Have you ever worked through the math of selling versus keeping a business?
The conversation with clients goes something like this:
Business Owner: Hey Paul, I think I want to escape from this business – How much do you think I could sell it for?
Paul: Valuations can get a little complicated, but on the back of the napkin we could take the annual cashflow and apply an average earnings multiple to get a value:
Annual cashflow = $100,000 x Earnings Multiple of 5X = Valuation of $500,000.
Business Owner: So, $100,000 per year of cashflow could be exchanged for $500,000 of cash?
Paul: Roughly and smoothly – yes. But there are a couple other factors to consider. You may have to pay capital gains tax on the sale – so after tax that might only be $400,000.
Business Owner: How much could I get in annual cashflow from the $400,000?
Paul: That’s really a question for your investment advisor, but my conservative portfolio returns about 4 to 5% these days.
Business Owner: So my cashflow after selling the business would be $400,000 x 4.5% = $18,000 per year?
Paul: Yes, but there is one other big factor to consider – the perks of business ownership. Does the business currently pay your cell phone, provide you a car, provide some promotion meals and clothing or any other perks?
Business Owner: Yes – that something I really don’t want to give up. Do you mean if I sell my business, then I have to pay my cell phone bill out of the $18,000 a year?
Business Owner – after pondering the choice…: So in summary, selling my business will turn $100,000 cashflow into $400,000 cash – which then turns into $18,000 a year cashflow with no perks!
Paul: It’s a back the napkin calculation, but that’s roughly, smoothly the deal.
Business Owner: I think I will keep it!
Paul: Good idea. Now there are some important things you might want to consider as a business owner:
- Have a “stash the cash” plan for the good years of ownership. This builds your investments outside the business and will grow the investment income cashflows over the long-term.
- Work on replacing yourself in the business, so you can have some freedom from the business, keep the cashflow and the perks and still enjoy your life too.
- There is an exit strategy choice that might allow you to keep some perks and some cashflow as your transition out – sell to the next generation or sell to key employees.
Business Owner: Yeah, lots to think about. How soon should I start this type of planning?
Paul: It’s kind of like planting a tree. There are only two good times to plant a tree. One good time to plant it is today, the other good time was 25 years ago.