How business owners can diversify net worth

M&A Advisor Tip

M&A Glossary: Family Offices

These are private family firms established by high-net-worth families to manage their wealth. Much like private equity firms, family offices will acquire, grow, and then re-sell a business as a way to generate financial returns. Many times, they have more patient capital, i.e., they do not have a set timeline in which they need to sell the business.  

Market Pulse Survey Q2 2023

M&A Feature Article

How Business Owners Can Diversify Net Worth

Business owners, do you know how much of your net worth is tied up in your business?

When you started your business, it may not have contributed much to your overall net worth. In fact, it may have been a substantial source of unsecured personal debt! But over the years, as your business grew, it’s likely to become your most valuable asset. And if you’re like the majority of business owners, most of your net worth is now tied to the business.

Let’s take a look at hypothetical business owners Eric and Kelley. They started their company in their early 30s. At that point, they had a little home equity and some retirement savings from their former jobs.

Now Eric and Kelley are in their mid-50s. They have $500,000 equity in their home, and their retirement accounts have grown to $600,000. Their business flourished and is now worth an estimated $5 million. All in all, that means Eric and Kelley’s business represents 82% of their net worth.

According to the Exit Planning Institute (EPI) our imaginary business owners are quite the norm. EPI estimates 80% of the average business owner’s net worth comes from their business.

Another study suggests the majority of business owners need to sell their business to fund 60%-100% of their retirement. Some owners are so busy investing in their business that they fail to put aside any other funds for their retirement.

That’s concerning, because many business owners wait until they want to retire to start exit planning. At that point, they may find their company isn’t worth what they thought it was, or worse yet, isn’t salable at all.

Given the significant portion of a business owner's net worth that is typically connected to their business, owners need to understand their business value, exit options, and what diversification could look like:

Get an accurate estimate of your business value. No matter what stage your business is at, it’s important to know what your business is worth and what you can do to enhance that value.

You may have heard that businesses in your industry typically sell for a five multiple of EBITDA or one times gross revenue. But those back of the napkin valuations don’t account for any number of factors unique to your operation that can enhance or detract from your business value.

Plan now for a future sale. Getting a regular estimate of value can help you make informed decisions about the future. This knowledge can guide strategic planning, expansion, investment, or diversification efforts. It also allows you to assess the salability of your business and make adjustments more strategically to make it more attractive to buyers.

Know your independence point. How much would you need in assets and passive income in order to fund your ideal lifestyle in retirement? Once your Net Number (your business value after tax liability and debt) exceeds your Lifestyle Number, you’ve reach your independence point and it’s time to consider your options.

Continuing to run your business past your independence point comes with risks. As we’ve seen over the past few years, market conditions can change rapidly. A business that’s thriving one day could be struggling the next, through no fault of your own.

Granted, you may derive a great deal of personal satisfaction from running a business—purpose, identity, challenge, influence—but at some point you need to decide if those benefits outweigh the financial risks.

Diversifying your net worth. Let’s get back to Eric and Kelley. They’ve run the numbers and talked to specialists. They know they could sell their business and retire comfortably. But they’re not quite ready to walk away. Do they have options to diversify?

Depending on the nature of their business, probably, yes. At this point, Eric and Kelley could take their business to market as a recapitalization strategy. They could sell a minority share to outside investors, allowing them to retain control of their business while diversifying their net worth.

Another option is selling a majority share to a private equity firm that wants Eric and Kelley to continue leading the business. This scenario injects new capital and connections into the company, potentially accelerating its growth. They’ll have the ability to sell their shares at some point in the future, ideally multiplying their financial reward. A partial sale like this will also remove any personal guarantees they may have attached to business debt.

Running a successful business is undeniably fulfilling. However, it’s important for business owners to understand how the business plays into their overall net worth and retirement goals. Make informed, intentional decisions about when to carry the risks of business ownership and when to take some chips off the table.