Planning for FATFIRE: A Comprehensive Guide for North American Entrepreneurs

Financial Independence, Retire Early (FIRE) is a movement that's gained significant momentum in recent years. The core idea is to save aggressively and live frugally to retire as early as possible. However, there's a variation of this strategy that offers a more opulent retirement lifestyle, known as FATFIRE.

FATFIRE proponents aim for a more substantial post-retirement income, typically upwards of $100,000 per year. This lifestyle maintains, or even enhances, the quality of living from their working years into retirement.

In this blog post, we'll delve into the details of planning for FATFIRE, specifically for entrepreneurs in North America. We'll use a hypothetical scenario where an entrepreneur named John aims to achieve FATFIRE in Canada. John's target is to generate a pre-tax income of $320,000 annually from cash-generating assets after paying off a $3 million mortgage.

Net Worth and Cash-Generating Assets

Net worth is the total value of an individual's assets, including cash, investments, real estate, and business ownership stakes, minus any liabilities. In the context of FATFIRE, it's crucial to distinguish between total net worth and the portion of that wealth that is invested in cash-generating assets. Cash-generating assets include investments that can produce a steady stream of income without depleting the principal, such as stocks, bonds, rental properties, and business interests.

In John's case, his primary residence, while a significant part of his net worth, does not contribute to his income in retirement and is thus not considered a cash-generating asset. Therefore, to achieve his FATFIRE goal, John needs to focus on growing his cash-generating assets to a level that can support his desired retirement income.

The Safe Withdrawal Rate (SWR)

The Safe Withdrawal Rate (SWR) is a guideline that helps retirees determine how much they can withdraw from their retirement savings each year without depleting their nest egg over their lifetime. Research suggests a SWR of 3-4%. For the purpose of this article, we'll use a conservative estimate of 3%.

The FATFIRE Target

To generate an annual income of $320,000, we'll adhere to a 3% Safe Withdrawal Rate (SWR). This approach suggests that you can withdraw 3% of your investment portfolio each year without significantly risking depleting your assets. Therefore, to generate $320,000 annually, John would need approximately $10.67 million in cash-generating assets.

Considering the $3 million mortgage, the target net worth for John to achieve FATFIRE is $13.67 million. However, it's essential to remember that this figure does not account for taxes, which can significantly impact the final total.

The Impact of Taxes on FATFIRE

When planning for FATFIRE, it's crucial to consider the implications of taxes, especially when selling your company. In Canada, capital gains—the profit you make when you sell an asset for more than what you paid for it—are taxed, but at a lower rate than regular income. Specifically, only 50% of your capital gain is included in your taxable income.

So, if John sells his company and makes a capital gain of $14 million, only $7 million would be included in his taxable income for the year. The actual tax rate on these capital gains varies based on the total taxable income and province of residence.

Determining the Exit Value of the Company

Given the tax considerations and the required net worth to achieve FATFIRE, the exit value of John's company plays a significant role in his financial planning. To cover his $3 million mortgage and have $10.67 million in cash-generating assets, John needs to account for both his desired net worth and the impending tax on capital gains.

If John owns 20% of his company, the business would need to be valued at approximately $68.35 million for him to reach his goal. This calculation assumes that the tax rate on capital gains is about 25%, which is a rough average for Canadian provinces.

This highlights the importance for entrepreneurs of building long-term value in their companies. An entrepreneur must aim to either grow their company to a value that allows for a comfortable FATFIRE exit or maintain a larger equity stake to meet their financial goals.

Equity Ownership and Its Impact on FATFIRE

A critical decision an entrepreneur makes in their journey is how much equity they should retain in their company. This decision is often shaped by how much external funding they decide to raise. While more funding might accelerate growth, it can lead to dilution of the entrepreneur's equity stake.

Let's consider the impact of different levels of equity ownership on the exit value needed for John to reach his FATFIRE goal. Specifically, we'll look at scenarios where John retains 100%, 75%, 50%, 30%, and 20% of his company's equity.

100% Ownership

If John were to retain full ownership of his company, i.e., he raises no external funding and thus experiences no equity dilution, the exit value needed for him to meet his FATFIRE target would be the lowest. This is because he would receive the entirety of the proceeds from the company's sale.

75%-50% Ownership

Should John decide to raise some external funding, resulting in him retaining 75% of the company's equity, the required exit value would increase. He would need to grow his company more, as compared to the 100% ownership scenario, to account for the fact that he would only receive 75%-50% of the exit proceeds.

30% and 20% Ownership

As John's equity stake decreases further to 30% and 20%, the required exit values would continue to rise. These scenarios would require John to grow his company significantly larger to meet his FATFIRE goal.

The decision to retain a larger equity stake by raising less external funding could reduce the exit value required to meet John's FATFIRE goal. However, it's crucial to balance this with the potential benefits of raising capital, such as accelerated growth and reduced personal financial risk. Ultimately, this decision depends on John's personal financial goals, risk tolerance, and confidence in his company's growth prospects.

Please note, for the sake of simplicity, this analysis assumes an average capital gains tax rate of approximately 25%. The actual tax impact could vary based on John's total taxable income and province of residence. Also, this analysis does not consider other potential sources of income or wealth, such as ongoing salary, dividends, or other investments, which could influence John's path to FATFIRE.

The Pathway to FATFIRE

Achieving FATFIRE as an entrepreneur involves a complex interplay of factors such as net worth, cash-generating assets, safe withdrawal rates, equity ownership, and taxes. 

While the goal may seem daunting, careful financial planning and business strategy can pave the way to a comfortable and early retirement. Whether it's expanding your portfolio of cash-generating assets, protecting your equity stake during fundraising rounds, or planning for the tax implications of a company sale, each decision plays a vital role in your journey towards FATFIRE. 

As you navigate this path, always remember that the goal is not just financial independence, but the freedom to enjoy the lifestyle you desire in your retirement.