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The idea of starting a business or owning rental properties builds over a period of time. Slowly you convince yourself you can really pull it off. You talk with family and friends first before speaking with your accountant. Owning a business is a dream you have had from a young age. The work involved is something you enjoy so you are motivated. A business plan is drawn up with the help of an accountant or attorney. With a business plan in hand you visit your banker for funding.
For our example we will use an ice cream shop as our business. Suppliers are lined up, employees hired, equipment purchased and promotion in place. Business is hard, but you deal with problems as they arise. Before you know it years get behind you as your business grows until locals use your business as a landmark (turn left at John’s Ice Cream Shack).
Now the discussion has changed when you visit the accountant. The loans were paid off a long time ago and money is building in the retirement and investment accounts. Only now do you realize you forgot one important part to your plan: the exit strategy.
Buying or starting a business includes plans for funding, promotion and management. Few advisors talk about how it will all end. So much focus is on buying the rental property or running the business that nobody has an idea when the right time is to cash in. Most people assume you run with the business until you get too old or too tired to keep going. Insane!
The Small Business Life Cycle
Business owners with a plan have a high rate of success. We hear about how many businesses fail in the first year, however, most businesses fail due to lack of a plan. Business owners with a plan frequently see their business deteriorate decades down the road as they decide to hang on for “one more year” rather than fail in the early years. I get it. Your business is your baby. Walking away is hard. It is what you do, how you see yourself. What business owners need to understand is that there is a simple way to determine when it is time to cash in and enjoy a simpler life.
In our example we have an ice cream shop owner with no loans or other outstanding debt. Annual sales are steady to slightly increasing at $500,000 and profits of $60,000. Your accountant does some market research and discovers ice cream shops generally sell for about 80% of sales in your area. Should you sell? A better question: If you don’t sell how much are you really making?
We will ignore taxes on the sale because you hired a smart accountant who has you set up with Section 1244 stock as a small business and under current tax law the entire gain is tax free. Another reason we will ignore taxes is because too many variables can change what your tax situation will be.
Because you run such an efficient operation your ice cream shop will sell for a bit more than $500,000, enough to cover selling costs and keep a full half million. Invested in an index fund you can expect a 7% return over the long-term. Under the 4% rule, where you only take 4% out per year, history shows you should never run out. At 7% your $500,000 will generate $35,000 per year; using the 4% rule you will have $20,000 per year with about half coming from dividends. This means if you keep working at your business you are making less than the $60,000 you think you are since you will get $35,000 without working. Are you willing to keep working the business for $25,000 per year since you only make $25,000 more per year by keeping the business over selling and investing the proceeds?
It gets worse. Same example, but you own the building and pay yourself $30,000 per year in rent. If you sell the business and keep the building you have $500,000 generating $35,000 in gains, plus $30,000 in rent income. Sure, you also received $30,000 rent from your own business if you didn’t sell, but are you willing to keep working for only $25,000 more when you could make $65,000 without working? All the money you saved over the years also throws off a massive income stream. Your investment army, supercharged by the business sale, provides you with more income than you spend in a year.
Income properties are just as bad. Let us assume you have ten rentals you bought years ago without an exit plan. As the years go by you have several million dollars in real estate paid off. The rent income is nice, but the hassle of owning rentals does start to get old. If your rentals are worth $3 million you should clear around $2.65 million and $2 million after-tax. At 7% you will have an income stream of $140,000. Even with the 4% rule you are looking at $80,000, more than enough for anyone to live extremely well.
At what point does running a business make no sense? At some point it is better to sell than continuing the business or keeping the investment properties. Is it about money? Remember, we call working for “money only” a chump’s game around here. Giving up a large part of your life to have more money is beyond insane! Remember, the buyer has certain tax advantages you don’t since you have depreciated so much of the business or investment property.
Before you start a business or buy rental properties you have to ask, “At what point do I plan on selling?” It is harder to sell when your business becomes your baby. A complete plan will help you realize your goals, including when to retire early.
Physician, Heal Thyself
Now I need to make a confession; I am a hypocrite. My accounting business has had no debts for decades. Selling my tax practice and building (or keeping the building for a stream of rental income) is the intelligent move to make. Using the math I outline above it becomes abundantly clear I should sell and move on. The only way to not sell and make the numbers work is to buy additional tax firms. The added tax benefits of expanding the firm would increase my income and skew the math towards retaining ownership . Unfortunately, by running a lean corporation the debts would soon be cleared and I would be in the same boat with only larger numbers. Tax offices sell for between 1 and 1 ½ times revenue. The way my firm is run would indicate closer to a 1.4 times revenue sales price.
So, what reason do I have to keep working? It is not the money, I promise you that. Sure, the money is good, but adding the sale of my business to the investment stack I already have would allow me a lifestyle much higher than I currently live (around $30,000 a year). The real reason I continue is because I love the work; I love the clients and the employees. It is what I do.
In my situation I came to a compromise (or cop out, if you will). I work hard during tax season for three months (something I really love doing) and hardly work the rest of the year. Instead of working harder at the business, I am sharing my 30+ years of experience so other tax pros can improve their skills and have what I have. I can create a better world without working more hours. I love what I do and cannot see myself ever leaving the field completely. My future holds more teaching than anything else.
By the way, I had an exit plan when I went into rentals. When I hit a certain point it was time to sell them all and did. For my accounting office I plan on stepping back completely when my youngest daughter graduates high school in 2 ½ years. In the mean time, I am grooming a group of people to run the business since I will be gone most of the time after that. I will speak for more years and, if you guys are interested, continue writing this blog. Until then I am really working for less money than if I sold the business and went full-retirement. Insane!