The Entrepreneur's Blind Spot
As a business consultant, I travel the United States meeting with small business owners whose businesses range from a simple $100,000 to $10,000,000 customer level revenue. Over the years, as I have met with these owners, I have seen a trend of self-reliance and a strong work ethic. They’re the hardest workers out there! When I ran my family’s franchise for 5 ½ years, my eyes were opened to the long days and the plethora of skills needed to run a successful business. To date, running that business, has been the hardest thing I have ever done. So my respect and admiration for small business owners runs deep.
However, there is another concerning trend that I am seeing. The owners that I support, as well as other self-employed friends and family, are not adequately prepared for retirement. I call this The Entrepreneur’s Blind Spot. When I bring up the subject, many tell me that they started an IRA a few years back, but keep “forgetting” to contribute or felt that they didn’t have enough to contribute at the end of the year. Most people don’t have “extra” money to contribute to retirement at the end of the year! You’ve got the holidays, vacation and expenses being put towards visiting family. Plus, if you didn’t prepare all year, then to magically expect to have $5,500 to contribute to your Roth IRA is truly unreasonable. Hence, it’s not going to happen, you’re planning to fail.
Another statement I get from these small business owners is they believe their business is their retirement. They feel that they will build the business and at 65-70 find a buyer and sell. They plan to use that money as their retirement.
The problem with using your business as your retirement, is there's no guarantee. Now I know what you are thinking. There is no guarantee with anything in life, especially when it comes to retirement. I completely agree. That is why it’s so important to diversify. Diversifying your retirement options, is key to having the highest chance of a successful, and possibly early, retirement.
I have been witness to many business owners, including myself, who sell their businesses. I’d say one in three turn out the way the seller hoped for, or better. The other two owners, get less of what they were hoping for in the sale of their business. One of the reasons this happens, is that many owners who come close to retirement tend to reach the “burn out stage”. The burn out stage in a business is when the owner no longer has their heart in it. This can happen for many reasons, but the number one reason I’ve seen, is a combination of age/health concerns. When you are 62 years old, 3 years away from selling your business, and you have a health issue; the business becomes much less important in your day to day life, if you care about it at all. If you, the owner, step back and the business becomes less profitable, this causes the value of the business to shrink. Now you have a shrinking business and you want to be done already! You’re “burned out”. When an offer comes along from a potential buyer, you have little negotiating power as your business is bleeding out and you don’t have the energy to stop it. So you take what you can get from the first offer and you’ve just lost several hundred thousand dollars from your “retirement account”.
There are many reasons for the burn out situation, beyond just health and age issues. You could need to devote more time to family, start/end a relationship, or maybe you’ve simply lost your passion for the business. Whatever the reason, you cannot rely solely on your business for retirement. Let’s walk through two simple scenarios of self-employed entrepreneurs together. We’ll take a macro level view of their finances and analyze the stability of their retirement.
Scenario #1: Sally Smith
Sally owns a carpet cleaning company. She hires employees from time to time, but prefers being in control of customer interactions and enjoys the simplicity of a micro business. She grosses $110,000 in customer level revenue. After her variable and fixed expenses, Sally takes home $75,000 a year. She works out of her home resulting in low overhead costs. She realizes by keeping her business small, the sale price will not be large in the future. So she sets up an individual Roth IRA and contributes $458 a month. This allows her to contribute the max of $5,500 for the Roth IRA each year. She also purchased her home, and uses it for the business. She receives a monthly rent payment from the business and tax credit for it, which facilitates Sally to pay off the mortgage early. She also loves skiing every winter, so she invests in a 600 sf cabin near her favorite slopes. The initial 20% down payment was saved from setting aside all of her tips and weekend work. When she wasn’t using the ski cabin, she rented it out as a vacation rental. The vacation rental paid the mortgage, maintenance, and maid: leaving her with a $5,000 a year cash flow which is what helps fund her Roth IRA.
