Should you sell your business? Even if someone makes what appears to be a smoking offer, you need to work the math. Will it give you enough to live on? Can you maintain your lifestyle? Let’s do the math.
There are a lot of variables. Let’s keep it simple. To figure out how much you need to sell your business for, start with the pre-tax income you will need to maintain your current lifestyle. Assume you need $300,000 before taxes. Yours could be more or less, but this seems like a reasonable number.
What is Your Investment ROI?
How much will you generate from investments? The conservative number that many financial advisers use is 4%. You can be more aggressive, but then you will have to deal with ups and downs of the markets. Let’s use 4%. At 4%, you will need $7.5 million in investments (i.e., $300,000 / (1 – 4%) )
How Much Equity Will You Roll?
Don’t forget the roll. Most private equity (PE) buyers will want you to roll a percentage of your equity forward into the private equity "Newco". This is a way of keeping you involved and interested.
You will be promised the proverbial “second bite of the apple.” This means that you will potentially get another windfall when the private equity company flips its
portfolio. This might be as soon as a couple of years. Or… not. Regardless, it does not help you maintain your lifestyle immediately after the sale. It does dilute what you will be able to invest for an immediate revenue stream.
So, how much do you roll? The PE guys will want you to roll up to 49%, which means less outlay for them. Most contractors end up rolling 20% to 40%.
Typically, the PE firm will want to keep you around for a couple of years, which means a salary. That gives you a chance to build up your investment portfolio. As a word of caution, in most cases, the PE firm will not match what you paid yourself. Also, the PE firm will frown on things like the company paid executive hunting trip and the company paid bass boat. In other words, you may need to subsidize your salary with some of your investment income. To keep things simple, let’s focus only on the investment side and ignore the salary.
So, how much do you roll? The PE guys will want you to roll up to 49%, which means less outlay for them. Most contractors end up rolling 20% to 40%. Let’s use 20%.
That means 20% of your sale price is unavailable to you for years. Instead of selling for $7.5 million, you must sell for $9.375 million (i.e., $7.5 million / (1 – 20%) ).
Don’t Forget Capital Gains
It gets more complicated. You have to factor in capital gains taxes. Today, the capital gains tax is 20%. There’s an additional 3.8% surcharge for Obamacare. These apply to the full sale price, including what you roll forward but cannot access until the PE firm flips it; $9.375 million becomes $12.3 million (i.e., $9.375 million / (1-23.8%) ).
Does Your State Tax Capital Gains?
Wait! $12.3 million is necessary to generate $300 thousand on an annual basis? Yeah. But depending on your state, it gets worse. Let’s say you live in California. The Golden State taxes capital gains at a top rate of 13.3%. The $12.3 million just became $14.9 million (i.e., $9.375 million / (1 – (23.8% + 13.3%).
Will Taxes Rise?
In 2022 things may get a lot worse. The Biden administration is calling for a hike in the capital gains rate to 39.6%. Add the 3.8% Obamacare surcharge and capital gains will be taxed at 43.4%. If you live in California, you get to pay another 13.3%, meaning governments claim 56.7% of the proceeds of the sale of your business. That’s more than you get. Why, it’s like government is the majority owner of your company! So, to maintain a conservative income stream of $300 thousand pre-tax, you must sell your company for $21.7 million if you live in California.
The Biden administration is calling for a hike in the capital gains rate to 39.6%. Add the 3.8% Obamacare surcharge and capital gains will be taxed at 43.4%
What is the Best Case?
Granted, the most extreme case was described above. Let’s look at a more optimistic one. Let’s assume an average return on investments of 8%. Let’s say you live in Texas, which doesn’t tax capital gains. Let’s say you sell to another contracting company and cash out 100% with no roll. If you sell your business this year, you will need $4.9 million. If you sell next year and the Biden capital gains hike occurs, you will need to sell for $6.6 million. It all depends on how risk averse you are regarding your investments, how much equity you need to roll forward, and how highly taxed you are based on where you live.
To summarize, with a risk adverse investment scenario, rolling 20% of the business forward into the Newco, and living in a high tax state like California, you would need a sale price of $14.9 million this year and $21.7 million if Biden’s tax plan is enacted next year. This assumes, of course, that the tax hikes are not made retroactive to the beginning of 2020 (it has happened before).
By contrast, with a moderately high risk investment scenario, taking 100% from the sale of the business, and living in a low tax state like Texas, you would need a sale price of $4.9 million if you sell this year. You would need $6.6 million under Biden’s proposed tax plan.
This is a big swing. It is important for you to identify what you need to live on, how much risk you can tolerate, what you are comfortable rolling forward, and then work backwards to the sale price. It is a big enough decision to make it with foresight and calculation.
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