Should You Exit?

By Matt Michel

Make sure you can afford to exit and that an exit makes sense. Here’s how to work the numbers.

Lots of contractors are taking advantage of the influx of private equity into the trades to take an exit while the taking is good. If you are considering selling, make sure the math works out in your favor. Make sure you can afford to exit and that an exit makes sense. Here’s how to work the numbers.

 

Identify What You Need

How much money do you need to support your lifestyle? Do not limit yourself by what you are spending today. Look at what you want. For simplicity, let’s make it a pretax number, so taxes must come out of it. Is the number $100 thousand per year, $250 thousand, $500 thousand, or more? Pick a number and get started.

 

Identify Additional Sources of Income

If you have additional sources of income separate from the business, such as rental property income, how much is it? Will you be old enough to collect social security? Visit a government website and calculate what you can expect.

 

Identify How Much Investment Income You Need

Subtract the additional income, including any social security income, from the amount needed to support your lifestyle. The deficit is what you need from investment income after the sale of the business. For example, if you have outside income of $40 thousand and want to live on $250 thousand, the investment income after the sale of the business must be $210 thousand (i.e., $250 thousand – $40 thousand). In other words, the pile of money you receive from the sale of the business will generate $210 thousand each year.

 

Identify How Much You Need to Net From the Sale of Your Business

Investment advisors will tell you to expect an average conservative return of 4% to 5%. Some years will be better and some years will be worse. If we use the 5% number, divide the investment income by 5%. $210 thousand divided by 5% equals $4.2 million. That’s the number you need to walk away with after the sale of the business.

 

Identify How Much You Need to Sell For

The $4.2 million is after taxes. You still have to pay a 20% long term capital gains taxes and the 3.8% net investment income tax that’s imposed to fund the Affordable Health Care Act. That’s 23.8% on the federal level. If you want $4.2 million, you must divide it by one minus the capital gains tax rate. So, $4.2 million divided by (1 minus 23.8%) equals $5.5 million. Note that many states impose their own capital gains taxes. You must factor in those as well.

Taxes are likely to be higher in a year. The current tax rates are scheduled to expire in 2025 and President Biden’s annual budget request proposed an increase in the long term capital gains rate from 20% to 39.6%. With 3.8% net investment income tax, the federal government’s take would increase to 43.4% if this becomes law.

 

Identify How Much Profit the Business Needs to Generate

Several factors affect how much you can expect to get from the sale of a business. Financial buyers value businesses based on expected future profit streams. Thus, if you are growing, your business is worth more because profits should be higher in the future.

In HVAC, the private equity interest is in the residential service and replacement markets. New construction and commercial companies are not valued nearly as much.

Often you will hear prices discussed as multiples. This means a multiple of EBITDA or earnings before interest, taxes, depreciation, and amortization. Essentially, this is the operating income of the business. While multiples are expected to trend down, they are currently in the 7X to 10X range. The larger the company, the higher the multiple that can be anticipated.

If we use an 8X multiple, we would divide the $5.5 million sale price by eight to determine EBITDA. Thus, $5.5 million divided by 8 equals $688 thousand in EBITDA.

 

Identify How Much Revenue The Company Need

What is your current profit margin as a percent of sales? If you do not anticipate it changing, divide the required EBITDA number by your profit margin. For example, if you are generating a 15% profit today, in the example above, you would divide $688 thousand by 15%, resulting in gross sales of $4.6 million. If you grow to $4.6 million in sales with a 15% net, you should generate sufficient EBITDA to command a $5.5 million sale price.

 

Why Sell?

The obvious question is why sell? The business is throwing off nearly $700 thousand in profit today (albeit, pre-tax), plus your income as an owner. This is a money machine. Why sell your money machine if you do not need to? Selling for a few million sounds great until you look at the tax impact and ability of the money to generate income. You might be better served by standing fast and transforming your company into a true business that can operate without you.

Matt Michel, Service Roundtable

A serial entrepreneur with 40 years of industry experience, Matt Michel is member of the Contracting Business Hall of Fame and a Speaker/Writer/ Rancher with Ranchlands of Texas LLC.

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