10 - Business Or Not A Business? ___________________________
10 - BUSINESS OR NOT A BUSINESS? _____________________________________________________________
I’ve met people who have their own business and plan to sell it for a good price and use that money to provide income for their retirement. Often, these businesses are one-person shops, a family business or a small business with only a few employees. In most cases, the owner’s involvement is critical to the business; if they are not working at the business, revenue falls. Most customers want to deal with the owner, the expert. Unfortunately, when it comes time to sell the business and retire, these owners are often surprised that the selling price is much lower than they thought it would be and they can’t afford to sell the business and retire. _____________________________________________________________
B USINESS OR SELF-EMPLOYMENT _____________________________________________________________ Many “business owners” do not have a business; rather, they provide their own “job”. They don’t own a business; they are self-employed. Understanding the difference is key to financial planning. _____________________________________________________________
Definitions
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Self-employment: Self-employed people generally find their own work rather than being provided with work by an employer, earning income from a trade or business that they operate. 74
74 http://en.wikipedia.org/wiki/Self-employment (Sunday, 31 March 2013) _____________________________________________________________ Profitable Planning & Management Inc. Page 109
Business Or Not?
I_____________________________________________________________ NTRODUCTION
10 - Business Or Not A Business? ___________________________
Business: the definition of a business that I like is “a commercial activity that produces profit whether or not the owner is participating in the activity.” A simple test to determine if a “business” is actually a business or self-employment is to have the owner go on vacation for a month and see if the business activity, revenue and profits continue at the same level or perhaps even increase 75.
Business Or Not?
If the business activity, revenue and profits continue at the same level, increase, or drop by a small percentage, then the “business” is indeed a business. The owner has passive income - “an income received on a regular basis, with little effort required to maintain it.” 76 If the business activity, revenue or profits decrease by a significant percentage or perhaps even stop while the owner is on vacation, then the “business” is not a business. The owner is self-employed. _____________________________________________________________
S ELLABLE OR NOT? _____________________________________________________________ Self-employment: it is very possible that a self-employed person cannot sell their business for enough money to retire. Why? As a self-employed electrician, consultant, carpenter, plumber, repair person, etc., what do you have to sell? What is a buyer getting from you? A customer list? How much value is there in that? A customer list is based on your relationships with your customers. Will a buyer be able to duplicate and maintain those relationships? Goodwill? Cash flow? Same questions as above.
75
http://www.builttosell.com/buy/ (Monday, 01 April 2013) http://en.wikipedia.org/wiki/Passive_income (Saturday, 06 April 2013) _____________________________________________________________ Profitable Planning & Management Inc. Page 110 76
10 - Business Or Not A Business? ___________________________
Business: a business that fits the definition on the previous page is sellable for a price that is typically 3 to 5 or more times the earnings before interest, taxes, depreciation, and amortization (EBITDA) although many other factors must also be considered 77. What is a buyer getting? They are getting a business that does not need the owner’s presence to be successful and profitable. There are managers and technical people in place to handle all the day-to-day activities and issues. The business provided passive income to the original owner and will continue to provide passive income to the new owner. For professional advice on this subject, visit www.BuiltToSell.com and/or buy the book “Built To Sell�.78 _____________________________________________________________
P ASSIVE INCOME _____________________________________________________________ Passive income is an income received on a regular basis, with little effort required to maintain it.
77
http://www.bealconsultants.ca/business-valuations/business-valuation-abuyers-perspective/ 78 http://www.builttosell.com/buy/ (Monday, 01 April 2013) _____________________________________________________________ Profitable Planning & Management Inc. Page 111
Business Or Not?
Basically, with self-employment, a buyer of the business has to duplicate the current owner, have the same knowledge and skills, maintain the relationships with customers, become their trusted expert, and work in the commercial activity every hour the business is open.
10 - Business Or Not A Business? ___________________________
The American Internal Revenue Service categorizes income into three broad types, active (earned) income, passive income, and portfolio income. It defines passive income as only coming from two sources: rental activity or "trade or business activities in which you do not materially participate." Other financial and government institutions also recognize it as an income obtained as a result of capital growth or in relation to negative gearing. Passive income is usually taxable. Business Or Not?
Some examples of passive income are: • Earnings from a business that does not require direct involvement from the owner or merchant; • Rent from property; • Royalties from publishing a book or from licensing a patent or other form of intellectual property, such as computer software product; • Earnings from internet advertisements on websites; • Dividend and interest income from owning securities, such as stocks and bonds, is usually referred to as portfolio income, which may or may not be considered a form of passive income. In the United States, portfolio income is considered a different type of income than passive income; • Pensions. The IRS has a specific definition of passive income that excludes some of the incomes listed above. Royalties, for example, are, according to the Service guide, generally nonpassive in nature. Additionally, interest, dividends, annuities, and gains from stocks and bonds, lottery winnings, salaries, wages, commissions, retirement income, guaranteed payments for services are considered by the IRS to be nonpassive. 79
79 http://en.wikipedia.org/wiki/Passive_income (Sunday, 31 March 2013) _____________________________________________________________ Profitable Planning & Management Inc. Page 112
10 - Business Or Not A Business? ___________________________ _____________________________________________________________
S UMMARY _____________________________________________________________
A simple test to determine if a “business” is actually a business or self-employment is to have the owner go on vacation for a month. If the business activity, revenue or profits decrease by a significant percentage or perhaps even stop, then the “business” is not a business. The owner is self-employed. If the business activity, revenue and profits continue at the same level, increase, or drop by a small percentage, then the “business” is indeed a business. The owner has passive income. Passive income is an important part of any successful financial plan.
_____________________________________________________________ Profitable Planning & Management Inc. Page 113
Business Or Not?
To determine if a business is a “business” or “self-employment”, determine the amount of active involvement required of the owner.