Every time a business generates an extra $1 of profit, the business’s owner has a choice to make—do you leave that money in the business to reinvest, or take it out to spend or enhance net worth? Most business owners don’t consciously think about this. Rather, the entrepreneurial habit is to leave most money in the business. As reinvesting in the business can make a lot of sense. In the beginning, when a business may be small and fragile, reinvesting might be required for survival. Once the business is established and expanding, reinvesting back into the business often seems like a no-brainer—it is the investment with the most potential for growth. As a result, business owners tend to reinvest most of their dollars over time, to the point where they end up with the vast majority of their personal net worth held inside their business by the time they reach an exit.
As exit draws near, reinvesting heavily, or even exclusively, back into the business can cause unintended challenges for an owner. In our experience, there are six important advantages owners gain by receiving appropriate distribution dollars along the way prior to an exit.
Risk reduction. We are all familiar with the dangers of putting all your eggs in one basket. Business owners are not exempt from this risk. Warren Buffet, somebody who knows about creating wealth through business, once observed, “You can get rich by only investing in one stock, but you can’t stay rich that way.” The risk is not just from concentration. Cash left in the business is also exposed to potential business creditors. Receiving money from the business well before exit reduces owner risks.
Reduces current income taxes. There are several ways owners can receive money from the business along the way and in the process reduce current income taxes. Retirement plans and captive insurance companies are two strategies that potentially can create tax favorable wealth accumulation for the owner outside the business.
Increases exit options. Owners who have predominantly reinvested in the business typically need cash at exit, because they have little to none outside of the business. The need for cash can eliminate creativity in exit options, such as giving the business to family—because usually they have no money. Selling the business to one or more employees also may be prohibitively difficult—because usually they have no money either. Many owners who would like to keep the business in the family, or would like to share the business opportunity with valued employees, cannot afford to do so. Receiving money from the business along the way preserves the owner’s exit options.
Increases control over the exit timing. Owners who have 50%, 75%, 90% or more of their net worth tied up in their business sooner or later feel stress and pressure to fully or partially cash out. Receiving money from the business along the way reduces dependency and stress, and increases control over choosing when the owner wants to exit.
Increases control over the exit terms. The less cash an owner has outside the business, the more cash that owner will need from the business at exit. When selling a business, owners who need a large portion of cash at closing may be unable to consider deal terms such as installment sales and stock swaps. While these options provide less cash at closing, they do offer potential advantages such as tax deferred sale proceeds. Receiving money from the business along the way maximizes flexibility at exit.
Reduces co-owner conflict. When a business has two or more owners, it is nearly inevitable that the owners will have some incompatible exit goals, no matter how well they get along. One owner may want to exit sooner than another. One owner may be willing to exit at a lower price than another owner would accept. One owner may want to sell, while another owner wants his or her kids to get the business. When business co-owners have reinvested exclusively back in the business, their competing exit goals will directly undermine one another’s success. Receiving money from the business along the way reduces potential co-owner conflict and goal misalignment.
Owners and their advisors need sound financial systems and forecasts to help them determine how much cash really is needed to fuel the business’s growth. Any cash not needed for the foreseeable future should be received by the owners to diversify their net worth, and minimize the pitfalls that can otherwise happen at exit. Remember, if later you realize you took too much cash out, you can always put it back in.
Contact us at info@flvcp.com for more information on creating an exit on your own terms.
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