taxes are 15 to 20% (and historically have been as high as 39% 14), depending on the amount of taxable income in a given year. 15 Those selling a business in such an environment can count on a 20% federal tax rate. If an entrepreneur is from the great state of Connecticut, there is a state capital gain tax rate of 7% 16 in addition to the federal capital gain tax. If a business exit results in a hypothetical gain of $10 million, the capital gains tax for those residing in Connecticut, would be $2 million payable to the federal government and $700,000 payable to the state government (for simplicity and illustrative purposes, we are ignoring the deductibility of certain federal taxes when computing state tax liabilities). This results in $2.7 million that cannot be compounded going forward and highlights that the only way to avoid capital gains taxes is not to trade. The implications of taxes alone, isolating all other factors that might manifest when exiting a business, are illustrated in Figure 3. Assume two scenarios relating to exiting and tax implications. In the first scenario (Figure 3[a]), an entrepreneur runs a business where equity value grows by 15% on an annual basis. This entrepreneur holds the business for 25 years and enjoys continuous equity compounding effects without any tax friction associated with exiting. At the end of 25 years, the entrepreneur exits and pays capital gains taxes of 25%. From an initial equity amount of $1 million, an after-tax net equity amount of $24.9 million is realized. This delightful outcome was facilitated at least partially by not trading or paying capital gains taxes and enjoying the continuous compounding nature of a hold strategy. In the second scenario (Figure 3[b]), a different entrepreneur is incapable of a long-term hold. This entrepreneur embraces the notion of holding a business for five years before exiting. We have assumed an identical return rate of 15%, for a consistent equity earning opportunity, and that the second entrepreneur is particularly skillful and capable of identifying successive opportunities with equally attractive returns that are available the day after an exit. Therefore, at the end of every five years, this entrepreneur experiences an exit and pays 25% of the gains in taxes. Running out this scenario over 25 years results in the second entrepreneur garnering $16.8 million after the final five-year investment period. Given identical returns over a 25-year period and ignoring all other factors (including transaction fees, idling cash, and redeployment risk), avoiding the exit nets $24.9 million, while exiting and paying capital gains taxes five times nets $16.8 million, illuminating the devastating impact taxes can have on a long-term wealth-building strategy. Capital gains taxes are legally avoidable only by not transacting, and there is no way to mask the invasive nature of taxes and how they eviscerate wealth. By not exiting multiple times, one entrepreneur accumulated 1.5 times more wealth than the other. Which entrepreneur would you prefer to be? 6 ON THE NATURE OF LONG-TERM HOLDS
Figure 3: (a) Continuous compounding with taxes paid once in year 25; (b) Continuous compounding with
taxes paid every five years (presented in millions)
(a)
Net proceed after tax $24.9
(b)
Source: Created by the case writers
Net proceed after tax $16.8
Transaction Fees
When an entrepreneur decides to exit a business, a fairly typical process is to hire an intermediary—an
investment banker if the company is large or a broker if the business is small. Investment bankers and brokers
provide the same service in a sell-side assignment. Their job is to sell the company to a qualified buyer at an
attractive price and ensure that the buyer shows up to the closing with the necessary funds. A typical
compensation arrangement for a sell-side investment banking assignment has a non-refundable retainer, a small
incentive fee for amounts up to a break price (a somewhat-easily achieved exit valuation) and increasing
incentive fees for escalating exit values.
If Nisha, a fictional entrepreneur, is thinking about selling her business and anticipates valuations of
approximately $100 million, she might negotiate a non-refundable retainer of $100,000 with a 1% incentive for
amounts up to $100 million, a 4% incentive for amounts between $100 million and $125 million, and a 6%
incentive for all amounts above $125 million (although every compensation structure is negotiated and unique,
these are illustrative terms). If Nisha sells the business for $100 million, the total fee will be $1.1 million
(representing 1.1% of the transaction). If Nisha sells the company for $125 million, the fee will be $2.1 million
(representing 1.7% of the sale), and if Nisha sells the business for $135 million, the fee will be $2.7 million
(representing 2.0% of the trade).
Besides the investment banking fees in an exit transaction, there are also legal fees and sell-side quality of
earnings (Q of E) fees. The legal fees for a sell-side project can easily be several hundred thousand dollars, a wise
investment since retaining a proficient corporate attorney well-versed in acquisitions is judicious and absolutely
not an area where a selling entrepreneur should be parsimonious.
