Why Business Owners Should Care About Wealth Management

Many private business owners never take the time to gain clarity about what is important in their business and their personal life. Many are consumed with dealings and other urgent and important matters that eclipse long term wealth planning. While creating a wealth management plan usually does not feel necessarily urgent, it is necessarily important.

Financial planning and wealth management help to preserve, protect and enhance your assets, so that they can provide you with a comfortable life and still be passed on your heirs. The wealth management process is an interdisciplinary one, involving an array of skills and professions. Working with your entire advisory team in a coordinated way generates successful outcomes. Under the umbrella of wealth management rest 10 areas (click on each for details):

  • Financial Planning
  • Value Creation in the Business
  • Financial and Capital Structure
  • Risk Management
  • Tax Planning
  • Asset Protection
  • Harvesting Value from the Business
  • Exit Planning
  • Investment Management
  • Wealth Transfer Planning and Legacy Planning


Financial Planning


Financial planning is a process that individuals and business owners engage in to identify, plan for and meet longer range financial goals. In this important planning stage, business owners determine how much money they will need in the future to live their daily lives and cover life-stage expenses such as educating children, retirement or unexpected medical expenses. Financial planning is an ongoing engagement and you should review your planning and strategy on a periodic basis.


For business owners, the company is often their most important financial asset—a generator of income and a store of long-term value. Sometimes this asset can be illiquid or unpredictable, so it is important to diversify, say into owning real estate or—when practical—investing outside the business.

For business owners to leave the business when they want, they need a plan. It is frequently the case that the core business won’t provide enough income after a liquidity event (sale or liquidation of the business) has happened. For example, a business that provides $200,000 per year for the owner while it’s operating will usually provide only 20 percent of that income after it’s sold.

Here’s how the numbers unfold. A buyer will often pay between three and six times earnings for your business. In the case above, this would provide the owner with $600,000 to $1,200,000 in capital before taxes. If we deduct 20 percent for taxes, the owner would be left with $480,000 to $960,000. Many financial planners think that a safe withdrawal rate from an investment for retirement is about 4 percent of the capital. Under the described scenario, the owner would be able to spend between $19,000 and $38,000 per year—far less than the $200,000 per year they were spending when they ran the business.

This means that our owner needs some other strategies to help reach retirement income goals. Combining a regular savings plan with real estate ownership is usually enough to help the owner reach financial independence.


Value Creation in the Business
For most private business owners, growing or maintaining their business is a primary concern, as it ensures that they will be able to sell or exit the business in the manner that is suitable and advantageous.

Creating value in a business requires not only tactical excellence, but strategic excellence as well. When you have a business that is tactically excellent, you will have a company that provides a nice job that pays a very nice salary. If you were to step away from the business for an extended period of time, your business would probably work less well and may even go out of business.

First, then, you must make yourself “operationally irrelevant” in your business. By doing this, you now have gone past creating a job for yourself to having a business that can run whether you are there or not. This is the sort of business that others would want to own, or what we call a business with enterprise value.

When business owners make themselves operationally irrelevant, they create personal capacity to change what they do at work. The owner can now spend time on strategic activities, which can increase the value of the business in two ways. First, the profits and cash flow from the business should improve, and second, a potential buyer will not only pay for the cash flow the business creates, but also the technology for creating the additional cash flow.

For example, if the owner of the business learns not only what the intellectual capital of the business is, but also learns how to charge for that intellectual capital, he can sometimes double or triple the value of the business. If the owner learns how to segment the business’s customer base and only allows the sales department to sell to the most profitable customers, the business value will increase. If the owner of the business learns to segment the business into very profitable niches and then finds ways of finding new niches, they will increase the value of the business, often by a factor of two or three times.


Financing and Capital Structure


How much cash should you have in your business? How much debt can it handle? Private business owners make these decisions every day, weighing prudence against possible diversification outside the business.


Bankers have opinions on this subject, sometimes strong ones. Just as you manage your other supplier relationships, you should manage your bank relationships. If your company is strong, then you are in a good position to set the terms of engagement with your bank. When this happens, you often have too much cash in your company or aren’t using debt in an effective manner.

If your company is not as profitable as you’d like or your company is expanding very rapidly, your bank may be less cooperative. In this case, you must understand how your bankers think and learn how to communicate with them in a manner that they understand.

Step 1: Understand your balance sheet

Most of the companies we work with either have too much or too little debt in their company. Business owners often don’t understand the proper use of debt. The decision of using debt or cash should be made in accordance with your personal risk tolerance, the operating cash needs of the business and the maintenance of an adequate return on equity for the owners of the company.

