Michael and Sharon Drake were eager to sell their 32-year-old business. Their CPA estimated that the company was worth about four times its annual cash flow of $500,000 (i.e., $2 million) and that the net sale proceeds, after capital gains taxes and selling expenses, would be about $1.5 million.
With annual compensation of $250,000 and income from their $1.5 million personal investment portfolio, the Drakes figured that $3 million in investment capital would allow them to maintain their lifestyles post-exit.
Are they correct?
As part of Step Two of The BEI Seven Step Exit Planning Process™, Exit Planning Advisors evaluate the amount of investment capital required to support a business owner’s post-exit lifestyle. They understand two key facts:
- Most retirees choose to maintain their normal spending habits after retirement.
- The Four Percent Rule. Since the mid-1990s, financial planners have generally recommended that their clients follow the Four Percent Rule when planning the rate at which they’ll withdraw from their retirement nest eggs. This rate is based on a study of returns from stocks and bonds. It assumes that at least 50% of assets are invested in stocks and that the nest egg must last 30 years. Today, many financial planners view a 4% withdrawal rate to be a bit optimistic. Peter Florio, a financial planner, explains, “In the past, studies indicated that a portfolio would last 25 to 30 years if we utilized a 4% withdrawal rate. Given what we have experienced in the market in the past 10 to 15 years, the safety of this rate has come into question.”
The Drakes’ Exit Planning Advisor used those two touchstones as guidance. She explained to Michael and Sharon that if they could sell their company at the price they expected ($2 million) and wound up with a $3 million nest egg after adding the net proceeds to their existing assets, they should plan to safely withdraw only 4% (or $120,000) from it per year. That $120,000 would cover about half of the Drakes’ current lifestyle spending. Michael and Sharon were stunned.
Their Exit Planning Advisor explained, as she’d done many times to owners in similar situations, that while the Drakes’ company produced cash flow of $500,000 annually—much of which they had invested outside the company after paying taxes—after closing, that cash flow would belong to the new owner.
This advisor knew from experience that an income shortfall is typical. Consider that lower middle–market businesses are generally valued at a 4 to 8 multiple of earnings (EBITDA), which equates to a 12% (8 multiple) to 25% (4 multiple) return, while the recommended retirement withdrawal rate from an investment portfolio is 4%.
To the Drakes, a “4 multiple” of earnings ($500,000 in earnings/cash flow and a $2 million value) equates to a 25% withdrawal rate. The net proceeds from the sale of their business would be about $1.5 million. A withdrawal rate of 4% results in $60,000 of income.
Put yourself in the Drakes’ shoes: Their financial security exit goal is $250,000 of annual income. If they sell now, their post-exit income is $120,000. Or, they can continue to own the company and receive their current $250,000 compensation and cash flow of $500,000.
Given this income disparity, why would the Drakes ever consider selling their successful business?
In preparing for conversations with business owners, we suggest that advisors consider four issues.
- Risk. If all of an owner’s eggs are in their business basket, you might suggest that a sale, and subsequent investment of the sale proceeds in a variety of income-producing assets, will lower his or her risk. As you make that suggestion, remember that many entrepreneurs perceive little difference in the risk involved in running a business they control, and the stock, bond, and real estate markets that they don’t control. If your client agrees with this mind-set, considerations of risk may not lead them to a sale.
- Inevitability. As you work with business owners, it can be helpful to remind them that exiting is inevitable. No matter what, a transfer of ownership will happen, if only through their estate plans. Many business owners wish to take control of that transfer during their lifetimes to ensure that their businesses continue under new ownership that appreciates their values-based goals, such as continuing the legacy and culture of the business, and the continued benefit of the business to employees and the community.
- Amount of non-business assets. Seldom are business owners’ non-business assets sufficient to offset the loss of compensation income, let alone the distribution of company income that occurs when they sell their businesses. With your help and proper Exit Planning, owners can increase their non-business assets by the net proceeds from the business sale, ensuring that their lifestyles continue at their pre-sale levels.
- Business owner’s desired exit date. Keep in mind that most owners want to exit within five years. This desire to exit on a specific timetable may be more important to them than their desire to maintain their income stream. The best way for you to prevent owner burnout from trumping financial security is to begin the Exit Planning conversation before burnout sets in.
Recommendations for Advisors
There are three recommendations you can make to clients like the Drakes.
- Explain the looming income disparity to your clients long before they decide to move forward with a sale. Many business owners, on some level of consciousness, realize that they will experience a reduction of spendable income, but seldom do they appreciate the extent of the disparity.
- Charge an experienced financial planner with creating a financial plan that describes the post-exit income the business owner desires and the likely income available from current assets.
- Determine how to best close the gap between existing resources and those needed to ensure the client’s successful post-exit life.
Business owners in the Drakes’ position have hard choices to make about their desired exit dates and the way they want to live their post-exit lives. Or do they? In our next article, we’ll look at how the Drakes and their advisors chose to deal with the above mentioned four issues.