It is also common to retain a sell-side Q of E firm for an exit transaction. This can be a national accounting firm or
a consulting firm specializing in Q of E projects. The purpose of a sell-side Q of E project is to go to market with a
document that verifies the nature of the business’ profits. This step eliminates or reduces a potential buyer’s
7 ON THE NATURE OF LONG-TERM HOLDS
ability to assail earnings of the company, addressing any large and recently won new customers while also accounting for the newly implemented expense reductions. The project can be thought of as more than an accounting audit because it addresses economic and financial issues (such as annualizing revenue gains and expense reductions). It will also highlight revenue concentration and other vital earnings issues. Like a top-flight lawyer, a reputable Q of E firm is a judicious investment when selling a business, but it is expensive and will cost approximately $50,000 to $100,000. 17 When considering transaction fees, entrepreneurs should realize that these exit costs are yet another way to prevent future compounding. The fees incurred are gone forever and are no longer working for the entrepreneur’s benefit. If an entrepreneur pays these transaction fees every few years, the nominal amount and the opportunity cost through compounding can become quite material. Preparing for a transaction When an entrepreneur begins to think about selling their business, their time and energy slowly shift from running and building the company (continuing to create value) to getting the business ready to go to market. We find that entrepreneurs often underinvest in the business during this time, potentially missing out on high return projects and opportunities. This can be detrimental to a business. As soon as an entrepreneur shifts into sell mode, investments in the company attenuate, the culture of transparency and collaboration becomes tense and untrusting, rumors begin to abound, and customers and competitors sense the changes and start asking uncomfortable questions. All of this results in a moment of value-creation stagnation or atrophy. The business is no longer being run to maximize long-term value. Instead, the exit finish line and getting a deal done are paramount, impairing the value creation and compounding machine. Idle cash Once the deal closes, the entrepreneur can breathe a sigh of relief, possibly gloating and calculating the resulting internal rate of return (IRR) of the venture. An IRR in the 20s or 30s is an excellent rate of annual return that will be very difficult to replicate after an exit. The entrepreneur’s gains (after paying taxes, investment bank fees, and legal fees) will initially idle in a money market account currently earning a meager .59%. 18 It is unlikely that an exiting entrepreneur will reap returns similar to their previous business while idling cash and figuring out how to deploy the windfall. If an entrepreneur envisions using their newfound capital stake to acquire or start another business, which many of our students articulate as their strategy, this idle period can easily be a few years. After exiting a business, an entrepreneur needs to exhale, pause, and figure out their next move. Finding a new business to start or purchase is hard work and requires considerable time before an entrepreneur is ready, to say nothing of possible false starts. This idle time is dilutive to wealth creation and compounding, a material opportunity cost. For example, given a 25-year investment program, an entrepreneur who turns over an investment every five years and then idles for one year while contemplating what to do next will have a cumulative idle time of four years. Their capital will not be working for sixteen percent of the investment program duration, causing significant detrimental effects on overall wealth accumulation. To illustrate the sensitivity of idle time, Figure 4 compares two simple examples. In scenario one (Figure 4[a]), we assume a continuous 15% return over 25 years, and in scenario two (Figure 4[b]), we assume an entrepreneur operates an asset for five years, exits, and then idles for one year before reentering an 8 ON THE NATURE OF LONG-TERM HOLDS
investment. In scenario two, we assume that the entrepreneur earns an identical 15% return while invested and no return during the one-year pause between investments. Rather than using future value calculations, we lay out the math in Figure 4 to depict the effects of compounding year by year and the impact of a one-year hiatus every five years. The results are stark. In scenario one, a dollar invested balloons into $32.90 over the 25 years with continuous compounding. In scenario two, the same dollar grows to just $18.82. Continuous compounding trounces an in-and-out strategy at the rate of 1.75 times, showing how pernicious to wealth accumulation idle time can be. Keep in mind that for this simple analysis, we have assumed no taxes. If taxes were accounted for, the divergence would be magnified, as we will demonstrate. Figure 4: (a) Continuous compounding for 25 years; (b) Continuous compounding for five years with one-year intervals of idling over a 25-year period (presented in millions) (a) (b) Source: Created by the case writers Redeployment risk Upon finding an investment opportunity, there is considerable entry risk. Entrepreneurs who had smoothly run businesses are aware that those companies tend to get bigger and better over time while enjoying lower risks. When starting or acquiring the next business, a magnified risk exists simply because the asset or project is new and unknown, even with the guidance of investment bankers and lawyers. Thus, the entrepreneur has traded a secure and known asset for an untested and unknown asset, which seems counterintuitive. When comparing an entrepreneur’s current business to a potential new project, there is asymmetric information. The entrepreneur knows much more about the risks of the legacy business (and how to mitigate those risks) than those of the new business. Despite what popular media narrates, entrepreneurs do not seek unnecessary risk; they try to avoid and mitigate risk. Yet students tend to paint a picture of moving from one entrepreneurial venture to another while disregarding risk implications. Furthermore, aspiring entrepreneurs may be overly optimistic, assuming that successive ventures will be equally successful. Some research indicates that serial entrepreneurs are no more successful than novice entrepreneurs. 19 Being an entrepreneur is extraordinarily difficult, and for those who are successful with their projects, we would genuinely like to think that part of the outcome is the result of being a student in a rigorous MBA program. It is also likely the results are attributable to personal genius, innovative ideas, and assiduous work. The humbling truth is that luck also plays a role. We do not know how much, but all successful 9 ON THE NATURE OF LONG-TERM HOLDS
entrepreneurs (including us) have benefited from chance. 20 If you have experienced a successful entrepreneurial
venture, do not believe that your next project is guaranteed to be as successful. We have witnessed many
entrepreneurs who, despite having accumulated experience, wisdom, and capital, were unable to replicate their
previous accomplishments in successive ventures.