Let’s see how Sally will fair when she is ready to retire after 35 years of carpet cleaning (assuming she started at age 25 and retires at age 60):
-Carpet Cleaning Business with $110,000 in customer level revenue – approximate value $65,000. She includes a decent size production vehicle and has a detailed list of current customers and their contact info.
-Roth IRA – Assuming a stock market return of 10% for 35 years, she would have $1,490,000 approximately. (According to Ez Calculators Retirement App). At retirement she moves it to a more conservative account that has a 3% return. This allows her to take out roughly $6,000 a month ($72,000 per year) for up to 32 years. Remember, this is TAX FREE MONEY!!
-Personal Home – Approximate value $250,000 (25% of which was paid for by the business)
-Ski Cabin – Approximate value $250,000 (it’s in a high demand area). Sally only invested the initial 20% down and the rest was paid for by the rental income. Now that it’s paid off, it generates $32,880 in annual revenue with a 75% occupancy rate. After maintenance expenses, insurance, utilities and taxes; let’s say she takes home $27,000 a year.
With no mortgage payment, $27,000 a year coming in from her Ski Cabin, $72,000 a year from her Roth IRA, and a cool $65,000 to play with, Sally is in a great position financially, and she retired 5 years ahead of schedule. Sally is not planning on receiving any Social Security, neither should anyone who is born after 1975, in my opinion. If it comes, it’ll be just a cherry on top.
Scenario #2: Frank Clark
Frank is the owner of a $3,000,000 plumbing business. He spent his life building this business from scratch, pays himself $150,000 a year, and has over 20 full-time and part-time employees. He needed a lot of capitol to start up his business, so he had ignored his retirement plans hoping that the sale of his business would be his retirement nest egg. He spent his money on liabilities instead of assets. For example, he purchased a new car every few years and a larger home than he needed. With several expensive vacations and remodeling his home multiple times, he still owes money on the house. He used home equity loans to fund the expensive remodels. Frank purchased no other real estate. He started a Roth IRA, but didn’t max it out each year, and some years he didn’t contribute at all. Frank only reached $250,000 at retirement. When Frank is 3 years out from selling his business, he has a major health incident. He is 57 years old. He is no longer able to run the business like he used to, and wants to sell quickly. However, because he needs to find a buyer who can qualify for funding such a large purchase, his pool of potential buyers shrinks. He hires a broker, who charges 10% to sell his business. It takes almost two years to find a buyer, and even then the buyer only offers him $600,000. His business shrunk dramatically during those two years due to his health and disengagement.
With Frank’s planning, let’s see how his retirement situation works out with the same assumptions as Sally. He started at 25 years old with his business and hopes to retire at 60 after 35 years of work:
-Plumbing Business - $600,000 (with a 3% return he can take out $5,000 a month for 12 years before he depletes this money)
-Roth IRA - $250,000 (with a 3% return he can take out $3,000 a month for 7 years before he depletes the account)
-Personal Home – $600,000 however, he owes $350,000 still with a monthly payment of approximately $2,700 a month including his insurance, HOA and property taxes. His equity is $250,000.
-Liabilities - $600 a month car payment, $300 a month credit card payment.
Frank’s Income: $8,000 a month which reduces to $5,000 a month after 7 years
Frank’s Liabilities: $3,600 a month
Frank’s Net Income: $4,400 a month which reduces to $1,400 a month after 7 years
Which business owner is better off in the end? Obviously, Sally Smith made simple, but strategic ASSET purchases throughout her life. Even her personal home, which is a liability for most people, was an asset as she charged the business “rent”.
Frank Clark was singularly focused on only one asset; his business. He did a great job growing the business, but forgot about diversifying and purchasing other ASSETS with the money his business gave him. Had his business sold at full price at its peak, he could have received $1.5-$2 million for his business (or maybe even more). However, since all of his eggs were in one basket, he was left having to scramble to make things work. There are still actions Frank can take to improve his situation, but he is clearly in a worse position than Sally, who on average earned half of what Frank brought home over their careers.