Today, all owners face three significant headwinds that increase the difficulty of a successful business exit. One is our flat economy—today and for the foreseeable future. The second is the substantially higher tax bill that’s due upon the sale of a business. And last, but not least, is the long-term mediocre investment climate that depresses the amount of income owners can expect from their sale proceeds and other investments. Combined, these three headwinds wreak havoc on an owner’s ability to cross the finish line at all, let alone as they originally planned.
Previous articles have looked at the first two headwinds (first and second). Today, let’s look at how the last of these headwinds affects your efforts to leave your business in style and what actions you can take today to minimize their effect.
Headwind 3: Dwindling Returns on Investment
Many of us of a certain age consider 6-10% to be a conservative return on the investment of our sale proceeds because that’s what we enjoyed during the years we started and grew our businesses. Those days and those returns are gone. There has been minimal growth in the stock market since 2000 and bond rates have plummeted to less than half of what they were just a few years ago.
From 1975 to 2000, the S&P 500 had an average return (dividend included) of 16.88% per year. Contrast that with this century: From 2000 through 2013, the average annual S&P 500 return (including dividends) was 2.324%.
From 1975 to 2000, the yield on 10-year U.S. Treasury bonds was approximately eight percent (8.37%). During the past six to eight years: approximately three percent (3.78%).
“The yield on the benchmark 10-year Treasury note is just under 2.2%, compared with more than 6.5%, on average, since 1962, according to quarterly Bloomberg data. And bond investing is likely to remain challenging for years to come. Investors may face a double-whammy — low yields now and the prospect of significant losses as yields rise.”
Of course, we can hope that the stock market and investment returns will grow significantly in the future. Or we could experience another “Great Recession” during which we’ll watch stock prices fall 30 or 40% and deflation emerge thus lowering the already-low bond rates to something uncomfortably close to zero.
We do know former owners who returned to work when their investment portfolios did not perform as anticipated. Those in their 40s or 50s were capable of restarting their business lives, but most of today’s Boomer owners are older than 55 and returning to work in 5 or 10 years for five or ten years is not only unappealing, but likely undoable. Few owners want to return to work after their exits because they’ve exhausted their savings.
To prevent this unpleasant scenario many financial advisors consider a 3-4% return on liquid funds to be a safe and reasonable return estimate for their clients.
If you take this conservative approach based on the investment experience of this century, it’s likely that your investment return will be 50% or so of what you would have expected during the 1980s and ‘90s. That means your nest egg needs to be twice the size to produce the same income as in past decades.
Little Time Means Little Room For Risk
When we are young and our income is the result of our business efforts, we invest in the stock market. We have time and the expectation of continued business income so we assume the greater risk of the stock market in hope of greater returns. After we exit and rely solely on investment income, we invest in presumably lower-risk bonds and settle for less income.
Mitigating Headwind 3
The best defense against diminished market returns is to acknowledge this reality and rely on a skilled financial advisor to inject that reality into your exit plan.
Decreased return expectations may prompt you to work in your business longer or to invest, rather than spend, excess distributions.
The strategies you choose to adjust to new market realities are part of the exit plan you and your advisors create.
The Headwind Trifecta
We haven’t talked about the effects that rising health care costs, increased life expectancy, globalization and Internet competition have on a company’s ability to grow and on funding a retirement. If we consider just these three headwinds alone—a stagnant economy, increased taxes on business income and sale proceeds, and a lackluster investment environment—the implications are clear:
1. It will take significantly more time to grow business value unless it is growing far faster than the GDP. Only 10% of middle-market companies grow faster than 5.5% plus the cost of capital per year.
2. Increased taxes serve to reduce the amount of capital both owners and their businesses can accumulate.
3. Compared to pre-recession levels, investment income has been halved.
4. Waiting for headwinds to calm is not an option.
The good news is that a successful exit and financially secure future are still possible. Like the headwinds the bicyclist faces, these headwinds lengthen the time it will take to reach your finish line or require more efficient effort on your part.
Unlike the biker who can wait another day to let the headwinds subside, Boomers contemplating their exits don’t have that luxury. Owners have to act to overpower them.
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