Five Principle Plan For Successful Insider Transfers
Basing an Exit Plan on false assumptions is a lot like building one’s house on sand, something none of us would ever do. But agency owners build their business exits on false assumptions far too often. Exit Planning is an owner-centric process. A plan’s sole purpose is to achieve the foundational, universal and aspirational goals of the owner. This sounds great, but the best laid plans of owners often go astray without planning based on solid assumptions and estimates. Many agency owners delay planning and are often more comfortable living in a fairy land of wishful thinking that a wealth generating exit will just happen. One of our jobs as advisors to agency owners is to replace false assumptions with stark reality. The Six False Assumptions As owners set their exit goals, the six most common false assumptions they make are:
- The amount of income they’ll need after they exit
- Their life expectancy and that of their spouses
- The expected rate of return on invested assets
- The value of their companies
- The likely rate of growth in business value and cash flow
- The net proceeds expected from the sale of their companies
- They underestimate the amount of capital required to achieve their needed post-exit income.
- They overestimate the amount of capital they’ll have available to them at their exit. (See 3 and 5 above.)
They grossly underestimate the amount of time they really need to grow value, cash flow and income-producing assets to achieve their income goals. (See 1-6 above.)
These consequences mean that owners cannot and will not leave their businesses when they want to, to whom they want, or with the money they need. But the most serious consequence of false assumptions is that owners who rely on them don’t feel any urgency to start planning.
Overcoming the Six False Assumptions with the Six Realities
- Post-exit income: Research indicates that retirees continue to spend 70 to 85percent of their pre-retirement spending.
- Life expectancy of owner and spouse: Use this calculator based on the Social Security Period Life Table 2000:https://rslic.metlife.com/lic/corpLongevity.do?target=calculate. Example: A husband and wife, both aged 65 and both with normal blood pressure, non-smokers (quit smoking), two or fewer alcoholic drinks a day, and frequent exercise. There is a 50% likelihood of at least one spouse living to age 95 and a 25% chance of one living beyond age 101. While this is generally good news and doesn’t affect an owner’s annual spending calculation, it does affect the total amount spent and how much capital owners will need for their lifetimes (and that of their spouses).
Expected rate of return. When owners expect a higher rate of return on income- producing assets, they lower their estimates of the proceeds they need from the sale or transfer of their ownership interest.
From 1975 to 2000, the S&P 500 had an average return (dividend included) of 16.88 percent per year. Contrast that with this century: From 2000 to 2013, the average annual S&P 500 return (including dividends) was 2.324 percent.
From 1975 to 2000, the yield on 10-year U.S. Treasury bonds was approximately eight percent (8.37%). During the past six to eight years it’s been less than four percent. In the first part of 2015 it is about 2%.2)
- Business worth: Agency owners should base an estimate of their business value on a valuation by an industry-specific expert. The expert can help identify the areas that will increase the agency valuation.
Projected rates of growth of business value and cash flow. Let’s assume that most businesses grow at a rate similar to that of the national economy as measured by the Gross Domestic Product (GDP).
From 1975 to 2000 GDP grew an average of 6.35 percent, per annum. Consequently, most businesses doubled their revenue about every ten years.3) Contrast that with the period from 2000 through today with GDP growth averaging less than three percent per annum. At a modest 3% annual growth rate a business will double in revenue/profitability/value roughly every 25 years or so.4) When the economy and your customers’ revenues are growing at three percent or less per year, it’s very difficult to grow your business by an annual amount necessary to experience significant increases in value. Unless, of course, you engage in business growth planning, which is at the heart of Exit Planning for agency owners.
- Net proceeds expected from sale of agency. Higher taxes affect the net proceeds they’ll take from the sale or transfer of their companies. If an owner sold their business before 2013 and, after taxes, had exactly enough cash to achieve financial security, they would have to sell that same business today by five-plus percent more to cover the higher capital gains taxes to end up with the same amount of cash in her pocket.