Josh Patrick
Every owner of a private business has a personal economic lifecycle. It’s important that you as a business owner understand which economic stage you are in. Once you understand where you are in your financial life, you have the ability to make stage appropriate decisions about the actions you should take for your financial life.
Adam Aardvark is 52 years old. He had run his company for 22 years and was thinking about getting out of his business. He just engaged the services of a financial advisor who specialized in working with private business owners like himself. The first thing his advisor did was give Adam a map showing the five steps in the financial life of a private business owner.
The financial stages are:
- Formation – This is where you are starting your business and have no time, money or effort for anything but getting the business off the ground.
- Investment – Your business now has positive cash flow and you can start thinking about your business as a financial success.
- Accumulation – Your business is a success. You are able to diversify your investments and are actively thinking about selling your business.
- Preservation – You are in the process of transferring ownership and control of your business. You will have liquidity from your business.
- Transition – You are comfortable with the sale of your company. You realize you have excess assets and wish to handle those assets in a responsible and tax efficient manner.
Stage appropriate actions will help you successfully move towards one of the goals for many private business owners: The ability to leave their business with enough assets to live their life with dignity and economic freedom.
The Formation Stage
You have started your business and are in the early stages of trying to figure out if your business will work. Every day is an adventure. You have no or little systems in place, you have no idea how much business you will do every day and just having enough cash on hand to pay your bills is a challenge.
You often won’t spend a lot of time on risk management issues or systems to run the business. Your only concern is to have enough money in the bank to open your doors for another day. The problem that you may face in this early part of your business is that if you don’t spend time working on systems to make your company predictable you will never get the chance to move to the next business stage.
In the formation stage of your business you have three things you need for success.
First, you must get your business to a position where you have predictable positive cash flow. It’s impossible to make your business successful if you don’t have enough money to pay the bills. You must spend your efforts making sure this happens.
Second, you must spend develop excellent systems to make your company predictable. The difference between many companies who earn financial success and those who just muddle through is whether the owner develops systems so their business runs well. If the owner spends all of their time concentrating on putting out fires because of lack of systems, they have no time to make their business better.
Third, you must become financially literate. The language of business is finance. For you to evaluate whether your business is achieving economic success you must know what the measurements for that success is.
It’s also important to note that measurements used by public companies and those taught in business schools are not always the measurements you will need for running your business. The rules of private business are often different than those used by major corporations.
Investment Stage
Your business has achieved regular positive cash flow. You go to work having some idea about how much cash your checking account will have at the end of the week. You have some predictability in your business and are able to start making plans that go out further than a week or two.
Your cash flow is good enough that you are able to start thinking about growing your business. You are able to move past the friends and family stage of financing. For the first time you notice some banks are willing to start talking with you about helping you finance your growth. You now are at the stage in your financial life where you have something to lose.
In the Investment Stage of your business you want to concentrate on the following activities:
- Developing basic risk management for you and your business.
- Putting together basic estate planning for you and your family.
- Begin a retirement plan to help save for retirement.
- Look at purchasing real estate for your business to operate from.
- Develop a banking relationship that will provide you with appropriate capital for growth.
Risk management and estate planning are often part of the same project. You should engage your lawyer, liability insurance agent, life insurance agent and your CPA for this project. They can help you put together a plan that makes sure you have an appropriate amount of liability insurance, life insurance, disability insurance, and medical insurance both on a corporate and personal basis. You now have assets that are worth something and you need to take actions to protect those assets.
Along with the risk management part of this project you will want to work with your lawyer and life insurance agent to develop a basic estate plan that will protect your family. At this point in your financial life, you don’t want anything fancy, just the basics. You are starting to become successful and doing serious estate planning will both cost you money and tie up assets that could be used more productively growing your business.
The next project is to start accumulating assets outside your core business for financial independence purposes. Most businesses by themselves will not get the owner of that business to financial independence. I find that most business owners we work with need to have assets outside the business to reach financial independence.
The easiest asset to get outside your business is the real estate you operate your business in. The second is to start a SIMPLE or 401(k) plan. For relatively little money either of these retirement plans can pay off handsomely in the future. Owning your real estate and having a retirement plan will start to move money outside your business. The cost is relatively modest and will provide high value in the future.
