Which MBAs Make More: Consultants or Small-Business Owners?
June 28, 2016
In our work studying entrepreneurship-through-acquisition (EtA) — in which individuals purchase an existing small business to own and run themselves — we’ve found that most graduating MBA students agree that being the CEO of a small firm dominates traditional post-MBA careers like consulting, investment banking, private equity, and the like on these non-pecuniary dimensions. Owners of small businesses can set their own hours, make their own management decisions, and take pride in the ownership of their work.
Also, as we explained in an earlier article, we believe that being an established CEO of a small firm involves much less angst than being a senior member of a consulting, investment banking, or private equity firm.
So, the remaining question about being a small firm CEO is the monetary reward; if the money is nearly the same, then the compensation as a small business CEO dominates other careers.
To ground our analysis, let’s assume that the alternative to being a small firm CEO is to follow a traditional post-MBA career and recognize that, at best, we can only compare expected paths because everyone’s experience will be different. So, we begin by assuming that the traditional path offers cash compensation equal to the average starting salary. (It might be tempting to turn to the highest starting salary paid, which typically goes to the graduate with the most experience in the most competitive market, who often earns crazy money their first year. But these are rare occurrences, and we believe that using the average yields a more accurate outcome.)
That average is actually hard to nail down, however. Some large sample surveys report that MBAs nationwide have an average starting salary of about $100K. Graduates from so-called elite schools make more, with some estimates of elite school average starting salaries in the $150K range. The relative compensation of a traditional career and entrepreneurship through acquisition hinges on salaries in the next 10 years and the carry from deals with investors who provided money to acquire the business. These are of course unknown and highly dependent on the job and the success of the small business itself. But here is a sketch based on the information we have at hand.
We’ll assume the salary in a traditional post-MBA job grows at a 12% compound annual growth rate (CAGR) so that it more than triples in the first 10 years, which is in line with post-MBA salary surveys we’ve done here at the Harvard Business School. We’ll also assume the cash compensation for a new CEO of a small business starts off at the average post-MBA salary, and its growth is generally tied to the performance of the company — both of which are typical from our experience as board members of these types of companies. Because we generally argue that those searching for a small business to buy should target slow-growing dull businesses, we’ve put this at 5% per year. The chart below shows that over the first 10 years of employment, the cash compensation from the traditional job dominates.
But the annual cash compensation only provides part of the pecuniary payoffs of the purchase of a small business because the entrepreneur also has a significant ownership interest in the company. The size of that ownership interest varies on how they structured their funding throughout the process, but for now let’s assume the entrepreneur has a 20% carried interest in the acquired company. (That means that the CEO keeps 20% of any cash distribution after the investors’ investment is returned and they are paid a preferred dividend.) The value of that carried interest, of course, depends on the performance of the business, its size, amount of debt used to finance the acquisition and the eventual pricing of a subsequent sale.
To make the analysis tractable, we’ll make some simplifying conservative assumptions: we’ll assume no growth in the business and, because there is no growth, we’ll assume that the selling multiple exactly equals the purchase multiple. We’ll also assume the entrepreneur acquired a $1.5 million EBITDA company for 4x paying $6 million and using 50% debt financing.
To keep things simple, we’ll take advantage of our assumptions of no growth and a constant multiple and ignore the actual timing of the cash flows. That means that, in this example, the purchase price and the eventual selling price will be the same so that the debt and the equity investment can be assumed to be repaid at the sale. This leaves us only with the cash flows that occur between the purchase and the eventual sale.
Add this to the cash salary and the entrepreneurship through acquisition path dominates the traditional post-MBA career path, as shown in the chart below.
