My guess is you’re planning to sell your business in the next five or ten years. You may have decided to sell when (and if) your business hits an arbitrary size; or you may have a round number your business must be worth before you agree to sell it. Those are reasonable approaches, but you may end up hanging on to your business well past its “best before” date.
The Risk On Threshold
There’s another way to think about the decision of when to sell your company. I call it “The Risk On Threshold” and it is a rule of thumb that was inspired by a conversation I had with Tim Malott, a partner at San Diego-based M&A firm Shoreline Partners.
Malott told me the story of a client of his, back in 2007, who had a business he estimated to be worth $30 million. Malott figured that, through some proactive tax planning, the owner would have been able to walk away with $20 million after tax and selling expenses. Financial planners usually agree that you can live for decades on four percent of your nest egg without ever having to worry about money. Four percent of $20 million is $800,000, or $66,666 dollars a month – enough to fund a champagne and caviar lifestyle for life.
Malott encouraged the owner to sell, but the owner figured he could double the size of his business over the upcoming few years and reasoned he would be leaving a lot of money on the table. Malott asked him what would be gained by doubling the business’s size; the owner would have been rich beyond any reasonable measure – why roll the dice?
Malott’s urging landed on deaf ears and the owner decided to proceed with his plan to double the size of his business. Then the 2008 recession hit, and within months, Malott estimated the business had lost two thirds of its value.
What did the owner get by waiting? Did hubris cloud his judgment? Assuming he could have funded his every whim and fancy on $66,666 a month, the only thing the owner gained by delaying the sale of his business was risk – all downside and no meaningful upside.
When you can sell your business and accumulate enough after tax proceeds to live comfortably for the rest of your life, you’ve reached The Risk On Threshold.
Here’s how to figure out your number:
Step 1: What’s your annual nut?
Ask yourself how much money you will need, on an annual basis, to live comfortably for the rest of your life, including any philanthropic gifts you may want to make, kids or grandkids you want to support, toys you want to buy, etc.
Many people overestimate this number. If you scale back non-essential spending, could you live on $3,000 a month? How about $6,000 a month? Surely $20,000 a month would suffice?
Step 2: What’s your company worth?
Next, figure out how much your business is worth. With business valuation – like a piece of art – beauty is in the eye of the beholder. It’s an inexact science driven by many factors. For the sake of this exercise, I’d recommend using the benchmarks we’ve seen through our analysis over at SellabilityScore.com. After looking at more than 10,000 businesses, we discovered the average multiple of pre-tax profit offered to business owners was 3.7 times pre-tax profit. For those companies that had at least $3 million dollars in annual sales, the average multiple went up to 4.6 times; and for companies with less than a million dollars in sales, the average was down around 2.5 times. Now you could argue your industry is unique, or your business is special, but using these multiples should give you a rough ballpark.
Step 3: What will the costs of selling be?
Next you need to figure out how much money will be left in your jeans after tax and expenses. Your tax liability goes beyond the scope of this article so talk to an accountant with experience dealing with the sale of private companies. Along with estimating your tax exposure, there may be ways you can restructure your company now to lower your tax bill before you sell.
The fees you pay to an intermediary to sell your company depend on its size. Figure around 10% of the transaction value for companies that have less than a million in sales, and closer to 4% for companies with at least $3 million in sales.
Step 4: Can you live comfortably off the proceeds?
Now take 4% (use 3% if you want to be conservative) of your nest egg after you sell your company and ask yourself if it exceeds your annual living expenses estimated in Step 1. If it does, then you have exceeded The Risk On Threshold.
You are “Risk On” when there are no meaningful lifestyle improvements to be gained by increasing the value of your business. The only thing you gain – from a financial perspective – is risk that the market, or your business, will drop in value. In order to justify hanging on to your business, you need to have some rationale beyond just funding your retirement. If your goal is to accumulate enough money to live comfortably for the rest of your life, then the ideal time to sell is when you hit The Risk On Threshold.