David Dodson (Stanford Graduate School of Business 1987) successfully acquired and ran Smith Alarm Company
in his first entrepreneurial venture. He operated and grew the firm for five years before selling the business to
an institutional investor, which resulted in a 40% IRR. 21 His second entrepreneurial foray, the acquisition of Auto
Palace, an auto supply parts retail firm with more than 100 locations, resulted in a partial loss of capital. 22
Dodson then assumed the CEO role at Paragon Electronics, a search fund company that printed circuit boards
and that had lost its CEO. His goal at Paragon was to prepare for a successful exit. Following this, Dodson was
the executive chairman at Worldbridge Broadband Services, a Colorado-based broadband telecommunication
technology services firm that merged in 2000 with a larger public telecom company in a successful exit.
Dodson’s most recent project, the consolidation of the septic cleaning industry under the Wind River brand,
grew rapidly but experienced operational challenges that required a recapitalization and a change in leadership
before finding more growth and extraordinary success. 23 Dodson is a smart and capable entrepreneur and
investor (he is also an award-winning faculty member at the Stanford Graduate School of Business). Despite all
of his talents and early success at Smith Alarm, successive entrepreneurial achievements were not guaranteed,
and Dodson had both wins and losses.
The benefits of holding a business
“Remember the power of compounding. You don’t need to stretch for returns to grow
your capital over the course of your life.”
Walter Schloss, a value investor
We think keeping a business that is performing well and has a durable investment thesis is a privilege and an
economic golden goose that should be nurtured, pampered, and retained for as long as possible. Doing so
provides a few other primary benefits beyond just being more fun: financial and non-financial compounding and
the ability to leverage the platform investments in starting or buying another business.
Financial compounding
When asking students who the wealthiest people were from their communities, the only discernable
commonality (other than being business owners) was extensive holding periods. Students have often queried us
on the tricks and secrets of business success, and we are disappointed to share that there are no tricks and
secrets beyond the power of compounding. As effective as compounding is, significant benefits only manifest
after several years.
In Appendix A, we mathematically demonstrate the power of holding and compounding for long periods. The
math is irrefutable, and if entrepreneurs account for all the friction in selling a business, they will see that the
necessary returns required to hold are much lower (and entail less risk) than the corresponding returns required
to trade in and out of assets.
10 ON THE NATURE OF LONG-TERM HOLDSIf an entrepreneur plays such math out over multiple decades, the numbers become staggering. As our students
have proven when recollecting the wealthiest people in their communities, wealth is built over long periods. The
myth of starting or purchasing a business and then rapidly flipping the company in five years or so is a plot sold
by the media and venture capital types.24 In reality, it is nearly impossible to amass a fortune in approximately
five years.