What happens if we take into account the timing of the cash flows? The usual timing of cash flows is that the debt gets repaid first, then the equity investors get their investment plus preferred return second, next the entrepreneur gets paid 20% of the preferred return, and lastly, the remaining cash flows are split 80% for the investor and 20% for the CEO. The bank and investors get paid off before the CEO gets any cash for the carried interest. But the advantage to the traditional path in the early years is very much offset by the impressive EtA cash flows that occur once the carry starts getting paid and even more so upon exit (which we’ve assumed in year 10 in this example). Here is the revised comparison:
Analytical readers may think this is a great opportunity to compute the present values of the two paths, perhaps using different discount rates the reflect the perceived risks of the two paths (the present values are close at 15% for the traditional path and 25% for the EtA path) in hopes of determining which path offers the highest compensation. (We recognize that some believe that the EtA path is more risky and thus would assign a higher discount rate. We are not so sure of that.) We don’t advise that approach. Instead, we think you should recognize that there are a lot of differences that we haven’t fully modelled. On one side of the coin, there are likely tax advantages from the EtA payouts and increases from growing the acquired business. On the traditional path side of the coin, there might be pensions or bonuses that we’ve not captured.
Overall, we think that this financial analysis shouldn’t be used to show that one path dominates another. To us, it shows that the compensation is reasonably similar across the two paths; certainly individual variations in experiences will dominate any systematic differences. With money out of the calculus, and the general assessment from MBA graduates that the non-pecuniary aspects of being a small business CEO dominate those of more traditional careers, we imagine that more graduating MBA students will choose the EtA path.
Of course, being a small firm CEO doesn’t appeal to everyone so the decision turns, as we think it should, on whether you appreciate and will thrive in a small business environment.
Richard S. Ruback
is the Willard Prescott Smith Professor of Corporate Finance at the
Harvard Business School. He has taught a variety of corporate finance
courses throughout his career and has served as an expert witness on
valuation and security issues. Over the last few years, he and his
colleague Royce Yudkoff have been developing and teaching courses on the
entrepreneurial acquisition of smaller firms. They are the authors of
the HBR Guide to Buying a Small Business (HBR Press, 2016).
Royce Yudkoff
is a Professor of Management Practice at the Harvard Business School;
he co-founded and served for over 20 years as Managing Partner of ABRY
Partners, a leading private equity investment firm. Over the last few
years, he and his colleague Richard Ruback have been developing and
teaching courses on the entrepreneurial acquisition of smaller firms.
They are the authors of the HBR Guide to Buying a Small Business (HBR Press, 2016).
This article is about ENTREPRENEURSHIP
June 28, 2016
In our work studying entrepreneurship-through-acquisition (EtA) — in which individuals purchase an existing small business to own and run themselves — we’ve found that most graduating MBA students agree that being the CEO of a small firm dominates traditional post-MBA careers like consulting, investment banking, private equity, and the like on these non-pecuniary dimensions. Owners of small businesses can set their own hours, make their own management decisions, and take pride in the ownership of their work.
Also, as we explained in an earlier article, we believe that being an established CEO of a small firm involves much less angst than being a senior member of a consulting, investment banking, or private equity firm.
So, the remaining question about being a small firm CEO is the monetary reward; if the money is nearly the same, then the compensation as a small business CEO dominates other careers.
To ground our analysis, let’s assume that the alternative to being a small firm CEO is to follow a traditional post-MBA career and recognize that, at best, we can only compare expected paths because everyone’s experience will be different. So, we begin by assuming that the traditional path offers cash compensation equal to the average starting salary. (It might be tempting to turn to the highest starting salary paid, which typically goes to the graduate with the most experience in the most competitive market, who often earns crazy money their first year. But these are rare occurrences, and we believe that using the average yields a more accurate outcome.)
That average is actually hard to nail down, however. Some large sample surveys report that MBAs nationwide have an average starting salary of about $100K. Graduates from so-called elite schools make more, with some estimates of elite school average starting salaries in the $150K range. The relative compensation of a traditional career and entrepreneurship through acquisition hinges on salaries in the next 10 years and the carry from deals with investors who provided money to acquire the business. These are of course unknown and highly dependent on the job and the success of the small business itself. But here is a sketch based on the information we have at hand.
We’ll assume the salary in a traditional post-MBA job grows at a 12% compound annual growth rate (CAGR) so that it more than triples in the first 10 years, which is in line with post-MBA salary surveys we’ve done here at the Harvard Business School. We’ll also assume the cash compensation for a new CEO of a small business starts off at the average post-MBA salary, and its growth is generally tied to the performance of the company — both of which are typical from our experience as board members of these types of companies. Because we generally argue that those searching for a small business to buy should target slow-growing dull businesses, we’ve put this at 5% per year. The chart below shows that over the first 10 years of employment, the cash compensation from the traditional job dominates.
