Sell Your Business And Cash Out!

“In fact, there is ultimately only one reason to create a business of your own, and that is to sell it.” Michael Gerber, The E-Myth Revisited.

Some people create a new business so that they can do what they love to do and/or what they are really good at doing. They think they can make a business out of their talent. The new business owner may not realize that there is much more to creating a business than just doing the technical work. Financials, marketing, ordering, collecting, etc. are all additional tasks to just doing the work. Is this a business that is building equity or are they just creating a job that looks like a business?

The goal according to Mr. Gerber is to build a business that has equity. This equity comes from cash flow, not the kind of equity one gets from buying a building and paying off the note. A business, that has cash flow, can be valued as a cash flow stream. That cash flow stream translates into equity when it is multiplied to figure the value of the business. A business with cash flow sufficient to pay the owner’s salary plus pay additional profits becomes a saleable asset.

How much is business equity worth? A business pays its owner a salary of $150,000 per year plus has net profits at end of year of another $250,000, for that year, is worth $400,000 to the owner. But what will someone pay to buy the business from the owner. At a multiple of 3 to 5 times earnings, assuming continuing income at that level, this business would be worth $1,200,000 to $2,000,000. If the multiple were higher, the business value goes up. The normal range for most business will be within the 3 to 5 range.

The decision to sell is a big one. The business is worth $400,000 in before tax cash flow to the owner. The owner, of course, will have to pay income taxes at ordinary income rates at least of 35%, so the owner could net about $260,000. The real value to the owner, while still working in the business, is $260,000 per year.

Compare to the sale of the business. Assume that the sale was at a five times multiple, then a sales price of $2,000,000. The business has been owned for more than a year so the proceeds will be taxed at long term capital gains rate, which is at this time, 15%. The owner will pay $300,000 in taxes with a net of $1,700,000. This net is about seven times the annual after tax value of $260,000.

The point of selling is to free up the equity. If the net equity of $1,700,000 were invested at 5%, the interest earnings would be $85,000 per year, before taxes. The seller of the business is trading $260,000 per year for less than $85,000 per year.

Most sellers focus on the gross amount of the sale, $2,000,000, in evaluating the transaction. The important issue is not the gross amount but the comparison of the cash flow before and after. There are other factors to consider: need for retirement, desire to use the equity to buy another business, desire to escape the business regimen, etc. The desire to build equity is not the only reason to create a business. If a business is properly created using the six systems for proper planning, the business also is a cash flow machine. The cash flow of the business may very likely exceed the potential reinvestment value (cash flow) of the sales proceeds. The seller needs to look at all aspects of the decision to sell.