The failure of successful family business owners to reach their personal goals, especially their financial goals, is not because they don’t try or care. In our experience, the main cause of failure is lack of clarity, a plan around the big picture, and a myopic pursuit of the "urgent."
There are 5.5 million family-owned businesses in the United States, comprising nearly 90 percent of all businesses. These companies comprise over half of the nation’s GDP and create three-quarters of all new jobs. Only 33 percent make it to the second generation and less than 12 percent make it to the third. Many family business experts believe that one common cause of failure in family businesses is a lack of transition planning and preparation.
We have found that a primary driver of a successful transition is financial freedom for the exiting owner. In many cases, owners have built a lifestyle that the business is able to support, but upon exit and a liquidity event, the assets are inadequate to support the retirement plan. Let’s look at two fictitious owners exiting their businesses.
READ MORE: Family-Run Businesses: Preparing the Next Generation for Success
Jim’s Trap
Jim, who is 65, owns 100 percent of a business that does about $3 million in sales. He has paid himself about $600,000 from the business each year, and the business has reported minimal earnings.
Jim is thinking about retiring in a couple of years and has talked to his CPA to get a sense of the business value when he sells it to his son. The CPA normalized the earnings of the business, making an assumption that a market wage for running it was $200,000, and that normalized earnings for the business were about $500,000. The CPA concluded that the business was worth about $1.5 million, or 3 times normalized earnings of $500,000.
Jim did a quick calculation. Knowing his son did not have cash to purchase the business, and that he would be paid from future cash flow, he estimated a 10-year payout, equating to an income of $150,000 for 10 years. Jim didn’t pay attention to capital gains taxes and other fees from the transaction, so his calculation was significantly inflated as a result.
Jim then thought about his savings, which were minimal. He and his wife had been living on the $600,000 "income" from the business and their lifestyle was dependent on a continuing income stream at that level. Jim added about $35,000 of expected Social Security benefits (at age 67) and discovered that he and his wife would have only $185,000 of taxable income per year if he retired at age 67, woefully short of his $600,000 lifestyle. And this would only last for ten years, at which time he would only have social security.
Jim realized that he and his wife would have to make a substantial adjustment to their marital lifestyle or win the lottery, in order for him to retire at age 67.
Jim is one of the many hundreds of thousands of baby boomer family business owners who did not transition the ownership of their businesses in the last decade and who haven’t built enough value and cash flow in their business for a successful transition and business end game that sets them up for the rest of their lives.
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Alan's Better Prospects
Now let's look at Alan, who is also 65 and thinking about retiring at age 67. His business is, for our purposes, is exactly like Jim's, generating about $600,000 in cash flow available to the owner on about $3 million in sales.
Like Jim, Alan has distributed just about all of the $600,000 from the business each year. The difference is that Alan realized that not all of that $600,000 was really his earnings. He thought a decent salary for someone else running the business was about $200,000 per year, but he and his wife organized their marital lifestyle to live on $300,000 (and paid taxes on that income).
Alan then took the after-tax remainder of his company's "income", or $180,000 ($300,000 less taxes of 40 percent), and invested it with a local financial planner. By the time he reached 65, they had been saving at the rate of about $180,000 per year for about 20 years, and they had an investment portfolio well north of $6 million.
Alan's financial planner made some calculations for them assuming Alan would retire and transition the business at age 67. He assumed that the business would transition to Alan’s son for $1.5 million, paying out over 10 years at $150,000 per year. He projected that with two additional years of saving, the couple's portfolio would be at about $6.8 million when Alan turned 67.
Using the combination of savings and business transition proceeds, the financial planner assumed that they could "pay" themselves about 4 percent of principal, or $280,000 per year. They would, he suggested, reinvest any return in excess of 4 percent to help protect their portfolio from inflation.
Alan mentally added about $40,000 per year of Social Security proceeds beginning at age 70 and realized that he and his wife were set to be able to retire on more income than they had been living on for many years.
Alan is one of a much smaller number of baby boomer family business owners who are in a position to retire nicely, having never had a business worth more than $2 million or one earning (normalized) more than $500,000 per year.
To achieve Alan’s outcome, two critically important things need to happen. First, it requires smart financial planning to take ‘chips off the table’ prior to retirement in order to start building a bank for retirement and not relying solely on a liquidity event with the business.
Secondly, it’s important to maximize business value (through value drivers) and develop the successor leadership to ensure there is a business with cash flow to deliver the maximum after tax proceeds to the exiting owner. These two drivers are the twin towers that help you build the bridge from where you are today to where you want to be tomorrow.
Oh, and one final, very important component. Get started now. Whether you are Jim or Alan, putting time on your side gives you options and allows you to exit on your terms.
Tom Garrity is the Managing Partner of Compass Point Consulting, Concannon Miller's business consulting partner. If you would like more information on this topic, Tom can be reached at 610‐336‐0514 or tgarrity@compasspt.com.