Trish Higgins (Harvard Business School 2013), along with her husband James and brother-in-law
Palmer, owns and operates Chenmark Capital Management. Based in Portland, Maine, Chenmark
is an operating investment vehicle that focuses on acquiring and building premier small and
medium enterprises (SME) with an indefinite hold period. Currently, Chenmark has operations in
lawn care, landscaping, frozen dough, and tourist businesses. Chenmark employs 450 people and
has $60 million in annual revenue. The Higginses were all previously Manhattan-based finance
professionals who grew weary of the buy-trade churn mindset that permeates Wall Street. They conceived
Chenmark to specifically build an organization that was focused on building long-term operating excellence and
accumulating wealth over decades by holding their businesses and compounding. Higgins explains:
James, Palmer, and I have been students of business focusing on winning entrepreneurs and
investors for a while. We are fascinated by who builds successful, enduring companies and who
does not. We have done the research and thought about how we want to be entrepreneurs. It
just seems so apparent that the folks who build the very best businesses from an operating and
wealth accumulation perspective do so over extraordinarily long periods of time measured in
decades. We think of ourselves as permanent capital – we own and operate businesses with a
forever mindset. It just seems obvious to us, when you avoid taxes, transaction costs, idle time,
and redeployment risk, you can not only create a fantastic business, but you can also build a
substantial amount of wealth. We just do not buy into the flipping mindset of most
entrepreneurs and investors. 25
Higgins is a thoughtful and reflective entrepreneur, and Chenmark is about ideas and implementation. Higgins
shares what is on her mind in an excellent weekly email blast that always helps us think and learn. It is located at
weekly thoughts.
Will Thorndike (Stanford Graduate School of Business 1992) is an investor, author, and thought
leader in the search fund world. He has invested in over 200 small businesses and is the
founder of the Boston-based private equity firm Housatonic Partners. Additionally, he is the
author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for
Success, an exceptional book that chronicles the stories of successful entrepreneurs and business
leaders who excelled at capital allocation and generated market and peer-trouncing public-equity returns. 26
Most of the “outsiders” chronicled enjoyed multi-decade tenures producing extraordinary compounded returns.
Thorndike observes:
I have been working with and investing in entrepreneurs for almost three decades. What’s
really fun is when entrepreneurs can generate compelling returns over very long holding
periods. That combination of performance and time is where the real net worth creation
occurs. I come from a private equity background, and I have seen many great businesses get
sold because of portfolio dynamics (usually relating to fund life) – not because the company’s
prospects were any less attractive. Some of the very best outcomes I’ve been involved with as
an investor have been in businesses that have had an extremely long-term horizon and can
excel without the friction (and tax inefficiency) of worrying about exits. Entrepreneurs and
companies often tend to get better with time and experience. I am now primarily investing my
11 ON THE NATURE OF LONG-TERM HOLDSown capital and am focused on giving talented entrepreneurs the time and runway to build
enduring businesses whose results can be measured over decades. 27
Non-financial compounding
In addition to financial compounding, an entrepreneur also experiences non-financial compounding when
engaged in a long-term hold strategy. Non-financial compounding is analogous to financial compounding except
that it relates to the abilities and effectiveness of the entrepreneur.
Learning to manage a business is hard work. When an entrepreneur first gets involved with a company, whether
through acquisition or startup, it takes time to become a proficient CEO. The incipient stages are awkward and
embryonic. It is difficult to get a rhythm and flow going because the entrepreneur is struggling to get everything
done and to learn as much as possible. The entrepreneur is often an unseasoned rookie lacking confidence,
experience, mettle, and knowledge. They operate cautiously, in fits and starts.
We think of a new entrepreneur as being like a freshman in high school: unformed and without footing. As with
a freshman, everything is slightly off-kilter for a new entrepreneur. Nobody (customers, employees, vendors)
knows what to make of the entrepreneur, and nobody gives the entrepreneur much thought or time. People are
slow to return calls or take meeting requests. The business is inchoate, and the entrepreneur is using all of their
might and energy to get it moving.
Over time, the freshman matures, seasons, learns the ropes, gets to know people in the business and industry
ecosystem, and gets the business beyond the embryonic stage. With each passing year, the entrepreneur starts
to understand the business more and more. Phone calls are returned, and meetings are accepted. As author
Malcolm Gladwell posits in Outliers: Why Some People Succeed and Some Don’t, it takes 10,000 hours to develop
a level of mastery and proficiency. 28 We estimate this to be approximately four to five years of being an
entrepreneur or CEO. This means that an entrepreneur does not hit their stride until they have been at the helm
of a business for half a decade. And what do many entrepreneurs think about doing after a five-year hold
period? They think about selling! We find this difficult to comprehend. Just as the entrepreneur gets proficient
at what they are doing, they decide to put the business on the market for sale. We think this precludes the
opportunity for fully monetizing all the hard work that the entrepreneur has invested in the business. Just when
the business is beginning to hit its stride and move past its uneasiness, the entrepreneur wants to move on.
Robin Kovitz (Harvard Business School 2007), the CEO of Toronto-based Baskits, feels similarly.
