How to Exit Your Business
Ah, the glorious conclusion. It has been quite a ride, hasn’t it? We decided to start a business, we started it, we even made some money! Good times…
For this final installment, I want to bring us back full circle. Let’s talk about why we started this business. It was to escape from cubicle nation, right? But that isn’t the only reason. You did it to make money, right? But how much money? Do you have your number? I hope you do, and I hope that you are close to reaching it.
This is the part of your business life cycle where being responsible, forward-thinking, and organized becomes the MOST critical. More people get screwed in the business exit than anywhere else, particularly with selling a business. People tend to act very dumb when large sums of money are involved. Mostly because no one ever taught us how to handle money properly, so we don’t understand it.
When it comes to exit strategy, there are two types of businesses: a lifestyle business a salable business and.
A Lifestyle Business:
- is primarily based on your time or the time of others.
- is not necessarily a sole proprietor, but may not be a scalable business.
- often has low repeat business or has a low switching cost. Switching cost means the cost to a customer to find a replacement. You might have a lot of repeat business, but if the customer experienced any sort of trouble, they could easily switch and wouldn’t be troubled by it.
A Salable Business:
- is replicable. This is critical and a MANDATORY part of a salable business. This is why most lifestyle businesses are not salable. No one could recreate what the owner does.
- has some sort of barrier to entry: a skill set, licensing, capital requirements, patent protection, licensing deal, brand value, etc.
- usually has a brand (or other intangible asset) and/or systems of production. The less barriers to entry you have, the more you have to rely on branding and systems. You cannot create barriers to entry (usually) but you can create systems and a brand yourself.
Exit Strategies For A Non-Salable Business
This is very easy. Your exit strategy is to stop working. Which means that you have to generate enough profit while the business is operating to cover your living expenses AND provide a substantial amount of profit that you can generate savings. If you have a lifestyle business and you are only producing enough to live on, it is not a viable business.
I’ll say that again, so we are crystal clear:
If you are running a non-salable business and only producing enough profit to live on, it is NOT a viable business.
So it all comes down to saving. If you save $10,000 a year and earn an average of 7% per year, even starting at nothing, you will have close to a million bucks. After 30 years, if you only earn an average of 6%, that end game number drops to about $800k. The point being, you likely need to save a LOT more than $10,000 per year.
This is why I don’t think a ROTH IRA or a Traditional IRA are very effective tools. They are just simply too small to be of much use. I would consider $10,000 your minimum savings goal for a year. Oh, and this assumes you don’t pay any tax on those investment earnings, and you have the $10,000 after you have paid your taxes for the year.
So with that, I made a basic structure to figure out what might be the best retirement plan for you. There are lots of other complexities that will affect this choice, obviously, but I like to use “target savings” as our guideline:
- Between $5k and $12k use a SIMPLE IRA
- Between $10k and $20k – $25k use a SEP IRA
- Between $15k and $50k use a 401(k)
- Between $75k and $300k use a defined benefit plan
Other complexities will affect this. You need to balance between tax-deferred money (like the accounts above), ROTH money, and taxable money. You could have a ROTH option on your 401(k) for example and in bad years (lower taxable income), put in ROTH contributions and in great years, do traditional contributions. You could fund a SEP IRA and then use life insurance to create a no-income limit, ROTH-like account for yourself outside of the SEP. But these strategies need to be put together with someone who knows you and knows what they are doing.
If you are running a lifestyle business, you need to have a laser-like focus on profitability because profit is the only value your business creates, and it needs to create as much as possible, so you can build your wealth.
Exit Strategies For A Salable Business
A salable business should also generate profit. But you might be building a growth business that doesn’t produce much cash yet, but could be sold for a big pot of money down the road.
A salable business, unlike a lifestyle business, could be generating enterprise value instead of immediate profit. You could be perfecting a system that you will franchise, establishing a brand that someone will want to buy, or even creating a new product that a large company might want to push through their distribution channels. The reality is, most businesses are not 100% salable or not salable. Even with a salable business, you should produce some cash flow that you might shelter using the vehicles above. A lifestyle business might be able to be sold (or at least pieces of it), but not at a high enough price to fully retire on. The wealth your business creates for you will likely come from a combination of savings and exit value.
The number one problem people face when selling their business (at least at the small business level where I live) is no new money. They want to sell to their partner, to their kids, to their friend who works in the business, etc. But the people who are doing the buying don’t have any sort of significant capital to contribute. Business prices are usually based on multiples of profit. So if I sell for 3 times profit, but I only have 1 times profit in cash from the business, how do I pay the purchase price? Maybe I stretch it out over three years, right? Who wants to buy a business that will generate them zero profit for three years? Not many.
If you go this route, you are not truly selling your business, you are likely just retiring with a pension. You will receive a monthly check for many years (usually 10 to 20). This is usually the only way to structure these deals that makes sense. But it carries its own risks: You depend on the continued success of the business for your retirement income.
We could talk forever about the intricacies of a traditional business sale (to an outside or new money buyer) but for our purposes, I just want to cover a few main ideas and some key terms. Businesses are usually priced on multiples or EBITDA (earnings before income tax, depreciation, and amortization) or gross revenue. What that multiple will be is based primarily on what the industry standards are. Most major industries have some typical ranges that businesses sell at. If you are selling a business that is new, or has a non-traditional product, it becomes even easier. It is worth what someone will pay for it. In fact, this is a critical point to understand for ANY sale, so I’ll say it again:
Your business is not worth what you feel it should be worth, or what it was worth sometime in the past, or what it could be worth, or what you need it to do be worth.
Your business is worth what someone will pay for it. Period.
Here are some key terms that you might find in a business purchase:
- EBITDA: Basically a measure of cash produced by the business operations.
- Stock Sale: The buyer is buying the actual shares of the company you are selling.
- Asset Sale: The buyer has agreed to purchase the assets of your company, not the company shares themselves.
- Gross Revenue: Total income of the business.
- Multiples: A number that you multiple by the base (usually EBITDA or Gross Revenue) to determine the value of the business.
- Earn out: A variable payout in the future, generally based on the performance of the company.
The complexity from selling a business comes from having to determine the price at the same time as the deal points. The major deal points that need to be agreed upon are: price, down payment, future payments (earn outs or a note), and any employment contracts if the buyer wants the seller to continue to work. Obviously, as a seller of a business, you want to get as much cash up front, at as high a price as you can. As a buyer, you want to pay as little cash up front as you can and force the seller to participate in the risk of the business by getting paid via earn outs (or variable payments). Somewhere in between these goals, a deal can usually be found.
I hope this outline has been helpful. In another post, I will tackle the problem of deferring taxes on a business sale.
Other articles in the So You Want To Run Your Own Business series: