Author Michael Podolny at Google+

Valuing a Small Business- Transferring Ownership to Financial Independence

Common Sense Strategies for Valuing a Small Business Higher

How Building Equity Translates to Financial Independence (Part 3 of 4)

We’ve been talking about a core goal of most business owners, earning a good return on their investment and having that contribute to their ability to achieve personal financial freedom.  We discussed that there are two ways of achieving a return on investment in a small, privately held business.  One can increase the overall equity value of the business and one can take a portion of the cash/profits produced each year by the business out and invest them.  These are not mutually exclusive.  In this post I will focus on how to use the underlying equity value of the business for contributing to personal financial independence.

For the value of the business’ equity to contribute to personal financial freedom there must be a mechanism for selling one’s equity, meaning that equity has to be turned into cash that can be invested in other assets.  This can be done via either an internal market (a succession/internal transaction) or the having the business sold to a third party. In calculating the ability of an equity sale to produce financial freedom, a number of variables need to be accounted for:

• The actual value that can be realized in an actual transaction (as opposed to the theoretical value from a valuation)
• The taxes that would be paid on the realized value
• The income that can be earned on the after-tax proceeds
• The taxes on the income that is earned on the proceeds
• The desire and rate at which one would access and spend the actual proceeds themselves

Here is a very simple example of how this might play out.  Let’s assume you have a business that has an average annual cash flow of $500,000 per year, that you can sell that business for 5 times its cash flow in an all cash transaction, that you will pay taxes of 25% on the proceeds of that transaction, that you can earn 5% on the proceeds, you have a 25% tax rate on that income, and you only want to use the income earned on the proceeds to fund your financial independence.

Transaction proceeds = $2,500,000

Taxes on the proceeds = $625,000

Net after tax proceeds that can be invested = $1,875,000

The income earned on the after tax proceeds = $93,750

The taxes on the income earned = $23,437

The after-tax cash to support your personal life style = $70,313

As you can see there are a lot of variables that need to be considered.  In addition to these other variables would be how much will you get from Social Security and when will you get them, do you have other assets, or do you have a retirement plan that you’ve been contributing to.

The key for you the business owner is to understand these variables and include them in your planning.  Forewarned is forearmed.  If you can do these analyses on your own so much the better.  But don’t be afraid to get help if you need it.  An owner can greatly increase their ability to increase their return on investment and achievement of financial independence just by understanding and slowly beginning to manage for these variables.