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Valuing a Small Business-

Transferring Ownership to Financial Independence

Common Sense Strategies for Valuing a Small Business Higher

How Using Free Cash Flow Translates to Financial Independence (Part 4 of 4)

We’re finishing up our discussion of earning a good return on investment on our businesses and having that contribute to our ability to achieve personal financial freedom.  In the last post I discussed how the overall equity value of the business could be used to achieve those goals.  In this post, I will be showing how taking out a portion of the cash/profits produced each year by the business and investing them can greatly increase an owner’s return on investment.

Why is this?  It’s because this strategy is additive to the overall equity strategy not an alternative to it.  It is like getting twice the value from the same investment.  Let’s look at the variables that need to be considered for this strategy to work.

For income distribution to contribute to personal financial freedom, it must be done on a consistent basis and those proceeds must be actually be saved and invested.  Therefore these variables need to be accounted for:

• Owners must distribute money on a consistent annual basis and have the discipline to save and accumulate those funds
• A rate that can be safely distributed must be calculated after accounting for taxes and necessary reinvestment in the business
• An intelligent, conservative, consistent investment strategy to produce a compounding effect on the proceeds
• The period over which the funds will be accumulated
• The amount that can be earned off the accumulated funds
• The taxes on the income that is earned on the accumulated funds
• The desire and rate at which one would access and spend the actual proceeds themselves

Let’s look at an example of how this strategy would work out using the same business base assumptions we used for the example last week.  That assumption was your business has an average annual cash flow of $500,000 per year. Let’s do our calculation over a 10-year period with no growth in cash flow taking place over that period to be very conservative.

We are going to further assume that you 30% of your cash flow each year is available after taxes and reinvesting in your business.  That cash flow is going to earn 5% a year and be reinvested to create a compounding effect.  Finally when we are ready to sell the business we’ll invest the proceeds that have accumulated at 5% and pay a 25% tax rate on that income.

Annual cash flow from our business = $500,000

Annual cash flow invested = $150,000

Total accumulated after 10 Years with compounding = $1,886,682

The income earned on the accumulated savings = $94,334

The taxes on the income earned = $23,584

The after-tax cash to support your personal life style = $70,751

Now look at what this has done for your financial independence. Your annual after-tax cash to support personal lifestyle from the sale of the business was $70,313.  To that we now add the $70,751 from your long-term savings program for a total of $141,064, a doubling of your return on investment applied to financial independence!

This shows you the power of this strategy.  Of course no one has the same cash flow year in and year out.  But if you make cash flow distribution one of the primary goals of your business and build your strategy around it, you will be amazed and the amounts you can generate, distribute and accumulated.

But this is not all.  In my next post I’m going to show you yet another tool for driving your return on investment and financial independence up yet another notch.