Written by: Kirk Licata, CFP®
Having been raised in a family whose livelihood depended upon a small business, I know from personal experience the extent to which the successes or failures of such a business can become integrated into an individual or family’s personal life. Will the profits from the business pay the bills, fund the desired lifestyle, pay for college, or provide for retirement some day? Considering that 20% of small businesses fail during their first year and only about half survive through their fifth year1, it’s apparent that striking out on your own is not for the faint of heart. Even for those who have achieved a rare level of success in their business, it is still even more rare that the ultimate sale of the business can fully fund their retirement.
To understand why this is true, we must first understand how a small business may be valued when it comes time to sell. Buyers of businesses are typically looking for the same things that all investors are looking for: cash flow, growth, or a combination of the two. Cash flow is the measurement that makes the most sense to discuss since it is a key metric for small business valuations. As a starting point, let’s look at a measurement called Seller’s Discretionary Earnings (SDE):
Total Sales – Cost of Goods Sold – Expenses + Owners Wage + Personal Expenses Paid for Through Business = SDE
Essentially, this formula tells buyers the cash flow that they can expect from your business if they purchase it from you. If you’ve made yourself operationally irrelevant, a feat that few accomplish but is crucial to increasing your valuation, you can use the formula above to determine your SDE. If someone needs to be paid to take over your responsibilities, you should subtract that salary from the SDE figure. Now that we know how to calculate SDE, we would want to find the appropriate industry multiple of SDE to assess the value of the business. Across all industries, the average multiple is between 2-4 times your annual SDE. 2
Example: Allison owns a business that has total annual sales of $3,000,000 with business expenses of $2,800,000; she takes an annual wage of $250,000 and has personal expenses of $50,000 (utilities, fuel, auto lease, etc.). In this example, her SDE is $500,000. ($3,000,000 – $2,800,000 + $250,000 + $50,000)
In Allison’s case, her business may be worth anywhere from $1,000,000 to $2,000,000 using the range of average multiples (2-4) if she has made herself operationally irrelevant. If someone must be hired and paid a salary to assume Allison’s responsibilities, then the valuation would decline further.
Let’s say that Allison strikes a deal with a buyer to receive the high end of the range and walks away with a $2 million taxable payout. Are she and her husband set for a 20-30-year retirement?
Well, through this exercise, we just learned that Allison and her husband are accustomed to living off an annual income of nearly $500,000 between her annual wage, the personal expenses paid by the business, and the annual business distributions she receives, a lifestyle that demands upwards of $20,000 per month. Will Social Security and their $2 million payout fund a $20,000 monthly lifestyle?
In today’s dollars, the maximum Social Security benefit that can be obtained at full retirement age is about $2,800 per month. Assuming her spouse is also entitled to a 50% spousal benefit ($1,400/ month), we’re off to a good start with nearly $4,000 in after-tax income to go towards our required $20,000 monthly spend, with the other $16,000 to be generated by investments.
In regard to the business payout, you may have noticed that I stressed the word “taxable” in an earlier paragraph. When a business is sold, part of the negotiations involves distinguishing between the portion of the sale that can be considered ordinary income and the portion that is capital gains income for tax purposes. For Allison’s sake, let’s say that she was able to minimize her taxes and was able to keep $1,400,000 for her retirement fund after all taxes were paid. At a hypothetical 6% rate of return on their retirement portfolio, Allison and her husband can withdraw their required $16,000 per month for approximately 10 years before completely depleting their savings.
As you can imagine, 10 years is not an acceptable expiration date for most of our clients’ retirement plans, so Allison and her husband would be forced to accept a dramatic reduction in their lifestyle during their retirement.
In conclusion, even with the benefits of a low-tax, high multiple payout on a business sale, which is already highly unlikely to occur, small business owners should give serious consideration to funding their own buy-out. Fortunately, there are many creative ways to extract maximum value from your small business earnings. Your LongView advisor is prepared to guide you through the process of leveraging your small business to create financial independence for you and your family, let us know when you’re ready to get started.
Examples are hypothetical and for illustrative purposes only. The rates of return do not represent any actual investment and cannot be guaranteed. Any investment involves potential loss of principal.