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 advantaged 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
Aswath Damodaran is a professor at NYU who teaches corporate finance, investing, and business valuation. He publishes estimates of EBITDA multiple benchmarks for use by his students, and anyone else who’s interested. 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. Here are Professor Damodaran’s valuation estimates for 2018. 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.