Those with too little debt keep large amounts of cash in the company and pay for everything with cash. Emotionally this is a great way to live. However, when it comes to getting an adequate return on your business, storing cash in your business often leads to not having money in the right place when it’s time to leave your business. That is, if you are too conservative, and hold too much cash in the business, you can miss many wealth enhancing opportunities.

There are several formulas that are crucial for understanding the capitalization of your business. Two formulas that deal with effective use of capital are return on assetsand return on equity. These formulas help you determine if you are creating true economic value in your business.

Additionally, when applying for loans your bank will be quite interested in two other figures, your debt-to-equity ratio as well as your cash flow coverage for your loans. Banks are interested in making sure their loans are repaid. Having adequate cash flow to cover interest and principle and having adequate ability to recoup the banks loans through liquidation are important from the banks point of view.

Step 2: Understand the cost of capital

Investing your own capital or your firm’s capital in your company is expensive. Investing borrowed capital in your company is relatively inexpensive. The idea sounds counter-intuitive. However, if you use debt appropriately in your business, you free up your cash for other money making opportunities. For example, it is easy and inexpensive to borrow money for equipment, because equipment loans are secured by the equipment. So it is better to borrow for this purpose and use your cash for another opportunity, such as a business opportunity for which a bank or other lending organization is not likely to loan you money.

Step 3: Become financially literate

More often than not, the business owners we work with don’t understand the financial ratios that drive their business. Because of this they don’t know if they are using their business cash in a manner that helps them reach their goals. Banks have guidelines for each business they deal with. Talk to your bankers and find out what they are expecting from you.

Step 4: Review your banking relationships

At least every few years, you should have a conversation with other banks that serve your industry and your community to find out what they have to offer. You may be surprised to learn that different banks have different priorities and that their goals change over time, sometimes to your benefit.

Still, it is true that a good bank is as beneficial as any other good supplier. A strong relationship is worth a lot, but you should work for the best deal that is in your best interest. You can be certain that your bank will work to make a deal that is in their best interest, just like every other supplier you deal with.


Risk Management for the Private Business Owner


Most non-business owners have a relatively easy time managing the risks in their personal and professional life. Risk management for the private business owner is much more difficult. Not only do they have to manage the insurance coverage for their personal and business risk, but they also need to have plans in place in case the worst should happen.


Plan for the worst

As the business owner, you need to work with your key employees to develop a list of the five to ten worst things that could happen to your business. Once this list is assembled you will want to call a meeting with your key managers, your liability insurance agent, your health insurance agent, your life and disability insurance agent, your attorney and your CPA.

The first step you will take is to review the list and see which of them would have the potential for putting you out of business. These are the risks you and the assembled team will want to concentrate on.

Many risks can be insured. For example, you can purchase insurance for personal injury in case the products you make injure someone. However, just having insurance coverage may not be enough. You will also want to have plans in place for how to protect the reputation of your company.

We’ve all heard about companies where someone is badly injured by a product or service the company provides. Often with smaller businesses this can mean the end of the business. The business may have had adequate insurance, but maybe they didn’t have a plan to make sure the public knows the problem has been fixed. It’s having this plan in place that can mean the difference between success and failure in a risk management plan.

Coordinate your personal and business risk

We often see that business owners have one agent for business insurance and another agent for personal insurance. There is nothing wrong with this as long as the coverage is coordinated between the two. Most business owners we know don’t bother with this coordination if they use two agents.

One of the most important insurance coverage you can purchase is an umbrella policy which typically has a limit of $2,000,000 million or more over your basic policy coverage. Umbrella policies all have requirements of underlying coverage before they will kick in. You need to make sure that your underlying coverage for your personal and business life is adequate. The only way to do this is to coordinate coverage between the companies you use.

If you don’t have one agency covering both your business and personal life, you will need to get in writing from both agents that they have reviewed your policies and believe that your coverage is adequate and complete.

Have ownership for the right policy in the right place

We often see life insurance inside the business that has been purchased to protect the owner’s family should they die. In our view, this is a mistake. If the owner dies, the bank will have first claim on the insurance proceeds, not the owner’s family as they intended.
A sad fact about private business is that most businesses will not exist if the owner is not available for coordinating day to day operations of that business. A way to protect your personal risk is to make sure that insurance is owned and placed in the right place to have the correct effect.


Tax Planning and the Private Business Owner


One of the largest costs you face as a private business owner is the cost of taxes. One of the advantages of running a private business is that you have the opportunity of using legitimate tax deductions that favor you as well as your business.


