Information Saves the Day: One Owner's Exit Planning Story

Submitted by John Brown on Mon, 07/13/2015 - 5:00am
Businessman with a Smile

In the last two articles, we argued that until advisors break an owner's Misperception Spell, it is difficult for them to generate the energy required to protect and grow business value and cash flow to the levels they need to ensure their financial security upon their exit. We find that stories are one of the most effective ways to illustrate to owners the value of many aspects of Exit Planning, so today we present an Exit Planning story to illustrate the evolution that takes place when an owner moves from a "plan" based on assumptions to one based on accurate information. In this case, our story of Francis demonstrates the value of the process we use to accurately assess the financial barriers that stand between owners and their successful exits.

Francis and His Asset Gap: An Exit Planning Story

Francis opened our meeting with his assessment of how much he would need to support the post-business life he desired. "I think my business is worth about $1.5 million today, and I plan on growing cash flow much more quickly now that the recession is over. My investments float around $500,000. I think my wife Rita and I can live on $120,000 per year, and I want to be sure I've got enough money invested to live that way for 25 years. It seems to me I could probably sell today and have enough. Don't you agree?"

"Let me get this straight," I responded. "You've just told me (1) what you think your business is worth and that it's going to be growing much more rapidly, (2) what you think you and your wife can live on after you exit, (3) how long you think you will live, and (40 that you believe that you can sell your business today for enough cash to live on. I don't know whether any of that is accurate, but I do know that if your estimates are as reliable as most owners', you are living in a world of hope, not reality."

Francis was no more flattered than are most successful business owners when I imply that they are dead wrong about their projection, that they misperceive what they have and what they need. Most owners are unaware of Misperception Spell, and, once aware, aren't happy. But before Francis could fire me, I suggested that we put his assumptions to the test by collecting empirical data. We'd then base his Exit Planning Process on that data rather than on his assumptions or mine.

"For the calculation of business value, let's use a credentialed business appraiser. I can provide a few recommendations," I told Francis. "Your CFO can generate accurate cash flow forecasts, and let's ask your financial planner to supply a realistic assessment of your future income needs and likely investment returns."

Francis quickly turned his focus to the practical. "And how much will all that cost?"

I could have answered his question with a few questions of my own:

  • What will it cost to base the biggest transaction of your life on assumptions?
  • What will it cost to run out of money and have to go back into the workforce at 70 years old?

But I'd pushed Francis as far as I could in one meeting.

Instead, sensing Francis's reluctance to spend money on tasks not directly related to producing income for the company, I suggested, "Let's at least weigh the cost of professional assessments against the cost of proceeding with guesses about cash flow, investment returns, tax consequences, and the rate at which you can expect the value of your company to grow."

Francis agreed to charge his CFO with providing cash flow forecasts, and I arranged meetings for Francis with a business appraiser and a financial planner. Francis agreed to hire them after learning what they would do and that their services would cost a few thousand dollars, rather than the $10,000+ he'd assumed.

The Results Come In

Within a few weeks, Francis and I met again to talk about the findings from his professional advisors. Let's examine the results and compare them to Francis's original assumptions.

Using the questions we listed in last week's article, we assessed Francis's ability to achieve his exit goals.

1. Is the financial security goal you set accurate or unrealistically low?

The financial planner found that Francis's assumption that he and Rita would be happy with a retirement income of $120,000 per year was completely unrealistic given Francis's current annual spending of $175,000 to $225,000. The financial planner suggested that Francis aim for a post-exit income of $200,000 per year as an alternative to slashing his spending by almost 50%.

Further, based on current life expectancy tables, 33 years was a better estimate of life expectancy for Francis and his wife post-exit than his estimate of 25 years. Francis would need more capital to fund a longer post-exit life.

The Question for Business Owners: Is your financial security exit goal appropriate when compared to what you now spend?

2. Have you accurately quantified the resources (both business and personal) currently available to attain your financial security goal?

The business appraiser Francis hired estimated the current value of his business to be $1 million (pre-tax) versus Francis's estimate of $1.5 million. The financial planner used a 4% investment return for lifetime income planning purposes, while Francis had used 7%.

The Question for Business Owners: What is the actual value of your business vs. your guestimate? How much non-business investment capital is available to you today? What is an appropriate rate of return?

3. Is there a shortfall between the resources you have and those you'll need to achieve your financial security goal?

In Francis's case, the answer was a resounding "Yes!"

The Question for Business Owners: Is there a shortfall between the resources you have and those you'll need to achieve your financial security goal?

4. If so, how great is the gap between the value of your current resources and the resources you will need?

Francis will need at least $4 million of investable assets upon his exit date to yield $200,000 in annual income for 33 years (assuming an optimistic 5%, not the 4% return that most financial advisors recommend. Accumulating $5 millkon of investment capital rather than Francis's $4 million would be less risky given the current U.S. 10-year Treasury Bond rate of about 2.5% in 2015 and 3.7% S&P average return since 2000.). Francis thought he would need about $1.5 million to generate $120,000 of retirement income. His current assets include:

  • $500,000 of investments
  • +$800,000 (after tax) from the sale of his business
  • $1.3 million

Francis's total shortfall is between $2 million and $3 million. If we consider his expected Social Security benefit of $30,000 a year beginning at age 70, that income reduces his Gap by about $700,000.

The Question for Business owners: If you have an asset shortfall, has it been accurately quantified?

5. What must you do to bridge your Asset Gap?

Francis has three choices: (1) reduce his financial security goal, (2) increase the value of his income-producing resources, or (3) exit at the price he can get because he is just too burned out to stick around and build business value.

After a lifetime of hard work, Francis, like most owners, was not about to cut his post-exit standard of living. Nor was he burned out. In conducting his Gap Analysis well before he was ready to exit, Francis gave himself (and his advisors) time to develop and act upon a plan to incrementally grow business value and personal investments to the $2.5 million level necessary to achieve his financial security goal.

Armed with accurate data, Francis and I could now move forward and construct and implement a plan to bridge the Gap between where he was and where he needed to be.

Francis's story resonates with owners. Owners can relate to Francis and can compare his situation with theirs. Working with a team of advisors, Francis laid the foundations of a successful exit.