Is there a value gap in your business?
A lot of business owners find themselves in a goofy financial position in the years after they sell. It’s easy to assume that the money raised from a sale will provide security, but even a sale price into the millions may not be enough to sustain the same lifestyle as before. John H. Brown in his book Exit Planning: The Definitive Guide mentions how he discovered most owners actually spend MORE after they sell their business, not less.
This can create what is called the ‘business value gap’.
For example:
- While you are running your business, you earn 150K in salary, 100K in distributions, and you enjoy 100K worth of company perks and all the tax benefits that come with that.
- In order to sustain the above lifestyle after the business is gone, and to gross up your tax benefit, you will need about 400K each year.
- This cash flow must come from another source, usually cash or investments in the market.
- Let’s suppose the business sale will produce $6 million net after tax.
$6M seems like a nice cushion to help pay for that 400K per year lifestyle for a while. However, there is actually a gap of $4M.
Why?
The business value gap derives from the rule in the financial industry saying you can pull 4% of cash off of your investments without running out of money over time. Using those figures you need $10 million after tax to generate 400K of cash flow per year in income. On top of that, in these times of low interest rates, it’s particularly difficult to use cash or fixed income to generate substantial long-term income – possibly increasing the business value gap.
You may of course not mind that your $6M will evaporate in somewhere around 17 years if you were pulling 400k out each year, or you may even decide you’re one of the very few that can actually cut back expenses after you sell your business and can live off of 4% of $6 million ($240k).
The point is this: It’s a ridiculously easy calculation, however you must get a grip on your whole personal situation (and be real with yourself) before you sell. What do you need and what do you WANT? As long as you begin this conversation and have a foundation of a plan before the sale, there is plenty you can do to bridge the business value gap.
- Understand how much annual income you will need after exit.
- Estimate your own life expectancy + that of your spouse.
- Measure the guaranteed rate of return on your income you will get in the current market (or whatever investment vehicles you plan on using).
- Define the value of your company.
- Calculate the net proceeds from the sale.
A couple of simple pieces of division later, and you’ve unearthed any value gap you may have.
Now what?
If there is a business value gap there’s always the option of cutting down your lifestyle… but coming from personal and client experience, that’s not the appealing or easy answer. If you have time and are willing to do some work we advise you consider the following:
- Identify what your Value Gap is.
- Understand what the key value drivers in your business are.
- Focus on improving your value drivers so you can build the underlying enterprise value of your business.
- If you have time on your side, each additional year of salaries and distributions you receive reduces the net amount you need from the sale of the business.
- Come up with a normalized EBITDA (one without random anomalies) so you have a realistic number you need after you sell AND you have a clear number to apply your multiple to when calculating your company’s value.
Remember many business owners spend more money after they sell, so any value gap you calculate stands a good chance of widening in the future.
Don’t be deterred if you find a business value gap. If you give yourself enough time, there is plenty you can do to make it smaller.