Why Every Business Owner Needs to Know Their Wealth Gap
This month on the Illumination Wealth Blog, we want business owners and entrepreneurs to ensure their annual business planning— is aligned with their personal and financial goals. In today’s article, we want to focus on the wealth gap. What is the Wealth Gap and why does every business owner need to know it as they plan for 2021?
Planning for Now vs. Planning for Your Future
Many people own businesses that provide enough income for a nice lifestyle now but in many cases these same businesses do not have the value to sustain that lifestyle for its owner upon a sale. While you own the business, certain personal expenses can be deducted for tax benefits, you can pay yourself a healthy salary or use the profits to reinvest back into the business or other income-generating ventures.
However, not every entrepreneur has a solid exit plan. You may calculate how much income your business earns you each year and that’s great to know. Yet, you also have to think further down the road in order to determine how your business will help produce financial freedom for yourself and your family. You have to know what your business is worth now and what you need it to be worth in the future for you to successfully exit the company with complete financial freedom.
What is Your Endgame?
For many of you, your business is likely 80% or more of your net worth. It’s irresponsible to assume you will run your business indefinitely and at some point, it will be worth exactly what you need it to be worth when you’ve had enough. You might have outside savings and investments you are building, but will you be able to harvest the necessary amount of wealth from your business at your exit. What is your ideal endgame as the owner of your business?
Last year, I posted an article entitled “What is Succession Planning?” I won’t get into the details of succession planning here, but you may want to read that article when thinking about your ultimate exit plan as it affects your family, your employees, your business partners and anyone else affected by your business.
Exit Planning
Right now, we want to focus on the financial aspects of exit planning. Unfortunately, many entrepreneurs don’t start planning their exit until it is almost time to leave. Your exit plan should be put together much earlier as you build your business. It’s simply smart business strategy and makes the timing of your actual “sale-exit” irrelevant.
It must be proactively designed and refined along the way. Perhaps you’d like to leave your day-to-day role to free up more time for your family as opposed to waiting until you sell. Eliminating the dependency on you as an owner is life enhancing now and value enhancing for your business.
For the purposes of this article, we will consider the value of your business upon a sale. This gives the most tangible ROI calculation. Understanding your business value should not just be something that happens when you get burnt out, want to retire or you get an unsolicited offer. It takes a lot of planning and preparation. It is a major process that needs to take place.
As we said earlier, the largest asset that a business owner has by far is typically their business. How much of your net worth is tied up in your business (which is an illiquid asset)? Will you have long-term financial security if and when you sell the business?
Calculating Your Wealth Gap
Your wealth gap is the difference between the financial assets you currently own outside of your business and how much you will need for your desired lifestyle if you no longer own or earn income from your business. That difference is your Wealth Gap.
This figure will help you determine how much money you need from your business to cover that wealth gap. And don’t forget we’re talking about the net proceeds (after taxes, fees and any other expenses associated with your business sale).
To start, you must review your overall financial situation. This will include any financial assets you have outside of your business (stocks, real estate equity, savings, retirement accounts, etc.). Let’s assume you have $2mln outside of your business that is able to safely produce $90,000 of after-tax income.
Then, calculate your annual budget and lifestyle goals. How much annual income do you need to make in order to enjoy the lifestyle of your dreams (both now and in retirement)? Perhaps looking at your current lifestyle and goals you need $300,000 per year in after tax income.
This means that once you exit your business you will need to come up with $210,000 per year in income to have the $300,000 of annual income desired.
So just how much additional wealth do you need to bridge your wealth gap — about $5mln (not including any social security benefit).
This formula highlights the importance of being able to harvest actual value from your business.
Over 70-80% of business do not sell which makes understanding your business value really important and taking steps to make sure your business is transferrable and built around your financial life goals.
Determining the Market Value of Your Business
Once you know your wealth gap, you have to realistically project what your business is worth today. If you cannot quantify this, you are already at a significant disadvantage. A prepared entrepreneur will know what his or her business is worth now, what it should be worth in the future based on growth patterns and business trends, and of course when they plan to sell it.
If you have a solid projection of your business’s market value and when/how you plan to exit the business, that’s great. If the numbers don’t add up to cover the wealth gap you have calculated, then you have much more work to do before you are financially prepared for life after business. You’ll need to work on your retirement savings plan and/or your business plan to get your company’s value where you need it to be.
Your Planning Partner
Illumination Wealth is here to help with all your financial life planning needs, including business planning, retirement planning, tax planning and exit planning. Let our team provide honest advice and sound guidance as you define your wealth management goals and navigate your way along the journey to financial independence. Contact us today to schedule an introductory call with one of our top financial advisors.