Basing an Exit Plan on false assumptions is a lot like building a house on sand, something none of us would ever do. But owners build their business exits on false assumptions on a daily basis. In this article, we'll look at a few of the most common false assumptions owners make about their exits.
Exit Planning is owner-centric. A plan's sole purpose is to achieve the foundational, universal, and aspirational goals of the owner. However, business owners often stray from their commitments to create proper Exit Plans, and the reasons for straying are obvious. Business owners often make the mistake of believing that they can either plan their exits later or that they don't have much of a need to plan. One of our first jobs as business advisors is to replace false assumptions with stark reality.
6 False Assumptions Business Owners Make
As business owners set their exit goals, the most common six false assumptions they make are:
- The amount of income they'll need after they exit.
- The life expectancies of themselves and their spouses.
- The expected rate of return on invested assets.
- The value of their companies.
- The likely rate of growth in business value and cash flow.
- The net proceeds expected from the sale of their companies.
The faulty assumptions lead to serious consequences:
- They underestimate the amount of capital required to achieve their needed post-exit income. (See 1, 2, and 4 above.)
- They overestimate the amount of capital they'll have available to them at their exit. (See 3 and 5 above.)
- They grossly underestimate the amount of time they really need to grow value, cash flow, and income-producing assets to achieve their income goals. (See 1-6 above.)
These consequences mean that owners cannot and will not leave their businesses when they want to, to whom they want, or with the money they need.
But the most serious consequence of false assumptions is that owners who rely on them don't feel any urgency to start planning.
Overcoming the 6 False Owner Assumptions With 6 Realities
1. Post-exit income: Research indicates that retirees continue to spend 70 to 85% of their pre-retirement spending.
2. Life expectancy of owner and spouse: Use this calculator based on the Social Security Period Life Table 2000. Example: A husband and wife are both aged 65, have normal blood pressure, don't smoke, have two or fewer alcoholic drinks a day, and frequently exercise. There is a 50% likelihood of at least one spouse living to age 95 and a 25% chance of one living beyond age 101. While this doesn't affect an owner's annual spending calculation, it does affect the total amount spent and how much capital owners will need for their lifetimes (and that of their spouses).
3. Expect rate of return. When business owners expect a higher rate of return on income-producing assets, they lower their estimates of the proceeds they need from the sale or transfer of their ownership interest.
From 1975 to 2000, the S&P 500 had an average return (dividend included) of 16.88% per year. Contrast that with this century: From 2000 to 2013, the average annual S&P 500 return (including dividends) was 2.324%.
From 1975 to 2000, the yield on 10-year U.S. Treasury bonds was 8.37%. In the first part of 2015, it was about 2%.
4. Business worth: Don't base an estimate of business value on anything other than a valuation by a valuation expert.
5. Projected rates of growth of business value and cash flow. Let's assume that most businesses grow at a rate similar to that of the national economy, as measured by the Gross Domestic Product (GDP). From 1975 to 2000, GDP grew an average of 6.35% per annum. Consequently, most businesses doubled their revenue about every 10 years. Contrast that with the period from 2000 through 2015, with GDP growth averaging less than 3% per annum.
Applying the Rule of 72 to that growth rate, businesses will double in revenue/profitability/value roughly every 25 years or so. When the economy and your customers' revenues are growing at 3% or less per year, it's very difficult to grow the business by an annual amount necessary to experience significant increases in value. Unless, of course, owners engage in business growth planning, which is at the heart of Exit Planning for many owners.
6. Net proceeds expected from sale of company. Higher taxes affect the net proceeds business owners will take from the sale or transfer of their companies. If an owner sold her business before 2013 and, after taxes, had exactly enough cash to achieve financial security, she'd have to sell that same business by at least 5% more to cover the higher capital gains taxes to end up with the same amount of cash in her pocket.
The bottom line is that owners need accurate information and it is our job as Exit Planners to provide it. Given that so few business owners have ever talked to an advisor about their Exit Plans, the reason they don't have accurate facts is clear.
Less clear is why advisors aren't providing them!