The final project to tackle for the financial success in the Investment Stage is to develop an excellent relationship with your bank. You want your bank to help you grow your business. At the same time it’s important to note that your bank is a supplier. Your bank will support you when things are going well and will be gone if business deteriorates.
If you had taken the time to become financially literate in the Formation Stage of your business you will be in a position to speak with your bank in terms they use. You will understand what motivates your banker to make loans to you. Once you understand the banks motivations, you will be in a position to have them become an important supplier in helping you grow the value of your business.
Accumulation Stage
The Accumulation Stage of your business is where you move through making your business extremely valuable to others and then transitioning through an ownership change. This business stage is often where you spend the most years. The early part of this stage you are still accumulating assets. As time goes on you will start working towards a transition in your business to new ownership.
Adam found that he was in the Accumulation Stage of his business. He owned the real estate his business operated in, had good systems in place, had a good relationship with his bank and had started a 401(k) plan in his company eight years ago. His problem was he had not accumulated enough assets in those vehicles for him to retire. Adam asked his financial advisor to assemble some strategies he could use to reach financial independence.
Adam was at the stage in his business where the decisions he made and strategies he pursued were going to become more important as he moved towards transitioning out of his business. He needed to use some higher powered accumulation strategies and maybe start some new accumulation accounts to help him reach his goals.
Adam also learned that the Accumulation Stage of his financial life could last as much as ten to fifteen years. The amount of time spent in this stage of his financial life depended on how seriously he dealt with the financial challenges in the Accumulation Stage.
The issues that need attention in the Accumulation Stage are:
- Maximizing the amount that can go into your qualified savings and 401(k) plan.
- Carving excess profits off for investment and savings accounts.
- Increasing the value of your business.
- Understand how to preserve the cash flow check when you sell.
- Understanding the options you have for transferring ownership in your business.
The most important activity you can pursue at this stage in your work career is to dramatically improve the value of your company. This can only be done through using strategic initiatives that make your company more valuable for others to own.
An owner must have a company that is tactically excellent to pursue these strategic activities. He or she must have enough free time to spend their efforts on pursuing business value building activities and be pretty free of day to day activities in their business. If you, as an owner are spending most of your time on tactical issues, then you will not have the time to make your business more valuable.
Most Clients I work with have over 80% of their net worth tied up in their business. Improving the value of your company allows you freedom in how to approach your journey through the Accumulation Stage. Using business value building strategies will not only make your business more valuable but will also provide more excess cash that can be used for other purposes.
In many companies the owner can save up to $44,000 to $58,000 per year in their retirement account. If your company is tactically excellent and starting to pursue strategic initiatives to improve the value of your company, you will most likely have excess cash that you can put in your retirement plan. Saving this amount of money every year can go a long ways towards helping you reach financial independence.
Preservation Stage
Adam knew that five or six years from now he would be ready to market his business. He wondered what would be different as he got ready to sell his business and what strategies would be important for him to understand during this phase of his financial life.
When you get to the point where you are ready to sell your business, it’s time to make sure that you take the following steps:
- Have a financial plan done showing how you will live after you sell your business.
- Make sure the changes you made in your business continue until the new owner takes over.
- Have great advice to take you through this stage of your life.
- After you sell your business, show patience before making any irrevocable decisions about your finances.
- Have a plan for how you will invest your money
The first step to take as your enter the Preservation Stage is to have a financial plan that details distributions of cash for your life style. You will want to make sure your advisor not only takes into account spending patterns you pay for personally, but also life style activities the business has paid for. For example, many business owners have their automobiles owned by their businesses. If your business provides personal life style items, you will want to make sure you factor the after tax costs of these items.
As you put together your financial plan you will want to see which assets will provide money at different points in your life. You will also want to make sure the total assets you have accumulated stay at a level you are comfortable with. Many people we work with want to make sure that their asset base stays the same or grows once they sell their business. If this is true for you, you must communicate this need to your advisor.
In the Preservation Stage you must make sure your business value stays high. Most people we talk with want to sell their business to an outsider when it’s time to leave their business. If the changes you’ve made to increase the value of your business go away, the value of your business will decrease. We often recommend that you look at compensation programs for your key people that tie the value of the company to the amount of money your key managers get paid.
You might want to have a special program put together that pays your managers a significant bonus if you transfer your business for a price that you expect. This extra money that you pay to your managers often is a great insurance policy to make sure they continue working hard during the transition of your business.
