A question for you. 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 almost certainly negligible. Unless you purchased or inherited your company, it probably wasn’t worth much when you opened your doors. But over time, the proportion of your assets tied to your business may have crept up.
Let’s imagine a hypothetical business owner named Emma, who starts her company aged 30. She has a bit of equity in her first home and a small retirement fund. When she starts her business, it’s worthless, so it doesn’t yet factor into Emma’s net worth calculation.
But by the age of 50, Emma has built up £500,000 worth of equity in her home, her retirement nest egg has grown to £300,000, and her business has blossomed and is now worth £4,000,000. Emma’s company has crept up to represent nearly 80% of her net worth.
Emma knows that the first rule of investing is to diversify, which she is careful to do with her retirement account. Still, she has failed to achieve overall diversity given the success of her business. What’s more, she may have unknowingly passed something called “The Freedom Point,” which is when the net proceeds after taxes and expenses of selling her business would garner enough money for her to live comfortably for the rest of her life.
Your lifestyle determines your Freedom Point, but when you pass it, it’s worth considering the risk that you’re taking.
If this pandemic has taught us anything, it is that nothing is certain, 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 mean 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 involved in building a business, but keeping it may be unnecessarily risky. So what happens when you’ve reached the Freedom Point and want to diversify—but still don’t want to retire?
Here are three 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 more than 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.
When you sell your company, you’ll likely have to agree to a transition period of sorts. One of the most popular is 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 well worth considering.
Building a successful business is rewarding, but when your personal balance sheet gets out of kilter, it may be worth considering the risk you’re shouldering and the options you have for sharing some of it. In business sometimes the best way to maximise your reward, is to minimise the risk.