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Calculating Your Wealth Gap

By Generational Equity

02/08/2017

The premise behind the exercise is this: most entrepreneurs have nearly 100% of their net worth tied up in one highly illiquid asset. The upside to this situation is that for many, their business can fund a lifestyle that is keeping with the expectations of the individual and his/her family. And for many this situation is quite lucrative – expenses that you incur as a business owner may be legitimately written off via the company that you own and this allows you to travel, lease vehicles, and provide for your family in a way that would be nearly impossible were you not a business owner.

However, as we have found over the years, the real calculation that you need to make is in relation not to the annual income the company provides you, but to what the ROI (return on your investment) will be when you eventually exit. And sadly, this calculation is often not done early enough, preventing the business owner from defining key financial metrics until it is far too late.

As we always tell business owners that attend our executive conferences: selling a business is a PROCESS, not an EVENT.

If you treat it like an event, odds are you will sell when you have to, not when you want to. The difference between these two scenarios can mean millions to you and your family. This is how our friends at Axial (a leading online website that connects capital providers with those in need of investment) describe the situation:

More often than not, the largest asset business owners have is their business. Some may have as much as 90% of their net worth tied up in this illiquid asset. The majority haven’t saved adequately outside of their business, which means that when it comes time to sell the business, they are financially dependent on it to fund the rest of their lives.

The reality is that employees are often more financially prepared for retirement than the owner of the business that they work for. This situation becomes even more problematic for business owners that do not calculate their wealth gap until after they exit the business and deposit the proceeds of the event in the bank. Obviously, this is clearly not the time to sit down with your wealth advisor or financial planner and say, “Oops, I guess that is not enough for me to maintain my current lifestyle for the next 20 years or so.”

We agree with Axial on this point:

The owner may need to extract significant money from the sale of the business to achieve their retirement goals and support the life to which he or she has become accustomed.

For owners who find themselves in a similar situation, there are a few ways to reduce your dependence on the business and ensure your long-term financial security.

  1. The first step is to take stock of your financial situation including the assets you have saved outside the business and your annual budget.
  2. Next, calculate your wealth gap, which is the difference between what you currently have saved outside the business and how much you need to have outside the business to generate your desired long-term income. Using some assumptions, you can calculate how much money you will need to net, after taxes and fees, from the business sale.

Now this is great advice – we give the same to nearly every business owner we meet at our executive conferences. But there is a key missing link in this equation that needs to be addressed: What is your business worth? What value can be placed on it in today’s market?

If you don’t know the answer to this question, then your calculation for No. 2 above is going to be difficult to quantify. It is for this reason we say that selling your business is a process, not an event.

And for the Generational Group, our process for every client begins with a full and thorough evaluation of the business to determine what the business enterprise value is today. Once that is completed (which typically takes 60-90 days), the business owner can realistically determine if now is a good time to go to market or if the business needs to enter our hold-and-grow program via our Roadmap for Enhanced Value. This document examines a few dozen key performance metrics and provides our clients with strategies they can implement to attain a much better valuation down the road.

Axial describes it this way:

There are multiple ways to close a wealth gap, including:

  • Saving more money outside the business
  • Increasing the value of your company
  • Decreasing your spending and income needs
  • Developing additional sources of post-transition income

Building Value

Although all of these are important to consider, we have found that the far more lucrative option is the second on the list. It is more efficient to take a company worth $5 million today to an $8 million business in five years than to try to scrimp and save the $3 million difference. Saving that much money over five years may be nearly impossible for many business owners. And the fact is to bridge that valuation gap you may actually need to invest in your business to help it grow to a larger valuation.

But again, before you can implement strategies to build your business’ value, and positively impact your post sale proceeds, you must know what it is worth today. We agree with Axial on another point: you really need to start your wealth gap reduction process 3-5 years before you exit.

I cannot stress that point too heavily. It is distressing for our deal teams to work on a transaction for a client who is desperate to sell because one of the Big Ds has reared its ugly head (Death, Divorce, Disability, Disagreement, Disinterest), forcing the owner(s) to fast-track an exit. Under this scenario, if we are successful, and even if we are able to obtain an optimal deal for our client, the reality is there is always the question: what could we have obtained under a more thoughtful, planned, long-term process?

It is far better to spend a few years building value than to try and convince a buyer that the “potential” to do so is intrinsic to the business with a little planning and hard work. Sometimes that is a tough sell and impacts the ROI calculation of the buyer—i.e. if a buyer needs to have a 20% return over five years, but the current cash flow does not indicate that is possible, the buyer may still pursue the deal. However, they will structure their offer to account for this gap, possibly even using an earn-out, making the valuation contingent on future targets being hit (often revenue or earnings or both). This is not optimal for all sellers, especially those who are considering retirement post-sale; the idea of continuing to work for 3-5 years to ensure numbers are hit is far less than ideal.

To avoid this scenario, again, start your process today and spend time building value in the business.

And the key first step in this process is attending an educational Generational Group exit planning conference. These are complimentary and require no obligation on your part. They are designed to provide you with enough information to begin calculating your wealth gap and take steps to begin bridging it.

To learn more about our meetings and our firm, please use the following links:

By Carl Doerksen, Director of Corporate Development at Generational Equity.

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