Kovitz acquired Baskits in 2014 using a self-fund search vehicle to launch her entrepreneurial
career. After working on Bay Street (Canada’s version of Wall Street), Kovitz knew she wanted
to lead and build an operating company. When she was looking for a company to acquire, her
requirements were that the target had to be based in the greater Toronto area, be profitable,
and have the potential to grow. She was largely industry agnostic. Baskits, Canada’s largest gift
basket concern, fit the bill. Kovitz was at least partially influenced by her father, a successful businessperson
who built and operated a large meat-processing firm over decades. She saw her father’s business develop over
time and realized that a significant enterprise could not be built in five years. Kovitz shares:
Building a successful business takes time and is hard work – it can also be fulfilling and fun. I
have been running Baskits for five years now. I finally have found my rhythm and groove. When I
initially purchased Baskits, there was an inevitable J curve; I took a few steps backward before I
could plow forward. I had to make a big real estate move, and in a warehouse-distribution
business, that is not an easy task. I also implemented a fresh enterprise resource planning
system to streamline operations and improve customer service. I am only now fully reaping the
rewards of those early infrastructure investments. In the past five years, Baskits has grown
12 ON THE NATURE OF LONG-TERM HOLDSfourfold. I was pretty inexperienced when I first got involved at Baskits. I am a much better
leader today. With five years under my belt, I feel like I am just beginning to hit my stride and
cadence. Why would I ever consider exiting now? I am in this for the long haul. I love what I do.
As a mom with two little kids, I have flexibility and love being a role model for other female
entrepreneurs. My dad built a great business over decades. I want to emulate that model. I am
having fun, creating equity value at an attractive rate, and have a huge untapped runway ahead
of me. Why should I sell, pay taxes, and start over again with new risk and a steep learning
curve? That makes no sense whatsoever. 29
It is only after 5–10 years that an entrepreneur begins to fully benefit from non-financial compounding and the
CEO maturation process. But then it is wonderful. Potential customers call you. Acquisition candidates seek you
out and eagerly accept your calls and meeting proposals. Vendors want to work with you and offer you the best
terms and conditions. Bankers call on you because of your reputation and accomplishments. All the momentum
shifts in your favor. Nothing happens in the industry without your cognizance. As a result, life and business get
easier, and the company performs well and de-risks over time. Additionally, as a firm scales, things actually get
easier with more talented professionals, systems, processes, and infrastructure.
The key to non-financial compounding lies in Aesop’s fable about the tortoise and the hare. As hard as the hare
tries to fast-track the process through tricks and distractions, it is the tortoise that prevails with somber
persistence and diligence over time. No tricks, no secrets, just staying the course.
Leveraging the platform investments when starting or purchasing a business
When an entrepreneur initially starts or acquires a business, there are often significant upfront costs incurred to
get the venture going. For example, when purchasing a business, it is common for an entrepreneur to pay a
premium to get control of a platform (the business being acquired) that will be used for future business activities
and growth. To gain control of this platform, an entrepreneur might pay a premium entry multiple, say, up to
10x EBITDA. But it is likely that the entrepreneur anticipates that as a result of purchasing the platform, they will
now have the ability to either do additional add-on acquisitions at some amount less than 10x or grow
organically by redeploying free cash flows in the business at an effective rate less than 10x.
This allows the entrepreneur to average down the platform premium initially paid. When an entrepreneur holds
a business for a long period, the platform premium becomes less and less material. Furthermore, when an
entrepreneur only pays the platform premium once (by not selling), they avoid the most expensive part of the
entrepreneurial venture: the entry point.
It can just feel better and be more fun for some in the long run
Tom Rosztoczy is the CEO of Stotz Equipment, an Arizona-based John Deere dealership that
has been in operation since 1947 and currently has $440 million in annual revenues. Stotz
has grown organically by pursuing a regional serial acquisition strategy. Rosztoczy quickly
acknowledges that the math is compelling to be a long-term entrepreneur. But what truly
resonates with him are the qualitative elements embedded in a long-term strategy that
captures purpose and motive. Rosztoczy rejects the notion that wealth can be the singular
motive for an entrepreneur. Instead, he asserts that he is living his personal purpose through his business by
creating jobs and serving customers, employees, and his community. He would never choose to exit his business
and jettison the opportunity to discharge his purpose. Rosztoczy states:
We have partially grown by making acquisitions, and when we buy something, we do so
with the mindset of owning it forever. You can’t talk about a business having purpose
13 ON THE NATURE OF LONG-TERM HOLDSand meaning, a driving mission, and in the same breath talk about exiting in five years –
those two concepts just can’t rationally coexist. We keep redeploying free cash into the
business to grow and become better and live our purpose. We do not take a lot of
money out of the business. I live a comparatively modest lifestyle. I think one of the
reasons that a business does well for a long period of time and grows and continues to
generate exciting returns and compounds is because the people who own the company
aren't taking the money out of the business. They're leaving the money in the
business. 30
Despite being unabashed capitalists, we also have taken great personal enjoyment in building businesses over
long periods of time. It has felt magnificent to see our respective organizations grow and thrive. One element of
the journey we have particularly enjoyed was watching team members flourish, develop, and evolve over time.
