Why Business Owners Need to Diversify Away from Their Operating Business and How to Do It
Our clients are among the wealthiest people in the country. Every one of them has a net worth that exceeds the current lifetime exemption amount and, therefore, fall into the category of the 1%’ers. In, Why Business Owners Need to Diversify Away from Their Operating Business and How to Do It, Jeff Faulkner, explains we find many of our clients, when we begin to work with them, have liquidity, or wealth, apart from the operating businesses they own. Why?
Several reasons. Their operating businesses are capital intensive and require constant reinvestment. Their businesses are very productive and generally produce a return on investment of at least 20%. Where else can they put their money and get those kinds of returns? They have control over their business and know what makes it tick, what causes it to make money, and what gets it into trouble. The stock market is not generally something that our clients understand. The volatility of it causes them to cringe, and even more so in the context of mediocre, less than 10%, annual returns. So, they reinvest in what they know and what they are comfortable with, their own business.
Consequently, they are not well diversified. And worse, like most of us consumers, these wealthy dealers take their excess capital and buy second or third homes, or ranches, or farms, or worse – depreciating assets like fancy boats, or planes, etc., seemingly not connecting the dots on the return on investment. I suppose the psychological ROI on a personal ranch is worth a lot. But too much of this and there is a shortage of appropriate reinvestment in the business with the reinvestment being limited to the current operation without any real thought of significant growth beyond what is.
There is a diversification risk factor at play here.
There is also a strong potential of creating a problematic succession planning environment when all your eggs are in one basket. Especially when your lifestyle is dependent on that one basket. When it comes time to exit the business and your children, who have also grown accustomed to the lifestyle the business provides, want to take over, like most good parents you want to help them do so…and, you want to beat Uncle Sam, so you take advantage of your lifetime gifting capability.
And herein lies the origination of succession planning axiom #1 – “Never put yourself in a position of financial dependence upon your children.”
They may fail you. Just as importantly, you may fail them. Financial dependence on a business to support that lifestyle of the ranches and planes creates a significant succession liability. Those who remain financially dependent on an operating business tend to grip the baton too tightly during the succession transition and add significant delay to the hand-off and a smooth passage to the next generation.
So, what’s the solution? There are a couple of keys.
1. Establish a disciplined and focused approach.
Live on less than what you make. It’s astounding to me to see people who literally make millions annually and have close to zero liquidity.
2. Apply Discipline to an avenue that creates more opportunities away from your core operating business.
Let me go into a bit of detail here and explain two viable options, one more exciting than the other.
Most of our clients have an operating business that occupies a piece of real estate and a building that they own separately in a real estate company. The operating business pays rent to the real estate company for use of the land/building. When discipline is applied to paying down the debt on the real estate, there is inherent in the process the eventual creation of massive cash & wealth-generating machine. I have many clients who own their real estate free and clear and the operating business continues to pay a fair market value rent.
Now hold on, because this is where it gets powerful and fun.
Let’s say that after 10-15 years of paying down a commercial mortgage on your business’ property that the real estate company is generating $1 million of free cash flow. Let’s say at the beginning of every year you put that into a well-diversified stock/bond portfolio every year for 10 years and experience a 7% return on that money. At the end of the 10 years, you would have accumulated nearly $14 million apart from your operating business. If you took that $14 million and started living off of it, taking out the proverbial safe withdrawal rate of 4% per year, you could have an annual income of $560,000 apart from your operating business, without touching the principal, and make the succession transition to your children a little easier, right? But, hey, you’re an entrepreneurial, risk-taking multi-millionaire business owner, and that approach just sounds plain boring. I agree. You can do better. How?
That $1 million of free cash flow could translate into a $4 million to $5 million mortgage – EACH AND EVERY YEAR!!!!! In 5 years’ time, that’s potentially $25 million of something else added to your portfolio. Let’s assume that you’ve invested in other income-producing assets, maybe similar businesses to the original or may be entirely different, that garner a cap rate of 8%. Your real estate company is now generating another $2 million annually in rent payments that you could structure a mortgage payoff over the next 12-15 years, using the debt snowball approach – as one gets paid off, the free rent from the first acquisition is applied to the debt of the 2nd acquisition until it’s paid off and then both are applied to paying off the 3rd acquisition, and so on. At that point, say 15 years later, you now have acquired another $75 million in something other than your original operating business, and now you are sitting on real estate entities that are generating free cash flow of $3 million a year. That translates into a mortgage of $15 million – EACH AND EVERY YEAR!!!!! Let’s also say you started this process at age 50 and 15 years later you are 65 and your kids are now deeply involved in your business.
Do you think you could have, with such a strategy, created plenty of diversification for each of your children to find a place in carrying on your family’s legacy, enough income generation for you apart from the original operating business to continue to support your lifestyle, and something else for you to do in your “retirement” years? Not to mention the continuation of providing jobs, improving communities, positively impacting the economy, etc.? I think so. It just requires as stated above, a disciplined and focused approach. This is also why it’s so important for you as a business owner to not become too important to your operating business to the point it needs you. When you are the driver of operations you are IN your business and cannot rise to the level of focusing ON your business. You have to grow beyond being the COO. Otherwise, you inadvertently create leadership and growth lids that contain the expansion of your enterprise.
Read the article and then reach out to us to get some insights into your own situation. A few moments with us will provide you insight and clarity for your next steps forward. Contact Us
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