As you get ready to leave your business you will need advisors who understand the challenges at this stage of your life. Often you will need an attorney, your CPA, an investment advisor, an insurance advisor and an investment banker or business transition specialist. These people will help you make wise decisions about appropriate actions to be taking at this point of your life.
Transferring ownership of your business often provides the selling owner with a great deal of cash. Many times, this is the first time the owners has had a significant amount of liquid assets available to them. It’s important that you have a strategy for how to invest your money and are comfortable with this strategy before you sell your business. As you’re going through preparation for the transfer of your business, you must spend time working on your investment strategy. If you try to make an investment strategy after you receive your cash, you may feel pressured and might not make long-term decisions that are in your best interests.
Many times making the transition from owning a business to having cash takes requires you to spend time getting used to this new personal economic reality. This may be the first time in your life that you don’t have regular cash flow and checks coming to you. You need to take time and learn patience before making any irrevocable decisions about what to do with your assets.
You may feel pressure to start doing significant planning. Often it’s best to wait six months or a year before putting any assets away for others. It’s fine to start planning and make initial moves into the Transfer Stage. You want to be comfortable with your own financial situation before making irrevocable decisions that are required in the next stage of your life.
Transfer Stage
You have successfully built and transferred your business. You also are living with the results of your work and are happy with the results. This allows you to move to the final stage of your financial life, the Transfer Stage. In this part of your financial life you will focus on the following activities:
- Serious estate planning where you make irrevocable decisions about transferring assets.
- Have an understanding of how family legacy and charitable intent work together.
- Learn an understanding of the difference between ownership and control.
- Successfully move into the next stage of your life.
Most private business owners are hesitant about doing serious estate planning while they own and operate their business. We find the main reason for this is they aren’t sure the business will truly create the money they expect when it’s time for the leave. In the Transfer Stage, you have sold your business and turned your main financial asset into cash. You also have spent a period of time where you’ve gotten used to the cash and understand what your real cash needs are.
Now it’s time for you to have a conversation with your family and estate planning team about what’s to become of the assets you’ve built. Some of the issues you will want to consider at this stage in your life are:
- How much money is enough for your children to inherit?
- What are your feelings about grandchildren and do you want to help them in their lives?
- Gain an understanding of the estate tax system and how it would specifically affect your assets.
- Learn about how philanthropic activities can be combined with your planning goals to help you save taxes and achieve responsible cash management in younger generations.
- Decide how much money you want to your heirs to pay in estate taxes.
For the first time in your life irrevocable activities are appropriate. This means you will want to give away assets and never have ownership of them again. I like to see our Clients in this stage of their life gain significant knowledge about the difference between ownership and control.
In the Transfer Stage there is a very good chance that you will not want to own all of the assets you’ve accumulated. If you are a typical business owner, the main challenge with giving up ownership of those assets may be the feeling that you also are giving up control. There are many estate planning techniques that allow you to transfer ownership, but maintain control over those assets for as long as you’re alive.
Developing an understanding of our estate tax system and how it integrates with charitable planning is often appropriate. You may find that you have accumulated more money than you are comfortable leaving your children. You also may feel that you’ve paid enough taxes in your life and don’t want more money to go to Uncle Sam on death.
I’ve found that having our Clients develop an understanding of philanthropic activities and funding at this point in their life often allows them to realize several goals. I believe any effort you spend on this activity can help you achieve several goals.
You have now made the complete cycle through your financial life. You started off in the Formation Stage where you concentrated on making your business a business. You then moved to the Investment Stage where you concentrated on making your business more successful and finding others to fund your growth. The third step on the ladder was the Accumulation Stage where you took excess cash and started accumulating assets that would help you retire in comfort. You transferred ownership of your business and entered the Preservation Stage. Finally, you entered the Transfer Stage and moved your assets to whom you want in the manner you want.
It’s important for you to focus on stage appropriate activities as you move through your business life. Having good advisors can help. At the end of the day, it’s your job to become educated to what you need to do, find the right advisors and continue moving forward. If you take the time and effort to do so, your efforts will pay off with better plans that provide outcomes you want.
The views expressed in this article are those of the authors and may not reflect those of NFP Securities, Inc. Neither Stage 2 Planning Partners nor NFP Securities , Inc offers legal or tax services.