Understanding your break-even point as an owner
Over the last few weeks, MarshBerry has dedicated time to evaluating the potential implications for a firm’s value if deal multiples decline at some point over the next decade in a similar fashion as they rose in the past decade. Likewise, we have considered the possible effects of a capital gains tax increase on take-home proceeds. Will valuations decline? We aren’t sure. Will capital gains tax rates go up? Possibly. Will capital gains tax rates go down? I guess it’s also possible. Bottom line, we don’t know what will happen to value or taxes but you, the owner of an agency or brokerage, should be aware of how potential changes may affect your value or proceeds.
You should also understand your break-even point as an owner. This can best be defined as the number of years you need to continue working as the owner of your firm to net the same amount of income you would generate in a sale. Why is this important? Because firms primarily sell to transfer risk. We have commented for years that owning an insurance brokerage may be the greatest investment of all time. People don’t typically sell because they can get a better return on their cash by investing somewhere else. They often sell to transfer risk – to take some chips off the table. Other times they sell because they believe there is a wealth creation opportunity with a new partner that could be greater than they could achieve by remaining independent.
Let’s consider a quick hypothetical case. Assume a $10,000,000 brokerage that has a single owner and the firm remains independent and operates at a 15% profit margin ($1,500,000). Let’s also assume the owner takes $1,000,000 in W2 compensation (salary and commission). So, the owner earns a total of $2.5M of income on an annual basis. Assume an all-in (Federal, State, and Local) tax rate of 42%. This means they would pay approximately $1,050,000 in taxes annually and net $1,450,000 per year.
Now compare that to a potential sale. If the owner enhanced their EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) to 30% or $3,000,000 and was able to command an upfront multiple of 10x, their gross proceeds would be $30,000,000. With an all-in capital gains tax rate of 25% (20% federal and 5% estimated state tax) the owner would pay approximately $7,500,000 in taxes and they would net $22,500,000 after tax on their upfront proceeds.
The owner would have to work for 15.5 years ($22.5M/$1.45M) to break-even on net proceeds. BUT, they would still own their business that likely has significant value. This is a hypothetical scenario but meant to be thought provoking. It assumes the firm isn’t growing. It assumes taxes don’t change (ordinary income or capital gains). It assumes the owner remains in good health.
Anyone can poke holes in this quick analysis. However, it is meant as a rough guide for owners to consider what they want their future to look like. Many owners are finding the potential of taxes going up as a reason to consider selling today. Other owners are doubling down and using the pandemic as motivation to dig in and scale their firm at a more dramatic pace than before. Too often owners “wake up” to a reality they never anticipated or planned for.
No matter what your situation, you owe it to yourself to evaluate the future. When a private equity firm makes a platform investment, they evaluate their exit strategy before the investment is made. Many entrepreneurs operate in the same fashion. They are focused on executing their business plan/strategy but constantly have an eye on their exit strategy. For some the exit is 15.5+ years away. For others it’s around the corner. We encourage you to consider your position and understand what is at risk no matter what decision you make. Change the variables that suit your situation but go through the exercise.
If you have questions about Today’s ViewPoint, or would like to learn more about today’s marketplace, please email or call Phil Trem, President – Financial Advisory, at 440.392.6547.
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Marsh, Berry & Co., Inc. and MarshBerry Capital, Inc. do not provide tax or legal advice. Tax and legal professionals should be consulted separately before making any decisions that may have tax or legal ramifications. Any references to tax implications in this presentation should not be interpreted as the provision of tax advice.