When is the Best Time to Sell My Business?
Entrepreneurs face multiple challenges over the life cycle of their business. Most effort and consideration is focused on the early formative years when failure is high. Most business owners are good at managing their company once they become established. The day-to-day events within the business are familiar and solutions fall under the skills of the owner.
As the business matures along with the owner, a difficult decision of transitioning the business to new owners is delayed. There are several reasons a business owner avoids the tough choices of selling or merging the business. The largest issue involves emotions. After decades of running the firm, the owner has a hard time letting go. It is their baby, remember. Business owners love what they do and don’t want to leave the work they love is another reason.
An overlooked and unaddressed issue in the sale of a business is familiarity. The business owner understands his business, but is unfamiliar with the financial ramifications of selling a business. Rather than undertake an unknown project (selling the business), the owner avoids the issue. As a result, the owner works well past retirement age and foregoes the free time he should have in his golden years. As age removes the vigor of youth, the business declines in value until there is little left to sell.
The Decision Process
Selling your business should not be determined by age or length of ownership. Once a business has reached middle age (10-20 years old depending on the industry) a serious discussion needs to take place. Due to the tax code and time value of money, most businesses need to buy, merge, or sell.
Buying a business allows amortization of goodwill and depreciation of certain items. The added economies of scale allow for accelerated rates of return for the new owners. After the purchase is absorbed, the firm needs to make another acquisition. We see this type of activity daily on Wall Street. Corporations can only maintain adequate rates of returns by buying, selling, or merging.
Merging is a combination of buying and selling all in one package. A merger allows all owners involved to stay with the new business if desired. It also allows owners to monetize their equity in whole or in part. A merger is an excellent way for owners to slowly transition out of the business, receive full value for their equity, and transition clients to the new business structure while the previous, familiar owner still works there.
Selling is the hard part due to emotional attachment. The old owner usually stays for a short while after the sale to provide a comfort zone for clients. There are major tax advantages to selling. If the business is set up as a corporation, it is called Section 1244 stock. As of this writing, 50% of gains from Section 1244 stock is exempt from any income or capital gains tax. The remaining profit is taxes at a maximum of 15% on the federal tax return. State taxes may also apply.
A business owner that does his homework can make more not working than keeping the business. In determining when to sell, one criterion is to calculate what the risk-free rate of return will be from the sales proceeds minus taxes. As many as 56% of all small business owners would get a pay increase if they sold or merged their company. Now we need to do some math to determine if selling a business is better than continuing under the current structure of ownership.
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Simple Math for Big Profits
The math of selling a business is straight forward. A business broker can give you an idea of what your business is worth. Some industries are easier to value than other. The best place to start is an estimated value. If the numbers determine you should sell or are close, you can then take the next step toward a more accurate valuation.
In our example I will use an accounting firm. Since I own such a firm and understand the value of accounting practices, my example will reflect close to real life experiences.
Our example accounting practice has $500,000 of sales in a year with an even mix of services between tax preparation, bookkeeping, payroll, and consulting. The owner is active in the business with a support staff of preparers and bookkeepers. After all expenses, our owner earns $100,000 per year.
Accounting practices sell for around 1.25 times sales, or $600,000 in our case. A typical tax/accounting practice has a small basis. Therefore, most of the sale price will be gain, treated as a long-term capital gain. Our accountant friend should understand the tax code well enough to be a corporation with Section 1244 stock.
Here is a visual representation of the math so far:
Sale price: $600,000
Cost of sale: $60,000
Gain on sale: $540,000
Tax on gain: $54,000
I calculate the tax on the gain at 10%. I arrive at this number deducting half the gain from tax and multiplying the remainder by the maximum long-term capital gains rate of 15%, or 7 ½% of the full amount. I add 2 ½% for state taxes, for a total tax of 10%. This is a reasonable number for most states.
How to Fund a Business Sale
You Have Cash. Now What?
In our example, our retiring accountant has $486,000 cash after taxes ($540,000-$54,000). You now take the $486,000 and multiply by the risk-free rate of return. I consider the 30 year Treasury bond the risk-free rate. If the bonds are held to maturity there is no market risk. The business owner will have a guaranteed steady income stream for 30 years.
At the time of this writing interest rates are artificially low from Federal Reserve intervention. I will use the historical average of the 30 year Treasury, 7 ½%. The seller’s income stream will look like this:
Annual Income: $36,450
Income from Treasury bonds is exempt from state income tax; another advantage to the risk-free yield. The owner earned $100,000 prior to sale. He would earn over $36,000 not working.
You can save most of the cost of sale if you sell the business yourself. You already know your competitors. Competitors looking to expand are a good place to start a conversation. Eliminating the sales expense brings the annual interest income to over $40,000 ($54,000 sales expense -$5,400 (10% tax) x 7 ½% risk-free return = $3,650 in added annual interest income + $36,450 interest from above = $40,095).
If the business owner earned less than $40,000 per year, sale would be a no-brainer. Since he earned $100,000, a choice will need to be made. A merger can provide greater value to the business seller while providing an income if working full- or part-time for the new firm.
The decision to sell is never easy. When emotions are removed and only facts are presented, it is easier to make the right choice.