Wednesday, April 18, 2012

Do You Have a Concentration Risk in Your Net Worth?

Most small business owners put everything they have into their businesses as they are growing them.  They are entrepreneurs, risk takers and are successful in part because of their willingness to take on risk.  Along the way, they build net worth and value in their business.  They also build a concentration in one stock, the stock of their operating company, comprising a large percentage of their personal net worth.  For most business owners the value in the stock of their operating company, along with the equity in their homes, will represent the vast majority of their net worth.

For most businesses owners, developing this concentration is almost impossible to avoid.  For some it is by design.  Many years ago I was touring a manufacturing operation with the owner who was giving me a tour of his facilities.  I asked him about other investments he had and I referenced the stock market’s activity that day.  We were up on the second floor of his warehouse and he motioned with his arm toward the floor below and said “this is my stock market”.  He went on to tell me he had no other investments and everything was in his business.  Although that works as long as your business works having most, if not all, of your eggs in one basket is generally a dangerous endeavor.  

It’s understood that in order to grow one’s business, capital is required and retaining profit inside the company is essential to its ongoing operations.  The challenge comes later in one’s career, as significant value in the business is accreted, to diversify holdings such that the concentration your business represents in your net worth is mitigated.  There are no hard and fast rules regarding how large this owner operated business concentration should be.  The goal to reduce the portion that your business value represents as a percentage of your overall net worth may not be achievable until your business hits the maturity stage of its life cycle.  That being said, the purpose of this article is to bring the issue to the forefront and have the business owner develop a plan to diversify away from this concentration.  

A goal I have discussed with business owners is aiming for the value of their business to comprise 25% or less of their total net worth.  Any business owner, particularly a construction firm, should seek diversification and mitigate any concentrations in their net worth.  There are a number of ways, after your business has reached maturity, to take some of the chips off the table.  These options include sale of minority stakes to key employees who desire, and are worthy of, equity ownership, sale of non-voting stock (in order to retain control), ESOPs, distributions of excess working capital (yes, this is still possible in 2012 in select cases) just to name a few.  The option you choose will depend on your particular circumstances.  Be sure to include the bond company and bank in any discussion regarding your options.  You don’t ever want to do anything to adversely affect your ability to obtain credit as you do your planning.  As always, consult with your trusted advisors as well.

We’ve all heard that the two of the strongest pillars of wealth are 1) knowing how to make money and 2) knowing how to keep it.  As I’ve cited before, the old saying goes all contractors are one bad job away from going out of business.  The execution of a plan for diversification is essential in keeping a lifetime of work and wealth accumulation intact and provides peace of mind allowing the entrepreneur to sleep easier.

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