Invest In Your Business For Wealth Creation
March 5th, 2020
Many of us feel an innate need to make contributions to tax advantaged retirement plans every year. When it comes to personal finance, much of what we read, hear, and see in the media centers on plowing money into your 401k every single year, no matter what.
In general it’s great advice. Save early and often, and take advantage of tax deferred compound income. And if you’re lucky, your employer might match your contributions or make a profit sharing contribution. If we’re going to build up enough savings to sustain our lifestyle through retirement, this makes perfect sense.
Every once in a while I’ll speak with an entrepreneur who is really working hard to build their business, but they can’t quite scratch together enough cash to fund their retirement plan for the year. They’re putting all their effort into their company and things are still just a bit tight financially. They feel like they should be contributing to the 401k they set up for themselves and their employees, but they can’t quite pull the funds together to do so.
For many business owners I speak with, the fact that they can’t fund their 401k for the year makes them feel inadequate. Like they’re not good at their job. Like they’re unsuccessful.
I wanted to write a post on this topic because entrepreneurs who feel this way are missing the forest from the trees. Regardless of whether you contribute to a retirement plan in a certain year, it’s far more important to sustain & grow your business. Because if you can find a way to grow your business each year, the increased value in your ownership stake will dwarf what you could ever contribute to 401k!
It’s OK to Skip a Few 401(k) Contributions
EBITDA is an accounting measure that stands for “earnings before interest, taxes, depreciation, or amortization”. It’s a decent proxy for free cash flow, and is often used in quick and dirty business valuations.
For example, let’s say your business does $350,000 in revenue one year. If your costs & operating expenses totaled $250,000, you’d be left with EBITDA of $100,000. The list of multiples ranges from 5-6x EBITDA on the low end to nearly 20x on the high end. Meaning, it’s very possible that a business with $100,000 in recurring annual EBITDA is worth at least $500,000 ($100,000 * 5).
Now, when I mean quick and dirty, this example is very quick, and very dirty. Business valuation is a field of its own, and not something I claim to be half way competent in. There are a ton of factors that go into what a business is worth, and EBITDA certainly doesn’t paint the whole picture. Nevertheless, the takeaway is important: if you can build a business with recurring annual revenue, that will persist even if you’re not around to drive sales, there’s a good chance you’re creating far more wealth than what you would maxing out your 401k contributions.
Wealth Creation Over
Creating recurring revenue, recurring cash flow, and recurring profits through entrepreneurship is a tremendous way to build wealth.
Let’s run with the example above over a longer period of time. This time, let’s say that you have the same $350,000 in revenue and $250,000 in costs (including your own salary of $100,000). Let’s also assume that you’re able to grow your EBITDA of $100,000 by 10% each year over a 15 year period. With an EBITDA multiple of 10, here’s how the value of your company would grow:
Growth can be challenging, but 10% per year is a very reasonable number. And the resulting company value after ten years is drastically higher than what could expect by maxing out a 401k. Making $56,000 annual contributions (the max this year) that grow at 7% per year only gets you to $773,721 after ten years!
Yes, I’m ignoring the tax advantage of making the deductible contribution here. The point is it’s OK to miss a few 401k contributions because you’re focused on building your company.
The enterprise value you’re building will be far, far greater than what you could ever build in a tax advantaged retirement plan.
Shore Financial is a fee-only, tax-focused financial planning firm located in Monmouth Beach, NJ.
Joseph Vecchio CPA, CFP®, MBA is the firm’s President and has dedicated his professional life to the finance and accounting professions.
Joe believes that people are being exploited by financial salespeople who are merely motivated by quotas, product sales and commission-based income! Shore Financial Planning was founded to provide peace of mind through conflict-free, value-added advice.
When you work with Shore Financial Planning, the financial advice we provide is ALWAYS in your best interest.
As a Certified Financial Advisor, NAPFA Professional, and Fiduciary Advisor, Joseph Vecchio offers unbiased and conflict-free financial advice & retirement planning services.
I specialize in helping small business owners solve these challenges. I am just like you. For the past 20+ years I have operated a successful small-business that has pro-actively developed strategies to adapt and profit form the constant headwinds of regulatory, technological and competitive changes.