This post was originally written in 2012 by financial planner, Josh Patrick, and updated by AT&Co. in October of 2021.
I’ve been speaking with and working with private business owners for over 15 years. Most owners have a dream of running their business for their working career, finding a buyer, and then riding off into the sunset with no other planning.
But thinking your business is all it takes to get to retirement is usually a myth. Businesses in the lower-middle market earn between $5 million and $50 million in annual revenue.
When you sell, your business valuation will be based on your earnings before interest, taxes, depreciation, and amortization (EBITDA). A multiplier will be applied to determine your company valuation. Both your EBITDA and the multiplier can vary based on your unique business as well as the industry you’re in.
For example, if we take a business that does $10 million in sales and has an EBITDA of 10%, we’ll see the following in a sale situation:
|EBITDA of 10%||$1,000,000|
|Sales price of 4.5 x EBITDA||$4,500,000|
|Taxes & expenses on sale (35%)||$1,575,000|
|Net proceeds from sale||$2,925,000|
|Annual income available at 4%1||$117,000|
Many investment advisors believe that an investor can spend 4% of their principal every year when their investments are in a balanced investment account. Note that this is not a guarantee of return. You should speak with your own financial advisor before making any investment or income assumptions.
If you take 4% of your earnings as a “retirement salary,” you’ll be living off $117,000 per year. The amount you earn post-sale is the conundrum that many private business owners face when they think about selling their business.
In this particular case, the owner has been enjoying $1 million of cash flow before interest, loan principal payments, capital investments, and taxes. The salary that an owner earns will, in most cases, be significantly more than the $117,000 the owner will live on per year after selling their business.
And, this is a business that is doing $10 million in annual sales, which makes it one of the top 2.5% of the businesses in the country. What would happen to you and your business? Are you in the top 2.5%?
If not, you might want to consider some of the following strategies so that you can afford to leave your business.
Know the Value of Your Business
Before you can plan for retirement, it’s important to know how much you can garner from the sale of your business. Too often, there is a valuation gap because business owners believe their business is worth more than it actually is.
Not only can a valuation gap draw out the length of a sale, but it can also leave business owners bitter and frustrated as they realize what they had dreamed for in retirement may not happen.
Receiving annual business valuations can help alleviate this. These annual evaluations do not need to be certified if they are only for internal use. Valuations allow you to see how much your company is worth and some of the things you can work on to help improve its value.
Start and Fund a Qualified Retirement Plan
I call this pre-funding your buyout. While your business is creating significant cash flow, take $40,000 to $60,000 of this cash flow and put it in a qualified retirement plan. Qualified retirement plans are advantageous because investment income grows tax-deferred. Examples of qualified retirement plans include:
If your portfolio is able to earn a 6% return and you fund a plan for 20 years with $50,000 per year, you’ll have a retirement plan nest egg of approximately $1.8 million at the end of that time.
Qualified plans are complicated beasts. There’s a great deal of customized design that can go into your plan. You’ll want to use an advisor who not only understands your investments but, more importantly, is an expert at what type of plan and how the plan can be designed. When used strategically, qualified retirement plans can offer considerable tax benefits.
In many cases, you can tell your advisor how much money you want to save and they can put together a plan that fits those parameters. I’ve seen business owners who got a late start save as much as $200,000 per year in their plan.
A potential downside to qualified retirement plans is that there are certain limits on how much you can contribute per year. Setting up a qualified retirement account is something that you should do while you still own your business, if possible. Otherwise, you will max your contributions after receiving the proceeds from the sale of your business and will still be sitting on a lot of cash.
Take Advantage of Other Tax-Efficient Investing Options
As mentioned, there may be limits on how much you can contribute to your qualified retirement account. But there are other investment options to consider, like brokerage accounts. Your financial advisor can help you come up with a plan that reduces your capital gains tax while also ensuring you have enough money to live on after you sell your business.
One simulation that your advisor might run is a Monte Carlo simulation. This method introduces random variables to determine the probability of different outcomes. From a financial perspective, it measures market volatility to determine how you would react under certain scenarios. This test is one type of measure that can help you determine how comfortable you will be in retirement if you’re living off the proceeds from your sale.
Purchase the Real Estate Your Business Operates In
If it’s possible for you to purchase the real estate you operate your business in, you should strongly consider this option. Many business owners who own their real estate will sell their business but keep the real estate and collect the rent.
Like a qualified retirement plan, starting early with owning your real estate is important. Many owners will buy the real estate their business is in and then “pay rent” to themselves for 15 years to pay off the mortgage. After the mortgage is paid off, the rent starts flowing to the business owner. Sometimes the income from rent is more than the income from the principal on the sale of the business.
Owning your own real estate makes leaving your business easier since you own considerable equity in a building.
A downside to this strategy is that you will need to become a property manager if you are renting the building to another tenant. You can hire property management companies to do this for you, though for a fee. These management companies can be responsible for collecting rent and dealing with tenant issues, so they could make your life easier if you don’t want to take a hands-on role after selling your company.
Start Passing Money to Those You Care About
You may want to pass along your retirement funds to those you care about. This cannot only include your family but charities as well. For instance, donor-advised funds are simple, effective ways to donate money to your favorite charities while also taking advantage of tax benefits.
A financial advisor can help you draw up an estate plan that enables you to start passing funds along to others. Doing so may reduce the funds that you have access to yourself, but it can also provide you with tax breaks that ultimately increase your net earnings post-sale.
Draw Up a Financial Plan Before You Sell
A sad experience is when a business owner sells their business, thinks they are going to retire, and then finds four or five years later they have to go to work for someone else. These sellers often have seller’s remorse. They wish they didn’t sell their business after all.
Doing a little financial planning before starting with a transfer strategy is always a good idea. The plan will tell you what your financial needs are before you start to plan the sale of your business. A trusted financial planner can help craft a portfolio that meets your post-retirement needs. Financial planners can also help you figure out how much money you need to live comfortably post-retirement while still meeting your goals.
It’s also important that you work with trusted business advisors before and during the sale of your company. These advisors can accurately determine the value of your business and how much you can expect to receive from a sale.
They can also help you determine which type of sale is best so that you can potentially keep things like your real estate investments. Merger and acquisition advisors with years of experience in the industry can help protect your interests — and help you avoid common mistakes when selling your business.
Josh Patrick is a founding principal with Stage 2 Planning Partners, a wealth management firm located in South Burlington, VT and Albany, NY. Josh specializes in helping business owners make their lives better by helping them create value in their business and life.