Recently I was talking to an entrepreneur that was in the process of selling his company. Now, this wasn’t a Software-as-a-Service company, but rather a services business with an expected valuation of 4-6x EBITDA (basically, profits). We got to debating the pros and cons of selling the business and I brought up the fact that selling the company, and the resulting passive income, would be much less than the profits now. Here’s how the math works out:
- Assume the business is doing $5 million in revenue and makes $1 million per year in profits (20% margins)
- Assume a valuation of 6x profits, so the business would be valued at $6 million (6x is high for a services business)
- Assume a tax rate of 25% (varies by state) on the long term capital gains from the sale for an after-tax take home of $4 million
- Income/rate of return scenarios:
- 5% of $4 million = $200,000
- 10% of $4 million = $400,000
So, after selling a services business making $1 million per year in profits, the owner would make $400,000 per year in income (if able to earn 10% per year on the money, which is high). Of course, the entrepreneur would have more free time, flexibility, etc. but he’d actually take home much less money. Most businesses are bought for a multiple of profits and the resulting income to the owners is significantly less than what they made before.
What else? What are some more thoughts on the idea that selling a company results in less annual income to the entrepreneur?