Typically, I write about what I refer to as “successful closely held and family businesses” that have minimum values on the order of $5-10 million or more, and often, much more.  But many small businesses don’t have and may never have such levels of value. Today’s post focuses on two baby boomer small business owners, Martin and Steve, whose 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.

With 76 million baby boomers out there turning age 65 at the rate of 10,000 per day and with businesses owned disproportionately by baby boomers, a fascinating dynamic is moving through America.

In a sense, this is old news.  The number of boomers is not new.  Back in 2005, Peter Christman and Rickard Jackim wrote a book, The $10 Trillion Opportunity. Their book predicted a tsunami wave of business transfers during the then-coming decade.

I wrote about the aging of American business ownership and anticipated a surge of corporate transactions on my blog and talked about it in speeches, as well.  But I didn’t write a book then.

All of us were wrong.  The massive restructuring of American private businesses that we anticipated has just not happened.

So what has happened?  I’ve had a few thoughts on the topic.  A couple of stories may illustrate what is going on with many small businesses in America.

Martin’s Trap

Martin, who is 65, 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 the business has reported minimal earnings.

Martin was thinking about retiring in a couple of years and hired a business appraiser to tell him what the business might be worth in the market if he tried to sell it.  The appraiser normalized the earnings of the business, making an assumption that a market wage for running it was $200 thousand, and that normalized earnings for the business were about $400 thousand.  The appraiser concluded that the business was worth about $2 million, or 5 times normalized earnings of $400 thousand.

Martin did a quick calculation. If he invested $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.

Martin then thought about his savings, which were minimal.  He and his wife had been living on the $600 thousand “income” from the business and their lifestyle was dependent on a continuing income stream at that level.  Martin added about $35 thousand of expected Social Security benefits (at age 67) and discovered that he and his wife would have only $155 thousand of taxable income per year if he  retired at age 67.

Martin realized that he and his wife would have to make a substantial adjustment to their marital lifestyle or win the lottery, in order for him to retire at age 67.

Martin is one of the many hundreds of thousands of baby boomer business owners who did not sell their businesses in the last decade and who don’t have realistic prospects for a successful sale and business end game that sets them up for the rest of their lives.

Steve’s Better Prospects

Now let’s look at Steve, who is also 65 and thinking about retiring at age 67.  His business is, for our purposes, exactly like Martin’s, generating about $600 thousand in cash flow available to the owner on about $3 million in sales.

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.

The combination of savings and business sale proceeds is expected to be $8.5 million.  The financial planner assumed that they could “pay” themselves about 4% of principal, or $340 thousand per year.  They would, he suggested, reinvest any return in excess of 4% to help protect their portfolio from inflation.

Steve mentally added about $40 thousand per year of Social Security proceeds beginning at age 70 and realized that he and his wife were set to be able to retire on more income than they had been living on for many years.

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 then $2 million, or one earning (normalized) more than $400 thousand per year.

Where’s the Tsunami?

I’m speculating here, but I think that one reason many owners of smaller businesses have not sold in recent years is they cannot afford to sell their businesses, retire, and maintain a semblance of their pre-retirement lifestyles.  I think there are a lot of Martins in the baby boomer small business world.

The tsunami may get pushed another few years if my thinking is right.  What do you think? Comment below because the question of the timing of the tsunami of business sales is an important one.

In the meantime, be well!

Chris