Statistics tell us that for most entrepreneurs and family business owners, their operating business makes up about 80% of their net worth. What’s more is that most business owners that we work with are what we think of as “business rich and cash poor.” They’ve built a very valuable – yet very illiquid – asset. The vast majority will rely on the liquidation of this asset in order to meet their retirement goals. While that liquidation may be a traditional M&A exit (i.e. a sale to a strategic or financial buyer), other viable options could also be a sale to family members, to management, or even to employees. Regardless, if the proceeds from the transfer are needed to fund retirement, creating a financial plan focusing on the liquidation outcome is the cornerstone of sound transition planning.
Why Traditional Financial Planning Often Fails
In one sense, it’s hard to knock financial planning. For the most part, financial planning embodies every bit of sound advice we’ve ever received: be prudent with your money, save well, invest wisely, and plan for the future. Most financial planners utilize sophisticated modeling techniques that are designed to help their clients understand what their retirement will look like based on their anticipated spending level, savings rates, and their current assets. In fact, most planners frequently use a Monte Carlo simulation, running 10,000 simulations of their financial plan in order to help assure a 95% (or better) outcome. What could go wrong?
Modeling using Monte Carlo – or any other technique for that matter – follows the old adage “garbage in, garbage out.” Remember we discussed that for most business owners, the preponderance of their net worth is tied up in their business, and that liquidating that asset is required to fund retirement? That’s an incredibly important input to any financial model: how much will they actually be able to walk away with when they transition ownership?
In my experience, most financial plans for business owners are constructed using a “guesstimate” for this number. Putting a finer point on this: the most important input to the model that helps guide retirement is a guess. Having been involved in thousands of valuation assignments, I can tell you with incredible certainty that this guess is almost always too high.
Getting it Right
Well before going to market, entrepreneurs need to understand two numbers. First, after all taxes and fees, how much do they need to walk away from any transaction with? This is where traditional financial planning shines. A good planner will work with them to understand their lifestyle needs and turn that into a financial plan that makes sense for them. Second, the owner absolutely must have a realistic understanding of the current market value of their company. The key word there is realistic – having a best guess isn’t helpful and potentially undermines the whole financial plan.
With these two numbers in hand – what business owners need from a sale plus where their current market values stand – they have essentially created a road map for where they need to drive the company. Is their company currently worth $15 million while their financial planner helps determine they only need $10 million? Great – they’re well positioned to transition at the time of their choosing. On the other hand, what if the numbers are reversed? If the business is only worth $10 million but they need $5 million more, then it’s obvious that there is some significant work to do.
So, what’s next? They need to create a growth plan that is geared not just towards revenue growth, but also towards growing enterprise value. We’ll cover that in our next article.