Understand where you are taxed

You need to know where you are paying taxes. For example, you might be organized as an LLC and choose to be taxed as a partnership. In this situation, you will pay Social Security and Medicare taxes on 100 percent of your share of the LLC’s income. If instead you choose to be taxed as a Sub Chapter S Corporation, you would be taxed only on the portion of the income you take as W2 income. This can often save you thousands of dollars on an annual basis.

Use multiple entities when appropriate

Having your assets owned by appropriate legal entities is not only important for asset protection, but also for tax planning. If you own real estate, you don’t want it inside either a Sub Chapter S Corporation or a C Corporation. You will want it inside a partnership or an LLC that is taxed as a partnership. This will allow you maximum flexibility when it comes time to sell or exchange that property in the future.

Often you will want to have a C Corporation and a Sub Chapter S Corporation for providing different services to your clients. We often see a C Corporation used as a general partner for real estate and the Sub Chapter S Corporation for assets within a corporation. This is an excellent asset protection strategy that doubles as a very good tax planning method.
C Corporations have items that can be deducted as normal business expenses that Sub Chapter S Corporations don’t. Working with your tax professionals to understand the difference between the two is important.

Take all legal deductions

Every year we get calls in December asking about deductions our clients can take to help limit their taxes. First, make this call to your advisors in June and you have a chance of making the deductions legal. Second, make sure you ask your tax professionals about anything that might be construed as a deduction.

One of the benefits of owning and operating your own company is that some of your annual expenses can be run as legitimate business expenses.

Tax planning must make sense

The goal is not just to pay fewer taxes. The goal is to use your money in an appropriate and smart manner. If you need an item for your business, then you should plan how to purchase that item at the lowest possible tax cost. If the business does not need that item, then just purchasing it to save taxes will cost you money.

Some owners attempt to save taxes by not reporting all their sales. The IRS is onto this and has been putting people in jail. Tax management is not about cheating on taxes – it’s about minimizing your tax bite in all legal and rational ways.


Asset Protection for the Private Business Owner


We live in a litigious society. If you haven’t been sued, you certainly know someone in your business community who has been sued, often with disastrous results. You should know the basics of asset protection, as there are simple things you can do now that might help protect you if a worst-case scenario comes to pass.


Have a plan

The first step in asset protection is for business owners to figure out what are the largest risks facing their business and then to craft a disaster plan to mitigate these risks should they come to pass. It’s important to be proactive not reactive when running a business.

Being proactive means having a plan in place that is ready to address a risk event before it happens. If you do this, there is a better than even chance that you will come out of the event whole. If you don’t have a plan, then you are not only dealing with the problem, but you are also trying to figure out what to do on the fly. This is where mistakes happen.


We suggest that as you assemble this plan you include your accountant, your lawyer, your insurance agents and key managers of your company. All have different viewpoints and information you will need in assembling your plan.

Use corporate and asset protection structures

Over and over again, I’m amazed by how many owners of private businesses don’t have at least one corporation for their business. In high risk businesses or high risk parts of the country you will want to have several corporations that protect various parts of your business.

If you are in a business where professional liability is not protected by a corporation, you should work with an asset protection specialist who will help you structure the ownership of your assets in a manner where it will be tougher for creditors to get you and your assets if the worst should happen.

We often suggest that contracts should be owned by one corporation and hard assets should be owned by another corporation. For example, if you are a construction company, the equipment you use is owned by one company. This company would lease the use of those assets to your operating company. This would protect the hard assets, or at least make it more difficult for creditors to attack those assets.

You must plan early

Transferring assets with the knowledge of an impending law suit will often not protect those assets. This type of asset transfer is called fraudulent conveyance, and all transfer assets tend to be drawn back into any settlement.

It’s important plan early if you expect to protect your assets from creditors. The name of the game in asset protection is often making it difficult and expensive for your creditors to prevail. You might end up paying some money, but that money will likely be less than if you had done no planning. Once a lawsuit occurs, your options are fewer and the chances of real economic harm larger.


Harvesting Value from your Business


Business owners who are beyond the start-up phase and have created some predictability in their revenues should begin to think about harvesting value from their business. Harvesting value, or extracting cash and using it to diversify investments and assets, is a primary means for ensuring that you have personal assets once you leave your business. Diversification is not for safety, but to expand the possibilities of what you can do later in life. This article covers some strategies to extract cash from your business while you are still actively engaged in it.


Buy some real estate

The first step in harvesting value is to own the real estate your business occupies. It is more advantageous to pay yourself rent than it is to pay someone else rent. When the owner of the business leaves their company, the rental income their building produces is sometimes worth more than the business itself.

