All owners want the same thing: Financial Freedom.
It doesn't matter what industry they're in, how many employees, revenue or profit amount, every owner wants—the ability to do what they want, when they want, where they want and with whom they want.
To improve your chances of achieving this goal, you need to start by knowing your financial freedom numbers.
These are the numbers that will help you determine what you need to achieve financial freedom, when you want to achieve it by, where you are now and what you need to do to get there.
Let's get you on the path by breaking down one of the critical numbers you need to determine:
Your Financial Freedom Wealth Gap — that's the difference between the amount you need to achieve financial freedom and the amount you have today.
Keep in mind, this is an extremely simplified example. It is designed to illustrate the concepts and give you something to start thinking about. To do so, I'm excluding important factors and variable, including:
- Annual expected inflation rates
- Annual expected tax rates
- Expected number of years until you want to achieve financial freedom
- Expected number of years you plan to live financially free without any additional income
- How much money you'd like to leave for inheritance of gifting
Step 1: Determine your Financial Freedom Annual Income Value
That is the amount of annual income you would need to support your dream life without having to work.
Here's a quick, back-of-the-envelope way to determine that:
Start with your current income and decide how much more or less you'd need or want to sustain your life without having to work.
Let's use $750,000/ year as an example.
Step 2: Calculate your Total Financial Freedom Net Worth
That is the total amount of investable net worth you'd need invested at an average expected rate of return to generate your annual financial freedom income amount WITHOUT touching the principal.
(Again, this is for illustrative purposes and is making the assumption you won't ever touch the principal.)
Let's assume you expect to generate a 4% return a year on total investable net worth during your retirement years.
You divide that into the $750,000.
So your back-of-the-envelope Total Financial Freedom Net Worth =
$750,000/4% = $18,750,000.
That means, you'd need $18,750,000 generating a 4% return to produce your annual $750,000 to achieve financial freedom.
Take a look at the different net worths needed at different rates of return:
3% = $25,000,000
4% = $18,750,000
5% = $15,000,000
6% = $12,500,000
Seemingly small differences make a big difference.
Step 3: Calculate the current value of your non-business assets
What is the total value of any retirement plans you have or regular, taxable brokerage accounts?
What about real estate investments?
What's the total value of these investments?
For this example, let's say they are worth $3 million.
(Just repeating myself, but this is static. We are not factoring in how much you'll be contributing to these accounts, for how many years and at what expected rate of return.
I'm simply trying to illustrate the concepts and get your mind working on them.)
Step 4: Calculate Your Wealth Gap
Your Wealth Gap = Your Total Financial Freedom Net Worth - Total value of your non-business assets.
This tells you how much of your total freedom net worth is currently made up by your non-business assets.
In turn, this reveals the amount you need to sell your business for to make up the difference.
Business owners are different from non-business owners.
For the latter, their net worth is composed of assets like stocks and bonds in retirement and brokerage accounts.
For owners, their biggest asset is their business.
For them to achieve financial freedom, selling their business is going to be critical to getting them there.
Step 5: Determine the STRATEGIC value of your business
What is your business worth?
Think about like this:
If you went to put your business up for sale today, what kind of offer prices would you receive?
Value is in the eyes of the buyer.
To calculate a valuation, use the basic formula:
Value = Profits x Multiple
Depending on the size of the business, profits are measured by either EBITDA (earnings before interest, taxes, depreciation and amortization) of SDE (seller discretionary earnings).
Essentially, these are the amount of cash profit a buyer would expect the operations of your business to generate.
This number is relatively objective. Math.
The multiple, however, is subjective.
It is a risk factor.
Every industry is associated with a range of multiples.
The range is determined by the marketplace. But where a business falls out in that range is in the current owner's control.
The more certain a buyer is that the operational profits will at least stay the same after the sale, the higher the multiple.
The less certain, the lower the multiple.
When a seller can't find a buyer that equates to a zero multiple.
To do a quick valuation, you can Google multiple valuations for your business and size and see what you find and then multiply that against your profits. (If you know your adjusted profits, that's the best number to use.)
As an example:
Profits = $2,000,000
Industry Multiple range = 2 to 7
Range Multiple Potential: $4 million - $14 million
Your Multiple = 3
Current Business Valuation = $6 million.
Now that we know that final number, we can solve for the number we started off looking for...
Step 6: Calculate your Financial Freedom Wealth Gap
Here's what we know from our example:
- Financial Freedom Annual Income Value = $750,000
- Expected annual investment rate of return = 4%
- Total Financial Freedom Net Worth = $18,750,000
- Value of non-business investments = $3,000,000
- Strategic business value = $6,000,000
- Profits = $2,000,000
- Multiple = 3
In a nutshell, your Financial Freedom Wealth Gap = Total Financial Freedom Net Worth - (Value of your non-business assets + value of your business)
Financial Freedom Wealth Gap = $18,750,000 - ($3,000,000+$6,000,000) = $9,750,000.
$9,750,000 — that's the amount of value you need to create between now and the time you want to achieve financial freedom.
Step 7: Closing The Gap
Your mission now is to create a plan that closes the gap between now and whenever you want to achieve financial freedom.
There are number of ways to do so:
- Increase profits
- Increasing the value of your non-business assets
- Increase your multiple -- remember, you got a multiple of 3. The max potential multiple was a 7. At a 7 multiple, you'd be valued at $14 million, not $6 million. That would take you a long way toward closing the gap....all without adding a dollar a profit
Achieving financial freedom is one of the greatest goals you can achieve for yourself, your family and causes you care about.
I hope this post motivates you to start as soon as possible working on your exit plan so you can maximize your chances of achieving financial freedom.
If you'd like help going through a more thorough and precise planning exercise as well as crafting a plan to close that gap, I'd be delighted to help.
Any questions? Send me an email at awohlberg@gjwadvisors.com.
