Of all the misconceptions by business owners, the ones surrounding their company’s value are both the most common and often wildly inaccurate.
I’ve been working for the last couple of months on the training videos for advisors in our new product, The ExitMap®. (You can take the assessment for free at www.myexitmap.com). In one session, we role-play a vignette about a financial planner discussing the value of a business with a client planning retirement. Part of it goes something like this.
Q: “So Bob, how much do you expect to realize from your business when you sell it?”
A: “I’ve heard from my accountant that most small businesses sell for about five times earnings.”
Q: “And how much would that be?”
A: “Well, I made about $150,000 in salary last year, and another $200,000 in profit. Add in my insurance policies and my car, my wife’s car and a few trips that combined business and pleasure. Say around $500,000 in total benefits. So I’d expect to get somewhere around $2,500,000 for the business.
Q: “What would that be after taxes?”
A: “I’d have to pay capital gains, so I’ll net in the area of $2 million.”
Simple, right? Let’s look at the reality.
Bob is calculating what the brokerage industry calls “Seller’s Discretionary Benefits” or SDE. While it is a legitimate way to look at the full value of business ownership, ball park valuations of 4-5 times pre-tax earnings don’t apply to that calculation. Cash flow expensed for benefits (rather than dropping to a taxable bottom line), isn’t included in those earnings multiples. The traditional multiple for a small business sale averages 2.5 time SDE, or half of what Bob is estimating. We are immediately reducing the likely price to something like $1,250,000.
Next, about 90% of small business sales are asset transactions. Only about 10% close as a transfer of stock ownership. Double that tax estimate from 20% capital gains to a 40% ordinary income rate.
Businesses transfer debt-free. So if Bob owes another $300,000 on his credit line, that comes off the top from the proceeds, but the tax is still payable on that $300,000.
So Bob’s $1,250,000 drops to $750,000 after taxes, and to $450,000 after debt repayment. He has lost three quarters of the amount he was planning on for retirement.
The problem is exacerbated when the planner dutifully enters $2,000,000 in his retirement software, assuming that the owner certainly knows the value of his business. That happens more often than I care to discuss.
These misunderstandings are just the tip of the iceberg. There are another half-dozen common mistakes when owners look at their value. In many cases it results in owners being highly insulted by legitimate offers from qualified buyers. I’ve also seen them renege on accepted offers when they finally have a CPA model the tax impact.
(NOTE: I do not perform valuations, give tax advice, or broker businesses. My recommendations here will not generate revenue for me.)
If you are like 85% of all owners and plan to sell your business to a third party, the first thing to do is engage a valuation professional. The second thing is to take that valuation to your accountant for tax modeling. Start your exit planning by embracing reality. You’ll be a lot happier in the long run.
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