We have watched team members build families, purchase homes, and even leave the company for enviable and
more prestigious opportunities. Knowing that we have, in some small way, helped facilitate them in enriching
their lives is fulfilling and joyous. Creating jobs and compensating and treating team members fairly over a long
horizon just feels good, like the way business is meant to be conducted (at least in our vision).
Additionally, by being a long-term operator, a company builds deep roots in the communities in which it
functions. Participating in the local Chamber of Commerce, helping staff the toy drive for the United Way, and
sprinkling donations to worthy local philanthropic organizations are the kind of ties and bonds that help
communities thrive. As a long-term entrepreneur, you have the privilege of playing a valuable role in
communities where you have a human and economic interest.
Social advantages and prestige also accrue to the entrepreneur and CEO who is a long-term holder. You develop
a leadership position within the community and have a purpose, an identity, and a platform from which you can
build an organization that reflects your personal values and vision. This role is truly rewarding and fun; it can be
impactful in a constructive way when carried out with benevolence.
Don MacAskill is the founder and CEO of the image-sharing and hosting company SmugMug, a
2020 recipient of Forbes magazine’s Small Giant award. In operation since 2002, and despite
being located in the heart of Silicon Valley in Mountain View, California, SmugMug is the
opposite of the venture capital ethos that permeates high technology startups. MacAskill
started SmugMug, which now has $66 million in revenue and 210 employees, 31 without raising
external capital and ceding control—and timeline—to outside investors. Instead, he built a
business model predicated on customers paying for services (an anomalistic strategy in Silicon
Valley), and this allowed him to construct a business with a long-term and enduring mindset. MacAskill’s
business views were influenced by his partner and father, Chris, a successful entrepreneur in his own right. Chris
was the founder of Fatbrain.com, 32 an online bookstore that initiated an IPO and ultimately was acquired by
Barnes & Noble.com in 2000 for $64 million. 33 MacAskill witnessed the pressures of being public through his
father’s experience and likened it to “the Wizard of Oz, everything is different behind the curtain and not nearly
as exciting or impressive. There are lots of costs of being public and exiting.” MacAskill further shared:
You make very different decisions when you think about building a business for an exit. That is
exactly what SmugMug is not about. When an exit is always in your mind, it is harder to be
operational and customer-centric, it becomes all about financial performance and not even
operating financial performance – but investment performance. There are many ripple effects
when you are all about an exit. We are building an enduring company that I control and can
determine where we are going. I purposefully elected not to bring in outside capital even
though I have been approached many times by investors. I have learned a lot by watching other
14 ON THE NATURE OF LONG-TERM HOLDSpeople’s mistakes. I am deeply motivated by my purpose, values, and emotional state. I
thoroughly enjoy the people I work with and the customers I serve. SmugMug provides me and
my family with a delightful lifestyle, so I am not motivated exclusively by money. I get three
significant rewards from running SmugMug:
1. I work with and learn from great people
2. I enjoy building cool and meaningful things, and
3. It’s fun!
I am fortunate that SmugMug has a great business model, and we are growing and creating
material value. As long as that is true and I meet the three criteria above, I am a very, very long-
term holder. Why would I ever give this up? 34
We are certainly in favor of building personal wealth at an exit, but there are life-enhancing advantages of being
a long-term business builder that might ultimately be more rewarding and fulfilling than having a pile of money
in the bank after a short-term exit.
Why entrepreneurs often choose to exit and how good those reasons actually are
We recognize that there are several reasons why entrepreneurs might consider not engaging in a long-term hold
strategy. Liquidity, diversification, overly generous valuation multiples, and flagging enthusiasm for the
relentless demands of running a business are often cited as catalysts for an exit. We can appreciate those facts
but still encourage entrepreneurs not to succumb to the temptation they present.
Liquidity
In our experience, perhaps the biggest point of misalignment between investors and entrepreneurs is liquidity.
