David Cummings on Startups

Making Less Annually After Selling a Services Business

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David Cummings

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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?

Comments

5 responses to “Making Less Annually After Selling a Services Business”

  1. Bert Clark Avatar
    Bert Clark

    David

    I’m a certified financial planner and you are not just correct, you’re WAY correct. Here are some observations:
    1. Anyone selling a business must understand that a lump sum payout may not last forever- there are numerous studies that show that in order to preserve capital you shouldn’t take more than a 4 to 5 percent ‘draw’ each year, pre-tax. Of course you can spend at whatever rate you like, but doing so at a rate higher than 5 pct each year over time means that your principal sum will likely decline. This is the approach taken by most nonprofit or educational endowments.

    2. A lot of entrepreneurs take their sakes proceeds and re-invest them in other startup(s). Special planning needs to be done to determine how much should be invested in speculative ventures, and how much should be invested for the long term.

    Bert Clark

    Reply
  2. John Avatar
    John

    Most owners of businesses receive compensation and write offs associated with their responsibilities. The $1mm profit is usually after a six figure salary, expensing a car lease and golf club dues (if not more).

    Reply
  3. Jeff Avatar
    Jeff

    Digital agencies (service businesses) are sold at the low end for 6x and the high end for 10x. So, definitely depends on the industry and corresponding exit size.

    Reply
  4. crowefourbridges Avatar
    crowefourbridges

    David,

    You are right that an entrepreneur of a successful business may not make as much in current income post sale, but that person would be insulated from changes in the business/industry which may negatively affect the value of his or her business. Owning a business is a risky venture which may reward an entrepreneur, but making a million per year doesn’t mean you will make it forever without a lot of hard work.

    When working with business owners, we often find that the decision to sell is driven by factors other than current income (e.g. need for time with family, desire to reduce financial risk or do other things, not enjoying business any longer, too much competition).

    Thanks for the posts. Keep them coming.

    Best,
    Chris

    Reply
  5. Dave Williams Avatar
    Dave Williams

    Selling is a great idea especially to help diversify your asset concentration risk. There is never the right time to sell, but if industry dynamics are changing- key employees getting recruited, more competitive firms in industry with deeper pockets, industry consolidation occurring, owner is burned out, getting bought creates greater opportunity (earnout, career at new company – comp package, status, etc), and this creates the opportunity to do bigger/ better things down the road, I think selling is a great opportunity for a startup entelrepreneur. It is hard to know if you are selling at your peak, but if the valuation isn’t what you want, consult an investment bank in your category and find out what you need to do to raise the multiple- proprietary tech, better processes, acquire a firm to add what you need, go after bigger clients, more organized financials, etc and then use this to help chart the optimal path to exit. Also, you should talk to a tax attorney as there could be optimal tax planning strategies to put in place now. It never hurts to look and evaluate options, plus having a slug of cash is great to have especially when the economy starts to tank again. Remember pigs get slaughtered!

    Reply

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