You will need to take some money out of your business for your down payment. You will also want to have the building amortized for no more than 15 years. This will allow you to have a building with no mortgage and plenty of cash when it comes time to leave.

Look at your 401 (k) plan

For many business owners, the next logical step is to look at their 401(k) plans to make sure they are putting the maximum away for themselves. If you are already putting 3 percent into your plan for your employees, you can often increase the amount you are putting away for yourself. If you can add another 2 percent for your employees, you can often save as much as $50,000 for you and your spouse on an annual basis.

Strong savings in your 401(k) plan often can make the difference between leaving your business on your terms or having to go to work for somebody else after you sell or close your business. This strategy is sometimes called “pre-funding your buyout.” Many businesses have little or no market value when it comes time to sell. But if the owners pre-fund their buyout with present cash, they are able to set their own terms when it’s time to leave the business.

Managing Debt for other Investments

We already have covered managing the amount of cash and debt you have in your business. It is important to have enough—but not too much—cash in your business. Excess cash is sometimes best applied toward diversification into other investments.
Those other investments could be a Roth IRA, stocks, bonds, other investment real estate or even passive interests in other businesses. Money that you are leaving in your company could keep you from profiting from other opportunities. Your business is a great value generator, yes, but what other opportunities are you passing up?

You need to do an opportunity cost analysis of leaving cash in the business versus using that cash for other investment opportunities. First, you must make sure your company balance sheet is solid. Most business owners have this instinct. But once that is accomplished, leaving more cash in the business can be damaging, sometimes very damaging.

The purpose of harvesting value is to insure future assets or income that can provide you and your family with a high standard of living in the future. Diversification can add options and that is what harvesting value is all about.


Leaving Your Business in Style


In the book How to Run Your Business So You Can Leave It in Style, author John Brown lays out a seven-step process for planning your eventual exit from your business. Those seven steps are:


  • Establishing Owners Objectives – (Financial Planning)
  • Establishing Business Value – (Value World Analysis)
  • Building Business Value – (Value Creation)
  • Selling to a third party – (Value Harvesting)
  • Transferring to Management or Family – (Value Harvesting)
  • Developing a contingency plan for the business – (Risk Management)
  • Family Wealth Preservation Planning – (Wealth Transfer)

Planning for a successful exit involves working with an advisor or advisors who have an interdisciplinary understanding of what needs to be done for a successful exit to occur.

But first, the main question

While working with a private business owner on the exit planning process, there is one question that must be answered before any other discussion takes place. That question: Should I keep the business and operate it as a cash generating machine? Or should I sell the business, change my day-to-day activities and live on passive income from the capital value I realize from the business?

The answer to the keep or sell question will help you determine an appropriate wealth management strategy aligned with your goals. Remember, all the advisors you work with during this process will have an agenda. You will need to drive your agenda and make sure you are working towards the outcomes that are important for you.

The sales process

Suppose you as a business owner have decided that you want to transition out of your business. If you have created a business with enterprise value (a business that someone else wants to own), you have several options.

The three main options are: sale to an outsider; sale to your managers; or passing the business to family members. In many cases you will want to examine all three at the same time before making a decision about the option you ultimately want to pursue.

Understanding value worlds

Private businesses have several market values at the same time. The difference in those values can be huge. For example, the liquidation value of a business might be $500,000 while the strategic value of the business might be $5,000,000. It is a critical part of the exit planning process to understand the different value worlds and how they fit in with your long-term personal economic plans.

We suggest that you value your business based on three or four different value worlds. This will help you make a more intelligent decision when it comes time to transition out of your business.

The advisory world

When selling your business, it’s crucial that you use outside advisors who understand the process. These advisors should have the ability not only to help you through the process, but they also should have a clear understanding of the different sales opportunities you have.

It is rare to find an advisor who understands and is conversant in all the transfer methods, so it is all the more important that you as the private business owner stay in control of your goals. This means you first need to be clear about what you want out of the transfer and then stay true to that as you go through the process.


Investment Management


Investment management is the traditional core of wealth management or financial planning as practiced today. Most financial planners concentrate more on investment management than on any other portion of the wealth management or financial planning process. They also earn most of their money from investment management.


Asset allocation should lead the conversation

The first area of focus for your investment management conversations should be about asset allocation. Research has shown that slightly more than 90 percent of your investment return will be determined by the allocation you choose for your investments. Approximately 4 percent of your return is achieved by the actual selection of stocks and bonds, according to Brinson, Hood & Beebower’s Financial Analysts Journal in both 1986 and 1991.

