Can The Investment Capital You Have Support The Post-Exit Lifestyle You Want
“Hank
McHenry” arrived in my office to talk about his interest in selling his
business. After a bit of introductory chatter, I asked Hank to tell me a
bit about his company and why he wanted to sell it. He
told me:
When I asked Hank what goals and aspirations he wanted the sale of his business to accomplish, I learned that there were three.
“Well Hank,” I answered, “my best guess may surprise you.” (I’m
guessing it will surprise you too.) I continued, “With some good
fortune, you might be able to exit your business by selling it to a
third party and achieve your three goals in about 15 years.”
Except for the sound of the gears churning in Hank’s head, there was silence in my office. As I suspected, Hank had quickly calculated that he would be 78 years old in 15 years and was not relishing the idea of staying in his business that long. But before he stormed out of my office he asked me how I had reached this, in his opinion, outlandish conclusion.
This is what I told him.
“First, you want to maintain your current lifestyle (post exit) and need your annual income of $300,000 to do so. Like most successful owners you compensate yourself based on what you spend. The balance of your company’s profits (in your case the $400,000 a year of EBITDA) you either leave in the business (if its growing and needs the cash) or you take it out as an “S” distribution and invest what is left after taxes.” Hank nodded.
I continued, “Once you sell your business, something has to replace that compensation. After you leave your business, you will have to depend on your accumulated investment capital for all but about $40,000 per year in Social Security payments. Right now you have about $1,000,000 of invested capital. You need an additional $5,000,000 to maintain your lifestyle of $300,000 per year.
If your reaction matches Hank’s you are likely asking, “Why so much capital?” Hank did not have access to my last post, Past Performance Is Not Indicative Of Future Results, but you do. As you recall, that article discussed the findings from a recent McKinsey study. It forecasted that investment returns from both stocks and bonds would remain historically low for the next 20 years and that the investment return on a mixed portfolio of stocks and bonds would likely not exceed 3% – at the most 4%. Further, most financial planners generally suggest that it may be imprudent for retirees to withdraw more than 4% per year from their investment portfolios.
For these reasons I suggested to Hank that he assume a withdrawal rate of 4% on his investment portfolio. Given investment capital of $1,000,000, he would need to add $5,000,000 to it to reach the $6,000,000 necessary to yield, at a 4% withdrawal rate, $240,000 per year. That amount plus his $40,000 per year in Social Security payments would just about cover his lifestyle goal of $300,000 per year.
Hank made a move toward the door, but I wasn’t finished. “Hank, since your business is not growing, I did not project any increased cash flow or any growth in value that would convert into a higher purchase price 15 years from now. Accordingly I assume that the present EBITDA of $400,000 will continue. After taxes that amounts to about $250,000 per year. After 15 years that totals roughly $4,000,000. That is $1,000,000 less than the amount of capital you need, but, given some marginal growth in the business or the investment portfolio, it is not too much of a stretch to assume that your combined investments might be at $6,000,000 or more.” Of course, I suggested to Hank that he and his advisors review these assumptions at least annually to see if any adjustments were needed based on actual performance.
Hank’s next question did not surprise me as it is one I hear from most business owners who suddenly realize they are short on the investment capital necessary to exit when they want, “What can I do to exit my business sooner?”
In response, I lay out the following options.
Option 1. Curtail your expectations about your post-exit lifestyle. In Hank’s case if he chooses to exit today, the income available to support his lifestyle will fall from $300,000 per year to approximately $120,000. To calculate that amount, add his $1,000,000 of invested capital to approximately $1,000,000 in net sale proceeds. Multiply $2,000,000 by the 4% withdrawal rate ($80,000). Add $80,000 to Hank’s Social Security payments of $40,000 per year and there’s the $120,000.
Option 2. Do nothing. Stay in the business indefinitely and continue to receive your current compensation. Invest the extra income from the business, but do not make any plans to grow the company or to exit.
Option 3. Grow your business. Create and implement an Exit Plan that focuses on growing both value and cash flow.
Option 4. Buy lottery tickets.
Hank was upset, but I suspect that before he walked into my office he knew he needed more investment capital. He just didn’t expect that he needed $4,000,000 more.
Once Hank accepted the McKinsey report’s projections of future investment performance and that a 4% withdrawal rate was appropriate, he realized that he could choose one of the four options.
Hank didn’t realize it, but in obtaining a professionally prepared valuation report, he had more information at his fingertips than most owners do. Most owners base their usually inflated assumptions about the value on their companies on conversations with friends or rumors about the sale prices of their competitors. With hard data, Hank could not fudge the value of the company or the value of future Social Security payments or the size of his investment portfolio.
If you are contemplating the exit from your business, I suggest that you take a snapshot of where you are today so you can assess the size of the gap (if any) between where you are and where you want to be (financially) when you exit. First, find the true value of your company and its likely sale price. Second, take the amount investment capital you have today and multiply that by a withdrawal rate of no more than 4%. If the result is less than you need to support your desired post-exit lifestyle, review the four options listed in this article. Hire an experienced financial planner.
When you understand how much invested capital is required to support your post-exit lifestyle, you can take action to secure the future you want for yourself, your family, and your business. I will discuss the range of actions available to you in future posts.
source - forbes.com
told me:
- He is 63 years old and the sole owner of the company.