We have observed (including in our own entrepreneurial experiences) the opposing forces of (1) the power of
compounding that we discuss in this note and (2) entrepreneurs’ desire for those things that their investors
have: liquidity and wealth. Some amount of liquidity is indeed essential, but after a certain point, more liquidity
is not incrementally useful—its utility declines. Entrepreneurs should seek to get some funds outside of their
business for liquidity purposes, but it does not require a complete exit and shifting from total illiquidity to total
liquidity. We think that somewhere between $5 million and $10 million is ample liquidity for most
entrepreneurs. Liquidity can be achieved through dividends from operations, a partial sale, or a dividend
recapitalization.
Diversification
Diversification does have value, but it is difficult to create copious wealth while being diversified. Like liquidity,
some diversification is likely useful, but complete diversification has diminishing utility. If you own a superior
business, some diversification might be emotionally necessary and provide peace of mind, but we would rather
sacrifice diversification for a superb compounding machine.
Linked to the liquidity concept, if an entrepreneur takes some amount of capital out of the business, in the range
of $5 to $10 million, this might provide ample diversification to then focus on the concentrated investment in
the compounding machine.
15 ON THE NATURE OF LONG-TERM HOLDSOverly generous valuation multiples Entrepreneurs are often seduced into selling a business because exit multiples appear to be at a zenith. It is fair to say that a disproportionately high multiple is akin to being paid forward for several years’ worth of work and gains; however, if you are viewing the world in decades or generations, a high multiple (say, 15x EBITDA) is not enough to overcome the power of long-term compounding and is ultimately just a short-term distraction. Entrepreneurs, bankers, and investors become giddy when 15x EBITDA multiples are in the air. This is a multiple that is seemingly not rejectable—unless you actually do the math and have a long-term horizon. To do this math, we first assume that we have an entrepreneur who, like Odysseus, is capable of resisting the temptation offered by the siren call of 15x EBITDA. Entrepreneur One grows EBITDA by 15% per year and maintains constant debt throughout a 25-year program of 3x EBITDA. At the end of 25 years, the entrepreneur has $77 million in EBITDA and $231 million in debt (3 × $77 million). This entrepreneur then sells the business for 10x EBITDA for a gross enterprise value of $771 million and a net equity value of $540 million. Taxes of 25% equate to $135 million, and our entrepreneur finally nets $404 million. See Figure 5 for a breakdown of the cash flows. Figure 5: Cash flows for Entrepreneur One, who continuously compounds EBITDA and exits the business for 10x EBITDA (presented in millions) Source: Created by the case writers In our second scenario, Entrepreneur Two runs a business and grows EBITDA at 15% per year, just like Entrepreneur One. Our second entrepreneur receives an offer to sell their business in year ten at an enticing 15x EBITDA, and they accept. We assume the same leverage of 3x EBITDA. At the end of year ten, Entrepreneur Two has $4 million in EBITDA and $12 million in debt. At a 15x EBITDA multiple, the enterprise value is $60 million, and the net equity value is $48 million. Of course, taxes need to be paid, and at 25%, they are $12 million, leaving our entrepreneur $36 million to redeploy after year ten. We assume Entrepreneur Two invests their proceeds in some type of portfolio for another 15 years so we can make a comparison to Entrepreneur One, who runs a 25-year program. We assume that Entrepreneur Two can invest the $36 million of capital with varying return expectations of 6%, 8%, 12%, and 15%. These returns present an array of different expectations and reflect investments ranging from a balanced portfolio of equity and fixed income securities in public markets to a portfolio of private securities concentrated in equity investments. For a proper comparison with Entrepreneur One, we calculate the future values of $36 million, Entrepreneur Two’s net after-tax proceeds at the various returns, and then assume that we liquidate all investments and pay taxes after 15 years. This provides us with a 25-year program consisting of holding a 16 ON THE NATURE OF LONG-TERM HOLDS
business and exiting it in year ten at a 15x EBITDA multiple and then deploying the after-tax proceeds for
another 15 years with a final liquidation and tax payment. The results are in Figure 6.
In every case, selling at the alluring 15x EBITDA multiple results in an inferior outcome when compared to
holding a business for 25 years and exiting at a 10x EBITDA multiple. We are implicitly assuming that
Entrepreneur Two does not transact in any way after year 10 and incurs no further taxes until year 25. Once
again, we see that holding and diligently compounding prevails over exiting—even at a stratospheric multiple.
