Small Business Diversification
The word entrepreneurship seems to make people think of a certain scenario. We all know a version of the “classic” American entrepreneur story. Person has a brilliant idea. Person brings the idea to life in their garage. Idea is a major hit. Person grows the business, brings in investors to expand, and they sell the business for millions to a large corporation. Everyone makes money. Person can retire. If they are too bored in retirement, they may try to start the process over again.
This is not what a typical entrepreneur looks like. The person above is a high risk, high reward entrepreneur. We only know the success stories because they resulted in extremely high rewards. A typical entrepreneur in America looks like the following story.
Someone works an average 9-5 job and is uninspired. They decide that they can offer their skills in a better way. They spend nights and weekends trying to sort out the details. They eventually quit their full-time job and take a significant pay cut. They struggle to pay the bills for the first three years or longer. They may fail. Eventually, the business starts to grow and make a decent profit. Most of the profit is reinvested in the business until they have a sustainable level of workload and income.
The key difference between these two entrepreneurs is that one has built the business in order to sell and the other has built the business in order to provide a product or service the best way they can. The first example allows business owners to cash out and retire if they wish. The second example creates a source of income for the business owner throughout life. These are the people you see running small shops and businesses around your community. Unfortunately, many of them are afraid to take too much of an income because they want to use that money to grow the business.
This scenario is all too common. Business owners will take a minimum income for themselves and keep reinvesting in the business. The goal is that the business will grow enough and provide a source of retirement income when the time comes. In general, this plan can work just fine. The issue is that business owners run a big risk by not diversifying into other assets and investments. The business may not be worth as much as they think when they are ready to retire. The business may not have any value to their family if they were to die before retirement. And, as we all know, the business may slowly lose money, and this puts their regular income and retirement at risk.
For those business owners in the second category reading this, my point is not to discourage you to reinvest in your business. This post is meant to encourage you to start thinking of your personal finances separate from your business. I went through this experience as well. My business provides income for me and my financial success is directly impacted by my business success. However, it can’t be the only form of financial security. Let’s look at some ways to diversify our business risk.
Retirement Accounts – First and foremost, business owners can set up a retirement account for themselves. Traditional and Roth IRA’s are the most basic options, but businesses can also set up their own business retirement account to allow higher level of retirement contributions. This is usually the best first step because it results in tax savings and allows you to grow your retirement accounts in investments other than your business.
Setting an Income – This is, surprisingly, less common than you think. Most small business owners withdraw money when they need it but keep the rest in the business. There are some tax planning items to consider around paying yourself a salary. However, it is important to remember that your personal finances are separate from your business finances. Pay yourself a salary and use it to finance your personal goals.
Business Continuity Plan – Write out a plan in the event of the business owner’s death. This is especially important if you are the sole owner. What happens to your family if you die tomorrow? Is the business worth anything? Don’t let all your hard work go to waste when you pass away.
Value the Business – Another good practice is to have your business professionally valued regularly. This will give you a better understanding of how much your business is worth. You will also be able to see how much of your net worth is tied to your business.
You have probably heard from any financial professional that investing everything in one company is a high-risk strategy. Having all your wealth tied up in your business should be no different. There is always the possibility that your business will fail to provide for you at some point during your life. Small business owners will naturally have a large percentage of their overall financial success tied to their business. Do everything you can to set yourself up for both business and personal financial success.
I love working with small business owners. They put their heart and soul into their business every day. My hope is that this post encourages you to separate your personal finances from your business and to diversify some of the inherent risk that comes from owning your own business. This will make things easier when you finally decide to slow down or step away from your business. Hopefully, that time doesn’t have to happen any time soon!
Mike Zeiter, CPF/PFS, CFP®
