Weekly Thoughts

We are often asked why we chose to set up Chenmark Holdings as a C-corp, rather than a more traditional investment fund. We are not tax or legal professionals, and our experience is not necessarily applicable to others but rather a reflection of our unique path, so talk to your advisors before making any decisions. That said, our hope is that sharing our thinking about structure may help others contemplating similar topics. Let’s break it down to a couple of key categories:

Double Taxation as a Benefit: A common reaction to the C-corp structure is “my god, the double taxation! Why would you do that?!”  This is because C-corps are taxed at the corporate level, and then again at the personal level if there is a distribution.  If you are looking to distribute returns to shareholders on a regular basis, double taxation is a legitimate concern.  However, we have an indefinite holding period and our goal is to keep cash compounding within our organization.  So, we actually see double taxation as an example of unpleasant design.  We are penalized if we take cash out of Chenmark, thus creating a structural impediment in service of our much larger goal.

“Holding Company” vs. “Fund”:  We believe that if we execute properly, we can use the cash flows from our companies to support the acquisition of additional entities–ensuring our capital raising needs remain limited.  Along the way we have contemplated raising external capital to capitalize more rapidly on what we see as a multi-decade opportunity in small business M&A.  In those discussions, most investors think in a “fund” framework.  We dislike this structure because funds inevitably have an end (even if it’s decades out), whereas a C-corp structure has a perpetual existence–something that can live on indefinitely.

Long-Term Tax Benefits:  While not the primary reason we decided to do a C-corp, there is a potential tax benefit for stakeholders selling shares of Chenmark stock.  The IRS has something called the Small Business Stock Gains Exclusion (a.k.a. Section 1202) which allows capital gains from certain types of small business stock to be excluded from federal tax.  There are a bunch of details, but as long as a) the stock was issued before the corporation had $50 million or less in assets, b) 80% of the corporation’s assets are for the active conduct of qualified businesses and c) the stock is held for at least 5 years, the maximum of $10 million or 10 times the adjusted basis of the stock can be excluded from federal capital gains upon sale.

Streamlined Cap Table & Org Structure:  Our goal is to maximize the free cash flow generation of each of our entities, but not all companies share the same reinvestment opportunities (case in point, the proverbial Bait & Tackle shop). The holding company structure allows us to easily divert cash flows from one entity with limited reinvestment opportunities to other entities with a better opportunity set, or to pool capital for the purposes of a new acquisition entirely without having to worry about different ownership structures between the entities.  This aggregation also allows us to consolidate certain administrative functions like benefit plans, insurance, financing structures, or IT security where we can leverage the group’s combined economies of scale for (ideally) higher quality and lower cost services than any one company would be able to achieve on their own.

One Team, One Dream:  In our opinion, the cultural component of this structure is probably the most powerful, and the aspect most frequently missed by outsiders.  Individuals working at our companies are compensated based on the free cash flow generation of their entity, but the ability to participate in stock ownership occurs at the holding company level.  The result is a team of small businesses that each have their own objectives, and a simultaneous incentive to help each other along the way.

We fully acknowledge our setup may not be for everyone.  We started with first principles for what we wanted to achieve with Chenmark before deciding on a corporate structure.  Going with a more conventional “fund” probably would have been easier at the outset, but, at least so far, the C-corp life is working just fine for us.