One of the questions we always ask when a business owner walks in our office is, “When do you want to leave your business? Often, the owner will laugh, and respond with “Yesterday. I might then ask when he or she realistically could leave. The most common answer to this question? Five years.
Five years sounds like a nice number. It’s long enough away that owners dream they might actually be able to leave. However, I find that if they don’t take very specific actions that allow them to leave, they’ll be saying “five years forever.
Consider one potential scenario. Let’s say your business makes $250,000 per year after taking out your own salary. Let’s also assume that salary is $100,000 per year. Of the $250,000 your company makes, you draw $75,000 for living expenses and leave $175,000 in the company for growth and tax purposes.
It’s now time to sell. You have a buyer who is willing to pay you enough money for you to net $1 million after taxes. This, you learn, is a usual multiple for your industry and gives you, after taxes, four times your average profits for the past three years.
You go to your financial adviser and ask him how much of this money you can spend every year. He says that a prudent investor would not want to spend any more than 4% of capital.
Here’s your basic problem. You used to receive $175,000 of income from your business each year. After your sale, you will only be able to spend $40,000 per year if you want to protect the capital amount you received for the sale of your business.
To help measure financial independence for our business-owner clients, I have created a tool that my firm uses called the Four Boxes of Financial Independence. They include:
- The capital income value of your business. In the example above, the capital income value is $40,000 per year.
- The value of your 401(k) and qualified retirement program.
- The income value or capital income value of investment real estate that your business uses and you own.
- The income value of any other investments you might have.
Let’s take a look at how this might work in practice for a 50-year-old business owner. His adviser might make the following recommendations:
- Establish a 401(k)/profit sharing program, in which he would put $46,000 per year in his account.
- Purchase a building in which to operate his business. When he turns 60, the building will be paid off and will produce $90,000 per year in free cash flow.
- Use value-building activities in his business to increase the free cash flow by another $100,000 per year. This would increase the value of the business by $400,000 when it came time to sell. Take $50,000 out of the increased profits and save it for retirement purposes in other investment accounts.
How do the four boxes work? Well, now he has a 10-year program that can get him to financial independence. Assuming a 6% return, the asset and income possibilities from the four boxes would be as follows:
- Business value after taxes has grown to $1.4 million. This allows the owner to spend $56,000 per year from this pot of money.
- His building has been paid off, and the owner will receive $90,000 in free cash flow for the building. If the owner decides to sell the building, he will have a capital amount of $900,000, which would produce $36,000 per year. Many owners of private businesses decide to keep their investment real estate producing cash for them instead of selling and reinvesting the proceeds.
- Saving $46,000 for 10 years in a profit sharing or 401(k) plan at a 6% return would give the owner a capital value of $606,000, or the ability to draw $24,000 per year for income purposes.
- The other savings account would produce a capital value of $660,000 and provide an income value of $26,500 per year.
The four boxes provide our owner with income of $196,500 per year. What does it all mean? Now, our owner can say -- definitively -- the he will be able to leave his business in 10 years, with the lifestyle he wants.