Financial freedom: Max portfolio and max business value

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.

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.

The main causes of failure are 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 more than half of the nation’s gross domestic product 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.

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.

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 accountant to get a sense of the business value when he sells it to his son.

The accountant 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 account concluded that the business was worth about $1.5 million, or three times normalized earnings of $500,000.

Jim did a quick calculation. Knowing his son did not have cash to buy 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.

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