When was the last time you calculated the percentage of your net worth tied to
your company’s value? When you started your business, its value was probably negligible. Unless you purchased or inherited your company, it wasn’t worth much when you opened yourdoors, but over time, the proportion of your assets tied to your business may have crept up.
Let’s imagine a hypothetical business owner named Tim, who starts his company at age 30. He has a little bit of equity in his first home and a small retirement fund. When he starts his business, it’s worthless, so it doesn’t yet factor into Tim’s net worth calculation.
By the age of 50, Tim has built up $600,000 worth of equity in his home, his
retirement nest egg has grown to $400,000, and his business has blossomed and is
now worth $4,000,000. Tim’s company has crept up to represent 80% of his net
worth. Tim knows the first rule of investing is to diversify, which he is careful to do with his
retirement account. Still, he has failed to achieve overall diversity given the success
of his business.
What’s more, he may have unknowingly passed something called “The Freedom Point,” which is when the net proceeds (i.e., after taxes and expenses) of selling his business would garner enough money for him to live comfortably for the rest of his life. Your lifestyle determines your Freedom Point, but when you pass it, it’s worth considering the risk you’re taking.
If this pandemic has taught us anything, it is that nothing is for sure, and a thriving
business one day can turn into a struggling company overnight. When your
business makes up most of your net worth and selling it would garner enough
money to retire, there’s no financial reason to continue owning your business. You
may enjoy the challenge, the social interactions, and the creative process of
building a business, but keeping it may be unnecessarily risky.
When you’ve crested the Freedom Point and want to diversity—but still don’t want
to retire—you have some options:
• Sell a Minority Stake: In a minority recapitalization, you sell less than half of
your shares. Often sold to a financial investor such as a private equity group,
a minority recapitalization allows you to diversify your net worth while
continuing to control your business.
• Sell a Majority Stake: In a majority recapitalization, you sell more than half
of your shares to an investor who will most likely ask you to continue to run
your business for many years to come. You get to diversity your wealth, keep
some equity in your business for when the investor sells, and continue to run
your company.
• Earn-Out: When you sell your company, you’ll likely have to agree to a
transition period of sorts. One of the most popular is called an earn-out,
where you agree to continue to run your company as a division of your
acquirer’s business for a specified period of time. Your earn-out may be as
little as a year or as long as seven, but the average is three years. Therefore, if you’re past the Freedom Point and can see yourself wanting to step down in the next three to five years, an earn-out may be worth considering.
Building a successful business is rewarding, but when your personal balance sheet
gets out of whack, it may be worth considering the risk you’re shouldering and the
options you have for sharing some of it.