Understanding Return on Labor vs. Return on Capital: The Two Small Business Owners

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In the previous post, we introduced two businessmen – Martin and Steve. Their businesses are worth about $2 million each.  Martin and Steve have taken two different paths in their treatment of the earnings of their businesses, and have widely different business end games and retirement prospects as a result.

Martin is 65 and owns 100% of a business that does about $3 million in sales. He has paid himself about $600 thousand from the business each year, and the business has reported minimal earnings. He and his wife have minimal savings and have been living on the $600 thousand “income” from the business and their lifestyle is dependent upon a continuing income stream at that level. An appraiser valued the business at about $2 million. If Martin invested the $2 million proceeds at, say, 6%, he would have income of $120 thousand.  Martin forgot about capital gains taxes on the sale, so his calculation was significantly inflated as a result. Wanting to retire at age 67, Martin knows it is not possible if he and his wife want to maintain their current lifestyle.

Steve, on the other hand, is also 65 years old and owns 100% of a business that also does about $3 million in sales. For the purposes of this discussion, his business is identical to Martin’s. Like Martin, Steve has distributed just about all of the $600 thousand from the business each year.  The difference is that Steve realized that not all of that $600 thousand was really his earnings.  He thought a decent salary for someone else running the business was about $200 thousand per year, but he and his wife organized their marital lifestyle to live on $300 thousand (and paid taxes on that income).

Steve then took the after-tax remainder of his company’s “income”, or $180 thousand ($300 thousand less taxes of 40%), and invested it with a local financial planner.  By the time he reached 65, they had been saving at the rate of about $180 thousand per year for about 20 years, and they had an investment portfolio of well more than $6 million.

Steve’s financial planner made some calculations for them assuming Steve would retire and sell the business at age 67.  He  assumed that the business would sell for $2 million and yield after-tax proceeds for Steve and his wife of $1.5 million.  He projected that with two additional years of saving, the couple’s portfolio would be at about $7 million when Steve turned 67.

Steve is one of a much smaller number of baby boomer small business owners who are in a position to retire nicely, having never had a business worth more than $2 million, or one earning (normalized) more than $400 thousand per year.

Return on Labor vs. Return on Capital

Where have the Martins of the world gone wrong?  Martin needed to learn a basic concept about business long ago. To keep the example simple, assume that there are two and only two kinds of returns from a business for a business owner who works in the business.

  • Return on Labor.  Martin’s return on his labor is the $200 thousand that his labor is worth in the context of the business.  The return on labor is the normalized salary.
  • Return on Capital (Ownership).  Martin’s return on capital is the $400 thousand that he continued to distribute to himself and to live on.

Martin probably thought he was really good as a manager and was worth a salary of $600 thousand.  But that was not the case.  He distributed his return on capital and consumed it.  As a result, he never accumulated anything outside the business.  His business is not sufficiently valuable to enable him to sell it and to retire well.

Steve, on the other hand, whether intuitively or otherwise, knew about his return on capital.  When he distributed his $400 thousand of return on capital, he made a conscious decision to consume $100 thousand of it (by raising his normalized salary of $200 thousand to $300 thousand.  The good news for Steve and his wife is that they saved and invested the remaining $300 thousand of return on capital after paying their taxes.

Steve and his spouse can retire nicely anytime they wish.  Not so with Martin and his wife.

What is a Business Adviser to Do?

Sometimes business advisers have to bring bad news to their clients.  Or sometimes their clients simply refuse to think about things like future retirement and their business end games.

I’m asked quite often if I have any magic answer to helping business owners with dilemmas like Martin’s. I don’t, other than to keep on keeping on.  Martin’s choices are limited.  If he continues on his current path, he won’t be able to retire without a substantial adjustment to lifestyle.  If he cuts his lifestyle now and starts to save, accumulation will be slow and limited by the time he has remaining to work.

Martin really needs to focus on building the value of his business.  If, for example, he could double its value over the next three to five years, to about $4 million, and save as much as possible during that period of time, he could improve his potential business end game outcome.

Can Martin do that?  I don’t know.  Maybe the right kind of consultant would work with him and help him grow the business.  In any event, what we do know is that Martin’s options are limited.  If you can help him understand his true situation, perhaps you will have opportunities to work with him as an adviser.

Steve, on the other hand, has been working with a financial advisor for years.  Because of how he has treated the earnings of his business, Steve and his wife have many options for the future.  And his business end game is much more clearly in focus than Martin’s.

Two Final Questions

Regardless of the size or value of your business, are you a Martin, who has not worked to develop liquidity and diversification outside his investment in his business and has limited options for retirement at this time?  Or are you a Steve, who has worked for years to assure that he and his wife can retire and live well for the rest of their lives?

In the meantime, be well!

Chris

Please note: I reserve the right to delete comments that are offensive or off-topic.

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