Should you be aiming to sell your business twice?
Andrew Moore, Senior Financial Planner in our Plymouth office explores the concept of selling your business twice. This article was originally published in the Summer Edition of Devon Life Business & Professional .
Following on from my previous article in Devon Life Business & Professional on the importance of having a clear game plan for your own life, I am going to touch on the specific issue of using a business to fund your retirement years.
For many business owners, a large part of their retirement plan is to eventually sell the business they’ve built, step back and enjoy a well-deserved and well-funded retirement. When it works, this strategy is brilliant, and we see many clients at this stage with a handsome amount of capital to make use of, and investment decisions to make.
The capital has transferred from one business that required management and took a lot of effort to sell to a portfolio of businesses or assets that don’t need managing and can be sold quickly. The word diversification sums it up nicely. This, of course, is in an ideal world and business sales are not always straightforward.
So, how can you sell the business twice? Let’s explore a few fundamentals before I explain the title of this piece.
What are buyers of any asset looking for? This question ties very neatly with another question that should be thought about. Where do investment returns come from? The buyer of a business is in the same position as any investor. They are going to hand over cold, hard cash in order to make a return. You will use the cold, hard cash from selling your business to provide the returns for your retirement by investing in other assets.
When you look at it, any asset is only worth buying because it produces earnings or cash flows that are dependable. Buy-to-Let property values are based on tenants having income to pay rent, and commercial property is valuable as long as you have businesses with earnings to pay rent. Without these earnings, both assets are liabilities.
Your business is only valuable because of the earnings it can produce in the form of dividends for any owner. These earnings need to be above and beyond the earnings of directors and those required to run the business. The business itself has to be earning a pay cheque, namely consistent profits.
This is where we get to an age old-problem. How much of the business profit is really the earnings of the director and not true business profits? The price someone will pay for a job, i.e. running your business, is not as high as the price that is paid for a business producing independent profits.
Are the directors paid properly? When you buy a ticket for a flight you are also contributing to the pilot’s pension. The pilot doesn’t sell his job when he retires as there is no market for it, therefore he needs to fund his retirement. This is standard practice for the majority of businesses. The cost of funding for retirement is in the price paid for the service or products. So, does your business include in its pricing the retirement funding of the current directors?
Your business needs to be producing enough cash to pay its directors properly, including their retirement funding, and have profits that are distributable to the owners. If it can show that this is happening consistently, then there will be a market for the business.
On the stock market a business needs to produce earnings and dividends for the shareholders. The company is valued on these earnings and their expected growth. It is no different with privately owned businesses. Investors are buying shares for the dividends produced, not for the chance to run a business or end up with a job.
However, private businesses are often owner-managed and the clarity between shareholder earnings and directors’ earnings is not always there. Often the directors sacrifice their own earnings and retirement provision for any number of reasons. This confusion is why purchasers of businesses have such a tough time identifying the true value of the business profits being produced. They need to identify a clear source of return that is going to justify the investment of their capital.
When working with business clients we explain that the business needs to show true profits and to fund the directors’ retirement. We use the concept of selling the business twice. If your business is to be saleable, it will have the resources to fund the directors’ pension fund. In effect, the contributions over the years are a way of selling the business to yourself.
When retirement comes, you should already have distributed the business value to your pension funds. You have already sold the business once. The second and true sale to an external party will be a bonus, the icing on the cake and not something that you are totally reliant on.
In fact, if you have been able to make that first sale to yourself it is a clear demonstration that the business has value and that the second, and real sale, is likely. If you cannot make the first sale, the second and true sale is looking less likely and relying on this as a retirement strategy is high risk. We don’t like high risk, so we ask our clients to work on the first sale and in this way the second one is more likely and also not so crucial.