Figure 6: Cash flows for Entrepreneur Two, who exits at year 10 for 15x EBITDA (presented in millions)
Source: Created by the case writers
Glenn Healey (Harvard Business School 1982) is an entrepreneur based in suburban Detroit,
Michigan. Healey operates a $36-million EBITDA portfolio of businesses, and he is not
interested in exiting in the foreseeable future. The companies are in two industries:
commercial fire protection and traffic control for road construction. Healey states:
Equity invested is $47 million, dividends paid from operating profits in 2019 were $23 million
and taxable income was $10 million. In addition, our EBITDA and dividends have grown
consistently for the last five years, and, during that time, we realized a portion of the equity value
increase associated with EBITDA growth through a debt re-capitalization. We think our businesses are
sustainable and will continue to have good growth potential. Even the proceeds from an irrational sale
price would come up woefully short of making economic sense, especially after considering the impact
of reversing tax deferrals. 35
Some entrepreneurs attempt to create a long-term strategy by stringing together successive short-term
investors who can then exit at premium valuation, like the 15x EBITDA mentioned above. This results in the
entrepreneur being a permanent presence in the business while successive investors swap in and out of the
enterprise every five years or so. While this does give the entrepreneur the ability to have a somewhat longer-
term view, the reality is that every few years, investors will need to ramp up the distracting exit process. Once a
transaction takes place, the entrepreneur will spend plenty of time getting new investors and board members
up to speed and learning the business. This might seem like a tenable solution for a long-term philosophy; in
17 ON THE NATURE OF LONG-TERM HOLDSreality, it probably feels like serial short-term investors being strung together and ales to a more permanent
capital base committed to a long-term horizon.
Flagging enthusiasm
Running and building a business is hard work, and an entrepreneur’s enthusiasm can certainly wane over time.
Still, if an entrepreneur finds themselves flagging, they can hire a professional manager to bear the burden of
running at least parts of the business. Hiring a professional manager to steward an organization is certainly risky,
but as an organization grows, entrepreneurs need to attract talent no matter what. Furthermore, a professional
manager might even be better than the entrepreneur at guiding the enterprise through later growth stages.
We think the typical arguments for selling and playing a short-term game are invalid, and entrepreneurs should
resist the temptation of a near-term exit. The only acceptable reason we see for an entrepreneur to exit a
business is if the investment thesis has materially changed and the entrepreneur is incapable of pivoting to a
modifying context. When the investment thesis morphs, it does indeed make sense to exit a business—that is, if
the entrepreneur and company are not able to react and adapt intelligently to a new, and possibly more
challenging, environment.
Charbel Zreik (University of Pennsylvania Wharton 2005) was in this exact situation in 2018.
Zreik was the CEO of Design Communications Inc., a provider of data, voice, and unified
communications technologies to the hospitality industry that is based in Syosset, New York.
Despite having grown the business over a four-year period, Zreik, who acquired the business
in 2014, felt that the investment thesis was changing and was not prepared to reposition the
company to address technological and market changes. Accordingly, Zreik decided to sell and
believes it was the right decision given the context. He elaborates:
I enjoyed being a CEO and running DCI. It was hard, though, and in the 2016-2018 window, we felt the
industry and business morphing. We were facing a decision to double down and rebuild the business
with lots of execution risk or pursue an exit. Large customers were driving investments in the company
that were easier to do at scale, and we did not have that scale and were not sure we wanted to take the
risk of getting there. The underlying investment thesis changed, and I thought it was the right decision
to exit, and I am glad we did. I generated a great return and truncated the risk. Yeah, I am a long-term
holder – if the investment thesis is holding up – mine did not – so it was exit time. 36
IRRs and MOIC – further evidence supporting long-term holds
If an entrepreneur holds a business for an extended period, their focus begins to shift toward multiple on
invested capital (MOIC) as opposed to IRR. As individuals who have operated our own businesses and invested
our personal capital, what excites us most is MOIC. IRRs can be splashy and sexy, but MOIC is what truly
generates wealth and converts to nominal dollars. We are skeptical of large IRR results over short holding
periods. Given the choice of a 35% IRR over three years or a 15% IRR over ten years, we would eagerly select the
lower IRR for the longer hold. For the mathematically curious, 35% IRR yields a 2.46 MOIC over three years *
while 15% IRR over a decade produces a 4.05 MOIC †. Given the choice of turning a dollar into $2.40 or $4.05, we
would choose the higher nominal dollar opportunity despite the lower IRR implications.
In Exhibit 1, we calculate IRR as a function of MOIC. It is worth studying the exhibit to understand at what IRR
rate an entrepreneur needs to compound their capital to achieve a certain MOIC. For example, if an
* FV=PV(1+i)n = $1 (1+35%)3= $2.46
† FV=PV(1+i)n = $1 (1+15%)10= $4.05
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