But the annual cash compensation only provides part of the pecuniary payoffs of the purchase of a small business because the entrepreneur also has a significant ownership interest in the company. The size of that ownership interest varies on how they structured their funding throughout the process, but for now let’s assume the entrepreneur has a 20% carried interest in the acquired company. (That means that the CEO keeps 20% of any cash distribution after the investors’ investment is returned and they are paid a preferred dividend.) The value of that carried interest, of course, depends on the performance of the business, its size, amount of debt used to finance the acquisition and the eventual pricing of a subsequent sale.
To make the analysis tractable, we’ll make some simplifying conservative assumptions: we’ll assume no growth in the business and, because there is no growth, we’ll assume that the selling multiple exactly equals the purchase multiple. We’ll also assume the entrepreneur acquired a $1.5 million EBITDA company for 4x paying $6 million and using 50% debt financing.
To keep things simple, we’ll take advantage of our assumptions of no growth and a constant multiple and ignore the actual timing of the cash flows. That means that, in this example, the purchase price and the eventual selling price will be the same so that the debt and the equity investment can be assumed to be repaid at the sale. This leaves us only with the cash flows that occur between the purchase and the eventual sale.
Add this to the cash salary and the entrepreneurship through acquisition path dominates the traditional post-MBA career path, as shown in the chart below.
What happens if we take into account the timing of the cash flows? The usual timing of cash flows is that the debt gets repaid first, then the equity investors get their investment plus preferred return second, next the entrepreneur gets paid 20% of the preferred return, and lastly, the remaining cash flows are split 80% for the investor and 20% for the CEO. The bank and investors get paid off before the CEO gets any cash for the carried interest. But the advantage to the traditional path in the early years is very much offset by the impressive EtA cash flows that occur once the carry starts getting paid and even more so upon exit (which we’ve assumed in year 10 in this example). Here is the revised comparison:
Analytical readers may think this is a great opportunity to compute the present values of the two paths, perhaps using different discount rates the reflect the perceived risks of the two paths (the present values are close at 15% for the traditional path and 25% for the EtA path) in hopes of determining which path offers the highest compensation. (We recognize that some believe that the EtA path is more risky and thus would assign a higher discount rate. We are not so sure of that.) We don’t advise that approach. Instead, we think you should recognize that there are a lot of differences that we haven’t fully modelled. On one side of the coin, there are likely tax advantages from the EtA payouts and increases from growing the acquired business. On the traditional path side of the coin, there might be pensions or bonuses that we’ve not captured.
Overall, we think that this financial analysis shouldn’t be used to show that one path dominates another. To us, it shows that the compensation is reasonably similar across the two paths; certainly individual variations in experiences will dominate any systematic differences. With money out of the calculus, and the general assessment from MBA graduates that the non-pecuniary aspects of being a small business CEO dominate those of more traditional careers, we imagine that more graduating MBA students will choose the EtA path.
Of course, being a small firm CEO doesn’t appeal to everyone so the decision turns, as we think it should, on whether you appreciate and will thrive in a small business environment.
Richard S. Ruback
is the Willard Prescott Smith Professor of Corporate Finance at the
Harvard Business School. He has taught a variety of corporate finance
courses throughout his career and has served as an expert witness on
valuation and security issues. Over the last few years, he and his
colleague Royce Yudkoff have been developing and teaching courses on the
entrepreneurial acquisition of smaller firms. They are the authors of
the HBR Guide to Buying a Small Business (HBR Press, 2016).
Royce Yudkoff
is a Professor of Management Practice at the Harvard Business School;
he co-founded and served for over 20 years as Managing Partner of ABRY
Partners, a leading private equity investment firm. Over the last few
years, he and his colleague Richard Ruback have been developing and
teaching courses on the entrepreneurial acquisition of smaller firms.
They are the authors of the HBR Guide to Buying a Small Business (HBR Press, 2016).
