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For many business owners, their business is their largest asset and a substantial portion of both their current income and future retirement plan. That makes one question especially important when preparing for an exit: How much annual retirement income will the proceeds from selling the business actually produce? This is an especially important consideration because a business owner shouldn’t assume that a business generating good income for the owner could be sold at a significant profit after paying business debts and taxes.  So as far as sale price goes, how much is enough? The 4% Rule provides a useful starting point for answering that question.    

The 4% Rule is a guide for how much a retiree can responsibly withdraw from retirement savings.  Under the 4% Rule, a retiree withdraws approximately 4% of their investment portfolio during the first year of retirement and then generally adjusts that dollar amount for inflation in later years. Although it is only a guideline, the rule can help translate the business sale price, together with other retirement assets, into an estimated stream of retirement income for an estimated period of time.  The 4% Rule was developed from historical market research examining how different withdrawal rates would have performed over long retirement periods. The objective is not to preserve every dollar of principal indefinitely, but to establish a reasonable starting withdrawal rate designed to reduce the risk of exhausting retirement savings during a retirement lasting approximately 30 years.

To better understand, consider a business owner who expects to receive a net amount of $3 million from the sale of their company. If the entire $3 million were available for investment after the transaction, a 4% initial annual withdrawal would equal approximately $120,000 per year. If the business owner has an additional retirement savings of $2 million, the total retirement savings of $5 million in a well managed investment portfolio would initially support an annual draw of approximately $200,000 per year.  But remember, the top line business sale price is not what the seller has to invest.  Debt repayment, transaction expenses, taxes, working-capital adjustments, deferred payments, seller financing, and other closing obligations can substantially reduce the owner’s net proceeds. A $3 million business sale, does not necessarily add $3 million to the seller’s retirement portfolio.

This is where the 4% Rule becomes particularly useful in exit planning. Instead of starting with the expected value of the business, an owner can work backward from their desired retirement income. If an owner wants $200,000 of annual income from retirement investments, the 4% Rule suggests a portfolio of approximately $5 million, that is 25 times the desired annual withdrawal. If Social Security, rental income, pensions, or other reliable sources will provide $50,000 annually, the portfolio may need to generate only the remaining $150,000, suggesting a net business sale proceeds target of approximately $3.75 million.

That calculation can expose a potential wealth gap, which is the difference between the investable assets an owner expects to have after exiting the business and the amount needed to support the owner’s desired retirement lifestyle. Identifying that gap several years before a sale provides time to increase business value, accumulate assets outside the company, reduce personal spending expectations, or reconsider the timing and structure of their exit from the business.  The 4% Rule is not a guarantee. Taxes, investment returns, inflation, asset allocation, longevity, and market conditions all matter. Nevertheless, it provides business owners with a simple framework for connecting business value, net sale proceeds, and retirement income in a useful format that makes sense.  Ultimately, a successful exit is not simply about selling the business for the highest possible price. It is about converting the value built in the business into enough financial resources to support the owner’s realistic goals for a sustainable retirement.  If you have questions or want help understanding andachieving your exit and retirement planning goals contact RC Kelly at 215-896-3846 or by email at help@rckelly.com.