Last month we discussed the first two steps of our firm’s six step planning process for helping business owners create the optimum succession plan for their business and exit plan for the owners (hereafter “owner” inclusive of group of owners) which best meets their business and personal objectives. These steps were:
Step 1: Helping the business owner identify his/her life objectives including retirement income, manner of disposition of the business and non-economic life objectives (objectives which add significance to the owner’s life); and
Step 2: Where is the owner (and business) now and what is the gap (in terms of meeting the owner’s economic life objectives).
This month’s article focuses on the next step of our planning process:
Step Three: Filling the Gap. What changes in the business’ value (and the owner’s net worth) are necessary in order for the owner to meet his/her economic life objectives?
In order to fill this gap, the owner’s advisors must be able to assist the owner in analyzing the following:
Assuming the owner has chosen an exit strategy of selling his/her business to an outside third party, what would be a reasonable expectation of the after-tax amount the owner would obtain upon a current sale of his/her business, i.e., what is the real market value of the business currently and, if sold at that value, what would be the taxes due upon the sale and what amount would left to be reinvested in marketable securities (or otherwise)?
If reinvested in the market, what amount of retirement income can the owner reasonably rely on? Most financial advisors conservatively will assume somewhere between 4 percent and 6 percent as a reasonable return on investment of the after-tax proceeds. Will this amount meet the owner’s objectives so that the business can be sold now?
If not, what is the gap, i.e., what is the increase in the fair market value (and sales price) of the business necessary for the owner to reach his/her retirement income and other economic objectives?
For example, let’s assume that the business has a current cash flow of $500,000 per year (after add backs and non-recurring expenses), and the business has a current market cash flow multiple of 5. Since the business also has $500,000 in long-term debt, a reasonable market selling price (after paying off the debt) would be approximately $2,000,000 ($500,000 times 5 equals $2,500,000 less $500,000 long-term debt equals $2,000,000).
Assuming taxes upon the sale are 25 percent of the sales price, the taxes would be $500,000. Therefore, the business owner would have $1,500,000 to reinvest after taxes ($2,000,000 minus $500,000).
Let’s further assume that the $1,500,000 can be safely invested at a 5 percent per annum return on investment and that this would produce $75,000 per year income. Assuming the business owner has approximately $100,000 per year of other retirement income from his/her assets other than the business (401(k) plan, Social Security, rental property, etc.), and that his/her objective is to retire with at least $250,000 per year pre-tax for his/her and his/her spouse’s joint lifetimes, he/she is $75,000 per year short of reaching his/her retirement income goals.
How much does the fair market value of the owner’s business have to increase before a sale can occur which will meet the owner’s objectives?
The answer is that the owner’s business needs to grow from a cash flow of $500,000 per year to $900,000 per year. An additional $400,000 per year at a 5 multiple will produce $2,000,000, which after taxes would give the owner another $1,500,000 to invest at an assumed rate of 5 percent per annum ($400,000 times 5 equals $2,000,000 less $500,000 taxes equals $1,500,000, times 5 percent equals $75,000 per year income).
Given the above facts, what steps should the owner take to increase his/her business’ cash flow?
Here is where the assistance of the owner’s advisors is critical. The items, common to all industries, which drive up the value of a business are called “value drivers.” Value drivers are what qualified buyers and investment bankers look for in a business that increases the business’ value.
Value drivers are characteristics of a business that either reduce the risk associated with owning the business (which increases the cash flow multiple which can be obtained in a sale) or enhance the prospects that the business will grow significantly in the future. There are many items that create value, including: proprietary technology, market position, brand name, diverse product lines, patented products, etc.
In next month’s article, we will look at those key value drivers that are common to most businesses.