Calculating the Freedom Point to Determine When to Sell Your Business

Like most business owners, your desire for freedom may be hardwired into your psyche. Though you could have had a job with a fancy title and competitive salary, your desire to make your own decisions led you to a road less traveled.

However, starting your company may not have facilitated the freedom you originally wanted. Even though you call the plays, it doesn’t mean you’re liberated from the demands of customers or employees. If you want more freedom, it may be time to sell your business and create a pool of cash that can generate the kind of income you need to fund your desired lifestyle.

If you have been hanging on to your business for too long, you may be risking the freedom you have earned.

When was the last time you calculated the percentage of your net worth tied to your company’s value? When you started your business, it was probably negligible. Unless you purchased or inherited your company, it wasn’t worth much when you opened your doors, but over time the proportion of your assets tied to your business may have crept up.

Using a hypothetical situation, you can understand this better.

A business owner named Tim starts his company at age 30. He has a little bit of equity in his first home and a small retirement fund. When he starts his business, it is worthless. So, Tim doesn’t factor it into his net worth calculation.

By the age of 50 however, Tim has built up $600,000 worth of equity in his home, his retirement fund has grown to $400,000 and his business is now worth $4,000,000. Over two decades, Tim’s company has increased to represent 80% of his net worth.

Tim knows the first rule of investing is to diversify, which he is careful to do with his retirement account. Still, he has failed to achieve overall diversity given the success of his business. In addition, he may have unconsciously passed something called The Freedom Point. The Freedom Point is when the net proceeds (i.e., after taxes and expenses) of selling his business would garner enough money for him to live comfortably for the rest of his life. In the parlance of Wall Street traders, Tim has moved “risk on”—a situation where he is taking on considerable risk.

So how can you calculate your freedom point?

First, estimate the income you will need to fund your freedom. This is entirely subjective— using what income level you will feel totally free without restraint. Your goal is to calculate the point where you will feel free of worry about money, so we suggest using a 3% withdrawal rate. Using the three percent rule, you can calculate the nest egg by multiplying your calculated income needs by 33.

Now estimate how close you are to The Freedom Point by assessing how much wealth you’ve created outside of your business. Do not include your primary residence in this calculation, because you’ll have to live somewhere after you sell your company. Include anything that could be sold reasonably easy, such as stocks, bonds, commercial real estate etc. Once you have calculated your assets outside of your business, deduct any debt you have on those assets.

You’ll need to estimate what the shares in your business may be worth to a buyer, so it’s best to talk to a professional. You will also need to consider the estimate of what it costs to sell your business including an intermediary, commission, and lawyers.

When you hand over the keys of your business, you’ll most likely have to do so without any long-term debt. Therefore, you need to add the amount required to pay back any business loans to the total funds you need to accumulate to reach your Freedom Point.

Take the wealth you have outside of your company and combine it with the after-tax proceeds you expect to gain from the sale of your company. Then subtract any long-term debt you need to pay back. When they add up to a number greater than the nest egg, you’ll need to fund a carefree retirement. You now have  reached The Freedom Point.

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