How You'll Know It's Time to Cash Out
How much do you need to sell your company for? Yes, right, I know: for as much as you can get. But seriously: What’s the price point on your business that will enable you to live off the proceeds the rest of your life as well as you live today?
It may sound like just another unanswerable existential question. But there is a real answer, and it’s this: 30 times your business income.
That means if you want to replace $150,000 worth of income from your business, you’d need to sell your company for about $4,500,000. How do I figure that?
Let’s assume you did sell your business for $4.5 million, which is 30 times the $150,000 of income you want to replace. With the sale, you’ll owe taxes. (Of course.) Let’s assume that, like most entrepreneurs, you have no significant cost basis in your shares, so you’ve suddenly got $4.5 million of capital gains. In general, Federal capital gains taxes will run you 15 percent. Most states will also tax the income, which will take, let’s say, another five percent in state taxes. That adds up to 20 percent gone to taxes. The actual number will vary with your specific circumstances, but the point is, it’s the after-tax proceeds that matter. That’s what you’ll have to live off.
Except that you’ll also have transaction costs for lawyers, accountants and other advisors. Let’s assume (conservatively) that runs another 1 percent. This means your sales price will be reduced by 21 percent, which puts your net at about $3.5 million.
The next step is to translate that $3.5 million investment portfolio into an annual income stream. A good estimate is that you can take distributions of somewhere between 4 percent and 5 percent of your investment portfolio each year and not run a big risk of bottoming out during your lifetime. So at 4 percent, that’s $140,000 of income, and at 5 percent, it’s $175,000 of income. Average them out, and you’re a little over $150,000.
If you run these numbers and figure there’s no way you can get 30 times the business income for your practice, then go on to step two, which is to figure out how to get to $3.5 million of investment capital with both your current retirement savings and the potential sale of your business. You do have retirement savings, right?
Let’s assume that you’ve saved $1.5 million in your SEP and IRA and other retirement accounts. That means you need to net $2 million from the business sale to get to the $3.5 million you need of investment capital. If you sell for $2.5 million, you’ll net about $2 million after taxes and fees. Add back your $1.5 million in retirement accounts, and you’re back up to $3.5 million. That means you’d need to sell your business for about 17 times the income you want to replace.
In my experience, business owners often underestimate how much investment capital they’ll need to replace the income their companies generated. It just goes to show you how valuable your company really is—because it takes a ton of investment capital to replace it.
Charles Farrell is a principal with Denver-based Northstar Investment Advisors and the author of the book Your Money Ratios: 8 Simple Tools for Financial Security. The Wall Street Journal called it ?one of the best financial books to cross our desks.?