As a business owner, planning for an eventual exit is essential. Even if selling your business may seem far off, proactive planning can help ensure you maximize your business’s value. After all, your business is likely your largest asset. To achieve a successful and satisfying exit, you should ensure that your business is ready for you to exit and that you are ready to leave your business.
A significant part of preparing yourself to exit your business lies in determining what you want from the transaction, which often differs depending on your reason for selling. Like it or not, no matter what you believe your company to be worth, the market itself is the ultimate judge of business value. Getting clear on what you want from the transaction is the first step in evaluating whether there is a gap between the minimum number you would accept in a sale and the maximum number a potential buyer would be willing to pay.
Figure Out Your Number
The first step in determining what you need from the transaction is understanding your reason for exiting. A business owner may decide it’s time to sell for many reasons. For owners who have dedicated most of their lives to building one successful company, the most common reason is they are ready to retire.
Most business owners value freedom and autonomy above all else. That’s why you started a business rather than working for someone else. If you sell the company, you want the financial freedom to do whatever you want, when you want, within reason.
Suppose you are stepping away from your business to enjoy your retirement. In that case, ensuring you have the means to provide reliable cash flow to fund your lifestyle is crucial. But how do you know what that number is?
Here’s your guide.
STEP 1: CALCULATE YOUR RETIREMENT INCOME NEEDS
What lifestyle do you plan to maintain throughout your retirement years? Budget your annual retirement income needs. If you don’t have a detailed budget, it is always better to overestimate your yearly needs to help ensure that your money will last for the rest of your life.
Consider any other goals you believe are essential to enjoy a fulfilling life. Taking care of your heirs, quality of life desires (homes, boats, travel, etc.), gifting to causes you care about.
STEP 2: DETERMINE THE OTHER SOURCES OF INCOME YOU’LL HAVE
Your business income won’t be there to fund your needs, but you’ll likely have other sources of income. Perhaps you purchased investment real estate and will have rental income. Most will have social security income. Determine all your sources of income before withdrawing money from your financial assets.
STEP 3: DETERMINE THE VALUE OF YOUR ASSETS BUILT UP OUTSIDE OF YOUR BUSINESS
While your business is likely your largest asset, you probably accumulated additional wealth in investments outside your business: retirement plans, brokerage accounts, savings, and other assets. Don’t include your primary residence.
STEP 4: CALCULATE WHAT YOU NEED FROM THE BUSINESS SALE TO MEET YOUR RETIREMENT INCOME NEEDS GOAL
Once you’ve determined your needs, sources of income, and value of your investable assets accumulated outside of your business, you could construct a Lifetime Cash Flow Plan. The resulting plan could help you determine the minimum number you need to sell your business for true financial freedom.
Don’t forget to account for taxes on the income you need to fund your needs and wants because it could be your most significant single-item expense during your retirement. The tax code applies various tax rates on different sources of income. Figuring this out accurately using a legal pad or spreadsheet is nearly impossible.
An elite wealth manager can help you construct a Lifetime Cash Flow Plan with sophisticated software.
STEP 5: DETERMINE THE “FRICTIONAL” COSTS OF THE BUSINESS SALE
There are fees associated with a business sale. You will likely want to bring in other professionals to facilitate the sale of your business and account for the additional expenses required to sell the business. Those professionals often could include at least one of the following:
- Business Broker: Assist with the sale of a small business. They usually charge a percentage of the sale price, often using a tiered fee schedule. Typically, you will see the following fees – 10% on the first million, 8% on the second million, 6% on the third million, etc.
- M&A Professional: Assist with the sale of a mid-sized business. Companies selling for over $10 million will require an M&A Professional to facilitate the sale. The business owner can expect to be charged a fee of 3% to 5% of the sale price.
- Investment Banker: Assist with the sale of a large business. Companies selling for over $100 million usually require an investment banker to facilitate the sale. The business owner can expect to be charged a fee of $3% with a minimum of $500 million.
- Legal Professional: Handles the negotiating, drafting, and revisions of the contract on your behalf. 2% to 4% of the sale price in legal fees is typical.
For example, let’s say you sell your business for $5 million.
$5,000,000 x 3% = $150,000
Total Professional Fees charged = $450,000
Your before-tax (gross) proceeds = $5,000,000 – $450,000 = $4,550,000
Make sure the sale price is not a number in your head. It should come from a market valuation of your company – an amount a buyer would be willing to pay for your company. As we have discussed before, business owners often have a biased view regarding the value of their company. The reality is that until you get a valuation of your business, the number you believe it is worth is more than likely higher than someone is willing to pay for it.
STEP 6: DETERMINE THE TAX YOU WILL PAY ON THE BUSINESS SALE
When you sell your business, the amount of tax you must pay will vary based on the tax rules in your jurisdiction and the transaction’s structure. You’ll likely have a combination of taxes, including federal and state capital gains, ordinary income, depreciation recapture on assets, etc.
It’s a good idea to consult advisors knowledgeable in tax mitigation before negotiating the transaction structure to discuss strategies for reducing your tax obligations. After you already negotiated the deal, it may be too late to minimize taxes. This step can make a meaningful difference in your net after-tax proceeds.
For example, let’s say you pay 20% in total taxes.
Total tax due = $5,000,000 X 20% = $1,000,000
Note: Some frictional costs, such as legal fees, may be tax deductible, but transactional fees are not under current tax law.
STEP 7: CALCULATE THE NET SALE PROCEEDS AFTER FRICTIONAL COSTS AND TAX
Subtract the total frictional costs and tax from the sale price to determine the net sale price after tax.
For our example, $5,000,000 – $450,000 – $1,000,000 = $3,550,000 Net Sale Proceeds
So, the big question: Is $3,550,000 equal to or greater than your number from step 4? If the answer is “yes,” then congratulations! You have met your Freedom Point.
Most business owners should perform this exercise periodically, even if they’re not thinking about selling soon. If you’re beyond your Freedom Point, you’re taking risks by continuing to run your business. That doesn’t mean you have to decide to sell, but you want to know this fact and probably plan additional protections around this valuable asset in your life.
If the answer is “no,” the net proceeds from your business sale are insufficient to provide financial freedom; you have some work to do.
The upshot is that you have options for increasing your business’ value:
- The most overlooked aspects of determining business value are often within your control. Based on our analysis of 1,511 business owners and their companies, the owner’s personal reason for exit and the actions they have personally taken to exit can predict up to 53% of the difference in the value of two seemingly similar firms. Developing a personal action plan can potentially increase a $5 million sale price to over $7.5 million. Get Your Personal Readiness to Exit Score
- Most business owners focus on their own business value metrics, not on the eight key metrics that a buyer will use to value it. After analyzing more than 50,000 business owners who completed a value builder questionnaire, we found the average business achieved a score that values their business at 3.5 times pre-tax profit. Improving your value builder score from average (59) to 80 potentially increases your selling price by 71% to 6.1 times pre-tax profit, or from $5 million to over $8.5 million. Get Your Value Builder Score
Together, your actions to prepare for exiting and your score on the eight valuation metrics from a buyer’s perspective can increase your business value 2.6 times. With proactive planning, a $5 million business value could become more than $13 million.
Arlington Wealth Management is a Registered Investment Adviser (“RIA”). Registration as an investment adviser does not imply a certain level of skill or training, and the content of this communication has not been approved or verified by the United States Securities and Exchange Commission or by any state securities authority. Arlington Wealth Management renders individualized responses to persons in a particular state only after complying with the state’s regulatory requirements or pursuant to an applicable state exemption or exclusion. All investments carry risk, and no investment strategy can guarantee a profit or protect from loss of capital.