- His annual compensation is $300,000, and he has an investment portfolio of about $1,000,000.
- His company has approximately 30 employees.
- The business has about $400,000 of EBITDA or cash flow. The business has been growing steadily, but not dramatically.
- A recent calculation of value placed the fair market of his company at about $1.5 million.
When I asked Hank what goals and aspirations he wanted the sale of his business to accomplish, I learned that there were three.
- Maintain his lifestyle. Hank and his wife were comfortable with the lifestyle that his $300,000 in annual compensation provided and were not interested in curtailing it.
- Sell the business to an outside third party. Neither Hank’s children nor his management team was interested in, or capable of, owning the business.
- Leave with post-exit financial security assured.
Recommended by Forbes
Except for the sound of the gears churning in Hank’s head, there was silence in my office. As I suspected, Hank had quickly calculated that he would be 78 years old in 15 years and was not relishing the idea of staying in his business that long. But before he stormed out of my office he asked me how I had reached this, in his opinion, outlandish conclusion.
This is what I told him.
“First, you want to maintain your current lifestyle (post exit) and need your annual income of $300,000 to do so. Like most successful owners you compensate yourself based on what you spend. The balance of your company’s profits (in your case the $400,000 a year of EBITDA) you either leave in the business (if its growing and needs the cash) or you take it out as an “S” distribution and invest what is left after taxes.” Hank nodded.
I continued, “Once you sell your business, something has to replace that compensation. After you leave your business, you will have to depend on your accumulated investment capital for all but about $40,000 per year in Social Security payments. Right now you have about $1,000,000 of invested capital. You need an additional $5,000,000 to maintain your lifestyle of $300,000 per year.
If your reaction matches Hank’s you are likely asking, “Why so much capital?” Hank did not have access to my last post, Past Performance Is Not Indicative Of Future Results, but you do. As you recall, that article discussed the findings from a recent McKinsey study. It forecasted that investment returns from both stocks and bonds would remain historically low for the next 20 years and that the investment return on a mixed portfolio of stocks and bonds would likely not exceed 3% – at the most 4%. Further, most financial planners generally suggest that it may be imprudent for retirees to withdraw more than 4% per year from their investment portfolios.
For these reasons I suggested to Hank that he assume a withdrawal rate of 4% on his investment portfolio. Given investment capital of $1,000,000, he would need to add $5,000,000 to it to reach the $6,000,000 necessary to yield, at a 4% withdrawal rate, $240,000 per year. That amount plus his $40,000 per year in Social Security payments would just about cover his lifestyle goal of $300,000 per year.
Hank made a move toward the door, but I wasn’t finished. “Hank, since your business is not growing, I did not project any increased cash flow or any growth in value that would convert into a higher purchase price 15 years from now. Accordingly I assume that the present EBITDA of $400,000 will continue. After taxes that amounts to about $250,000 per year. After 15 years that totals roughly $4,000,000. That is $1,000,000 less than the amount of capital you need, but, given some marginal growth in the business or the investment portfolio, it is not too much of a stretch to assume that your combined investments might be at $6,000,000 or more.” Of course, I suggested to Hank that he and his advisors review these assumptions at least annually to see if any adjustments were needed based on actual performance.
Hank’s next question did not surprise me as it is one I hear from most business owners who suddenly realize they are short on the investment capital necessary to exit when they want, “What can I do to exit my business sooner?”
In response, I lay out the following options.
Option 1. Curtail your expectations about your post-exit lifestyle. In Hank’s case if he chooses to exit today, the income available to support his lifestyle will fall from $300,000 per year to approximately $120,000. To calculate that amount, add his $1,000,000 of invested capital to approximately $1,000,000 in net sale proceeds. Multiply $2,000,000 by the 4% withdrawal rate ($80,000). Add $80,000 to Hank’s Social Security payments of $40,000 per year and there’s the $120,000.
Option 2. Do nothing. Stay in the business indefinitely and continue to receive your current compensation. Invest the extra income from the business, but do not make any plans to grow the company or to exit.
Option 3. Grow your business. Create and implement an Exit Plan that focuses on growing both value and cash flow.
Option 4. Buy lottery tickets.
Hank was upset, but I suspect that before he walked into my office he knew he needed more investment capital. He just didn’t expect that he needed $4,000,000 more.
Once Hank accepted the McKinsey report’s projections of future investment performance and that a 4% withdrawal rate was appropriate, he realized that he could choose one of the four options.
Hank didn’t realize it, but in obtaining a professionally prepared valuation report, he had more information at his fingertips than most owners do. Most owners base their usually inflated assumptions about the value on their companies on conversations with friends or rumors about the sale prices of their competitors. With hard data, Hank could not fudge the value of the company or the value of future Social Security payments or the size of his investment portfolio.
If you are contemplating the exit from your business, I suggest that you take a snapshot of where you are today so you can assess the size of the gap (if any) between where you are and where you want to be (financially) when you exit. First, find the true value of your company and its likely sale price. Second, take the amount investment capital you have today and multiply that by a withdrawal rate of no more than 4%. If the result is less than you need to support your desired post-exit lifestyle, review the four options listed in this article. Hire an experienced financial planner.
When you understand how much invested capital is required to support your post-exit lifestyle, you can take action to secure the future you want for yourself, your family, and your business. I will discuss the range of actions available to you in future posts.
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