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Retirement, Your Business Valuation and Reality

27/01/2020


Retiring on the terms you’ve dreamt for yourself and your spouse is a monumental accomplishment. As a business owner, having an accurate understanding of your business’ value today and what you will need to meet your retirement goals is critical to manage risks along the way and make the right decisions.

There are several key issues you need to consider for a successful retirement, including:

  • Does your retirement plan depend partly or wholly on the eventual sale of your business
  • Do you have an accurate idea of what a buyer would be willing to pay
  • Will the sale price of the business provide the retirement lifestyle you have in mind
  • Do you have the right tax structure in place to maximize the proceeds of the sale

What You Have

Investment decision making hinges on the relationship between risk and return. And that fundamental relationship impacts you as a business owner-manager when planning for retirement. Generally private, owner-managed businesses are perceived as higher-risk investments compared to large, diversified public companies.

Income returns an owner-manager may realize from a private business will reflect a higher risk — it can also reflect higher returns compared to public company investments. Consider this scenario:

Your business generates annual revenue of $2.5 million. After drawing an annual salary of $100,000, the business generates operating cash flow of $250,000.

After capital expenditures, loan re-payments and retaining some cash for working capital purposes, you typically take a $50,000 bonus or dividend. Your annual total compensation from the business is $150,000 per year.

Hypothetically, a similar-sized company in your industry sells for five times operating cash flow. Based on operating cash flow of $250,000, this suggests a hypothetical selling price of approximately $1.25 million.

What You Don’t

If you anticipate a retirement lifestyle requiring an income of $150,000, you need to focus on the gap between your current income and your retirement income. Using the scenario above, there are some criteria you should understand when planning your eventual retirement:

  • Post retirement, investments in a reasonably diversified portfolio can be expected to yield approximately 4.0 percent income on a pre-tax basis. This means if you invest $1.25 million, you could generate $50,000 per year before tax.
  • Currently, you generate $150,000 in pre-tax income as the owner-manager of a business. Assuming the $1.25 million valuation, a yield of 12.0 percent is implied.
  • A private company valued at $1.25 million generates an income yield three times greater than a reasonably diversified portfolio of public investments.

If you, as the owner-manager of this business, were unaware of the current value of your business and the eventual income yield your retirement investments may generate, you may underestimate the need for business growth or savings.

Mind the Gap 

How can business owners benefit from understanding this landscape better? As business management guru Peter Drucker put it, “if you can’t measure it, you can’t improve it.” Start by gaining an understanding of what you have, what you’ll need, and if there is a gap you need to close.

If your goal for retirement income is 80 percent of pre-retirement income, consider the requirements:

  • 80 percent of $150,000 in pre-retirement income is $120,000.
  • Old Age Security, Canada Pension Plan, spousal income and / or pensions may fill some of the gap, say a total of $30,000. Therefore, you’ll need another $90,000 to achieve your retirement income goal.
  • At a 4-percent yield on public investments, the required capital to generate $90,000 in income is approximately $2.25 million.

If your $1.25 million business value represents substantially all of the investable assets you have to provide for your retirement income, your net assets on retirement will need to be $1-million greater to achieve your retirement income goal.  

How can you close this gap? Consider the following:

  • Will organic business growth between now and the expected retirement date be enough?
  • Should you consider acquiring a competitor to achieve faster business growth?
  • Could you buy a building rather than rent space for your business to build equity in real estate in addition to your operating business value?
  • Will you have to alter your lifestyle today to invest more for retirement?

These considerations and more represent major business and life decisions that stand between you and the retirement plans you have in mind. Make sure you have clarity around your business’ valuation and what income you expect post-retirement so you can move forward now to close any gap.

For more information, contact Chace Hynes, Senior Manager, at 902.493.5439 or [email protected]