Concentrate on volatility

The second area of focus for your investment strategy should concentrate on the projected volatility of your portfolio. We believe that managing downside risk is much more important than concentrating on upside potential.

If you have $1,000 and have a 100 percent gain in your investment, you will now have $2,000. If you take $2,000 and have a 50 percent reduction in value, you will once again have $1,000. For this reason we believe that concentrating on a strategy that helps minimize downside risk is important for the long-term health of your portfolio.

Core and Satellite Investing

The third area of concentration should be on developing a core and satellite strategy. The core investments you have typically are stocks and bonds. Here you will concentrate on using cost-effective investment vehicles such as index funds or exchange-traded funds. We believe that in the core section of managing your investments passive strategies provide more long-term value than active investment management.

Satellite investment strategies will include those stock sectors where active management can add value. We believe the satellite sector of your investments should include alternative investments that are designed to provide regular returns no matter what happens in the broad market.

The goal of a core and satellite investment strategy is to provide you with positive inflation adjusted returns that have lower-than-average volatility.

Understand the movement to passive income

The fourth part of an investment strategy for owners of private business is to understand the impact of moving from an active income situation where you got a paycheck from your business to one where a major portion of your income will now come from the returns your investments provide. We often suggest that business owners have some active income in the portfolio, often from the investment real estate from which you run your business. You may decide to sell your business for many reasons. We often suggest that you keep ownership of the real estate you owned while running the business. The income from this real estate can become important in meeting cash flow needs after you sell your business.


Wealth Transfer Planning and Legacy Planning


Most private business owners stay away from wealth transfer or estate planning issues until they sell or have a liquidity event with their business. The reason for this is that wealth transfer planning often has irrevocable transfers attached to the process. Until you, the owner of the private business, actually have the cash in your hands you don’t often believe your business value is real.


Wealth transfer planning and basic estate planning help to facilitate the transfer of your business or assets. Estate planning is crucial to have in place before you begin the transfer of your business to your children or other family members. Not having done adequate wealth transfer planning can unravel the plans you have made with respect to who will run and control the company in the future.

Some estate planning basics

You will want to think about how much of your estate you want to go to your spouse or significant other and how much of your estate you want to go to your children or other heirs. You will also want to understand how to use what is called the unified credit for each of you to take maximum advantage of the estate tax exclusion the government gives you.

Basic estate planning is about managing risk. It’s about ensuring your children get a good education and your spouse has a good quality of life. Good planning also ensures that  your children don’t squabble about your estate after you pass on.

Working with a competent estate planning team will help you achieve basic risk management needs with ease. The core team we recommend would include an attorney who specializes in tax and estate law, an insurance agent who understands planning opportunities for the private business owner, and a CPA who understands the needs of the business after you’re gone.

Advanced planning opportunities

If the business is a large one and you want to pass it to the next generation of managers, or if you’ve sold your business and your estate value is more than $7 million, you will probably want to engage in more advanced planning in order to limit the estate taxes your family pays. You also will want to control who has influence in the business and make sure your children are treated fairly for estate distribution issues.

You often will run into the alphabet soup of estate planning at this point in your life. Estate planning professionals throw around terms such as GRAT, NIMCRUT, CRUT or defective trusts. Once you learn more about these techniques, you can employ them help achieve your goals.

The key to advanced estate planning is to have clearly delineated goals for what you are trying to accomplish. After your goals are established, you will want to use a seasoned team of professionals to put your plans in place. Your wealth manager will play a crucial role in assembling and coordinating the work of the team.

Legacy Planning

Legacy planning or philanthropic giving starts with an understanding of the concept of social capital. You are participating in social capital activities now in the form of paying taxes. You also have an option of diverting some of your taxable social capital to the organizations and issues you care about.

Legacy planning is often combined with wealth transfer planning. A successful legacy planning process will help you focus on ways you would like to see your money used, both while you’re alive and after you’ve passed on.


Each of these areas is complex and requires the engagement of specialized experts to handle properly and successfully. It’s best to create a team of advisors who collectively have knowledge in these areas. Typically, you will choose one of your team members to be your wealth manager. This person will be responsible for coordinating the management of your wealth with great input and direction from you and from advisors with knowledge in the above listed areas.

Your wealth manager should help you develop your financial mission, vision, values and goals, and then help to coordinate all of the players to make those goals come to pass. This series touches on the different facets that should be carefully explored.

Josh Patrick, founding principal of Stage 2 Planning Partners in South Burlington, Vt., specializes in working with closely held businesses. 

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