Imagine you are an entrepreneur. You started a company decades ago with a few thousand dollars, and now that company has grown into a large business that makes tens of millions of dollars per year in profit. But now, you are getting old and want to retire. Who do you sell your company to?

Route 1:

A competitor of your business offers to buy your business for $125 million. You can either take cash, or you can do a tax-free merger and obtain stock of the competitor in exchange for your company’s stock. You know that your industry has volatility, and you want to sleep well at night, so you opt for the cash so that you can buy a diversified index fund rather than have all your money in one stock in a single industry.

When you collect your $125 million in cash, you have to pay 20% in capital gains tax and another 3.8% in net investment income tax. All in, you have to pay $125 million * 0.238 = $29.75 million in taxes. You are left with $95.25 million to invest into a diversified index fund.

Route 2:

Now imagine that before you sell your business to the competitor, Berkshire Hathaway offers to buy your company for $100 million. That’s much less than the competitor offered, but wait a minute. Berkshire Hathaway is already a super stable, diversified company. From a retirement planning perspective, holding Berkshire Hathaway stock is just as good or better than holding a diversified index fund. That means if you sell your company in a tax-free merger to Berkshire Hathaway, you can end up owning $100 million of diversified investments instead of the $95.25 million that you would have had if you had sold to a competitor.

That is one way Berkshire Hathaway is able to buy companies for less than they are worth.