Ready, Set, Financial Readiness

As you may know, Exit Planning includes “financial readiness.” A well thought out plan addresses how much you will need in retirement. We just had our Freedom Point deeper dive webinar and we talked about how to calculate your Freedom Point.

Your Freedom Point is achieving the amount of money you desire that funds your retirement. Some business owners will get there, and then continue to stay. This is a big risk! Why? By staying beyond your Freedom Point, you risk what you do not need and want with want do need and want. For example, something you don’t know you don’t know may occur, which could affect your business, the ability to sell it, or require you to extend your exit and have to work longer. Think COVID, I would say many business owners were caught flat-footed with no contingency plan for a sudden worldwide pandemic. For some, they had to extend their exit, others in the midst of preparing for sale now have an asterisk on 2020 financial data. While everyone may understand why, buyers perceive risk when looking at numbers that need to be explained.


When you get to your Freedom Point, what can you do? What if you aren’t ready yet to exit? You could consider selling a minority interest, a majority interest or sell it all, with a contingency you keep working for the business for a period to facilitate the transfer. There are many ways to do this so if you would like to discuss your situation, please give me a call.


To calculate your Freedom Point, you need a firm grasp of how much you spend today. Why is that important? Well, it turns out that people’s spending habits before retirement are not dissimilar to those spending habits in retirement. But there may be considerations of this spending amount, first, what personal expenses does your business pay now? Cell phones, some insurance, country club memberships, car payments, and travel come to mind. Business travel where your spouse joins you may be where you get a chance to see the world. You stay at the finest hotels and many meals and activities may be covered? You’ve become accustomed to these kinds of trips and it makes staying at a Hampton Inn, when you are accustomed to a JW Marriott, a little unsatisfying!


So you want to inventory your spending and add back those business paid expenses to get a real idea of your spending. We use a program in our exit plans that links credit card and checking accounts, and all your spending is cataloged and organized. This can help you answer this question easily. We find many underestimate their “discretionary spending” until they see it appear on the screen!


Once you have the number, multiply it by twelve for your annual spend and need. You may need to adjust the amount downward, if you expect to retire your debt before you retire from your business. Now consider your lifetime streams of income? Social security for you and your spouse is a leading type of lifetime income. Pensions and annuities are others. Add the annual amounts of these payments together and subtract them from your total spend/need. What is that number? That has to come from your nest egg savings. It will likely be be supplemented by the net sale proceeds from selling your business.


How much money you take from your nest egg can have a big impact on how long your nest egg will last. As we discussed in the Freedom Point webinar, a 3% rate of withdrawal provides high confidence your nest egg will last three decades in retirement. You will take your nest egg and multiply it by 3% to get the amount you can reasonably add to your social security to live on in retirement.


As a business owner, your nest egg comes from savings & investments and from selling your business. A good exit plan considers how much money you will likely have saved at your exit date. You will need to subtract your expected savings from the amount your nest egg needs to be to determine how much your business needs to net from the sale. If you know the amount it needs to net, then you can predict how much it needs to gross at the sale, so after you pay your selling costs and taxes, the amount that is left over together with your savings is your nest egg. Is it enough? How do you figure it out?


To figure out what you need, take the amount to come from your nest egg and divide it by 3%. For example, if you need $12,000 a month (in addition to Social Security) to come from your nest egg, take a year of this and divide by 3% ($144,000 / 3% = $4,800,000). If you will likely have saved $1,800,000, then the sale of your business needs to net $3,000,000. If you accommodate capital gains tax estimates and selling costs, you may need to sell it for a price north of $4,000,000.


Knowing these numbers helps you to create your exit plan. If your business is currently valued at $2,500,000, then the gap is $1,500,000. If you you know when to exit, then it is easy to solve for how much you need to grow each year to get to your Freedom Point. Using a financial calculator, a business owner exiting in five years would need to grow at a compounded rate of 10% per year for each year to get to $4,000,000.


If the business owner saved more in the 401(k), he/she would need the business to sell for less, meaning the business could grow at a slower rate and maybe a more reasonable rate? Already maxing out your 401(k)? One solution may be to add your souse to the payroll? There are many advantages to having your spouse on the payroll, including saving $27,000, plus match, plus profit sharing, each year. If in our example above, your spouse were able to save $50,000 per year in a plan, that would take $250,000 plus growth off the amount required at sale. That lowers the business growth rate needed to about 8.5% a year.


Your Financial Readiness is a function of savings and business value. Putting together an exit plan helps you to know what you need and when (your Freedom Point). Knowing where you’re headed helps you to figure out how fast you need to grow your business.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. This is a hypothetical example and is not representative of any specific investment. Your results may vary.


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