"Well those cars never seem to stop coming ... Keep those lines and machines humming." — from "Car Wash" as performed by Rose Royce
Art and his wife Kerry own three executive car wash locations.
There are 36 employees. Even though it strained their budget, the couple initiated a group health insurance program and offered a 401(k) plan. Twice they loaned their own money to the business. Over the years, substituting for absent employees, they performed every task at all three locations. They sweated blood to build their business. Now their blood is tired.
The couple receives a buyout offer. The offer includes a payout that represents three years of the business's annual gross revenue, which averaged $1 million over the last three years. At closing, the couple receives a check for $2,000,000, with another $1,000,000 due in four equal quarterly payments of $250,000. The funds from the $3 million purchase price represent their retirement nest egg, which they are anxious to get invested to replace their business income.
Now, let's analyze their financial position. Assume the couple pays 20% in capital gains taxes, or some $600,000, leaving them with $2.4 million, not $3 million. Another consideration: during the year following the sale, the buyers were basically paying Art and Kerry with money that the couple would have made themselves had they continued to own. So the dilemma is this: sell and reap $2.4 million after taxes. Or hold on as owners for one more year and reap $1 million in gross revenue and maintain full equity. When we consider their financial position objectively and by adding in some additional taxes due, Art and Kerry will profit by less than $2.4 million by selling.
Art and Kerry are fictitious, but their situation is one many small business owners face when nearing retirement. Should they hold on or sell? When calculating the profit from a buyout, sellers must incorporate their tax bill and the "lost ownership opportunity" costs.
Now, if they invest their $2.4 million after taxes, and purchase securities which pay stock dividends and bond coupons, at a 3.5% yield they'll be able to generate somewhere around $84,000 annually in investment income. Combined with their Social Security payments, they may decide they are comfortable living on that annual income while attempting to grow their principal. Market investors understand the beauty of being a “limited” owner in a business (owning stocks and not whole businesses) and collecting “mailbox” money rather than “sweat” money.
So by selling, they can, pardon the pun, wash their hands of responsibility and liability. By taking the lump sum payout, they also protect themselves against a future business downturn. Of course, they also give up 100% equity in a valuable business.
Selling for three times (one year’s) gross revenue is not unusual for a small business owner. The math may always say “keep working,” but anyone ready for retirement may just want to be done. Some business owners reach a point where they simply can’t perform all the tasks necessary any longer.
Margaret R. McDowell, ChFC, AIF, author of the syndicated economic column "Arbor Outlook," is the founder of Arbor Wealth Management, LLC, (850-608-6121 — www.arborwealth.net), a “fee-only” registered investment advisory firm located near Sandestin. This column should not be considered personalized investment advice and provides no assurance that any specific strategy or investment will be suitable or profitable for an investor.