Owners of start-up companies have probably heard the statement, “You can consider your new business a success if you are in the black by the end of your third year in business.” In fact, one of the most common reasons new start-up businesses fail is being under-capitalized. New business owners sometimes underestimate the amount of capital needed to fuel a new enterprise and may find themselves investing more of their own capital into the growing endeavor. As a result, in the early years, they may not be able to take much in the way of salary or even reimburse themselves for their investment.
So, it is not surprising that, after the business begins to produce healthy profits, these owners want to begin reaping the rewards of their sweat, sacrifice, and effort. Soon, as the business profits continue to increase, many owners also increase their personal lifestyle. The boats, cars, second home, travel, country club, and other perks just seem to come with the success of the business. About this time in the life cycle of the business, additional family members may become involved in the business, and before long there are several family members and households dependent on the business profits to provide for the lifestyle they have now achieved.
This is a dangerous situation for several reasons. This pressure to produce cash may be draining the business of necessary capital for growth and sustainability. In our most recent recession, many owners found they had to make some very difficult choices. How long could they keep the business running during lean times and maintain the lifestyle they had grown accustomed to? How do you face the fact that you can no longer afford the luxuries the business has been paying for? What if the business can no longer pay family members that are now dependent on the business as their primary income? In fact, some businesses did not survive the recession, and some owners also lost substantial personal assets as a result.
Our process at Business Transition Academy Inc. helps owners prepare for their eventual business transition. One exercise that almost always takes owners by surprise is finding out just how much they derive from their business in the manner of salary, perks, and benefits. It is not uncommon for owners to want to minimize profits as a means of minimizing their tax burden and to use the business as their very own piggy bank. Soon, there is a very narrow grey line between their personal expenditures and the business expenses. In fact, a few days ago, I spoke to a financial advisor who had just met with the son of a successful business owner. The advisor was engaged to provide financial planning services to the son and was astounded to find out that the son didn’t even have a personal checking account. He had a company debit and credit card and absolutely no idea what he spent monthly. Maybe this is an extreme case, but most owners don’t realize all of the personal items and benefits the business pays for on their behalf. This practice, which may have started out relatively small and innocent, may now have grown substantially as the business grew ever more successful.
When planning for an eventual transition, taking stock of what the business pays for and how those expenses will be funded once the business is no longer the provider can be very eye opening. As a result, some owners will face some tough choices:
Do they need to stay and increase their business value?
Can they reduce their current spending?
Could they invest more outside the business?
Do they have to delay their transition plans?
Do they need to consider lowering their standard of living post-transition?
These are difficult decision to make, but an additional issue, potentially even more devastating, created by draining the business of profits is the loss of business enterprise, or sale value. As the owners have deceased company profits by ratcheting up their discretionary spending, improving their personal lifestyle, or attempting to minimize their tax liability, they have also, usually unknowingly, reduced their company’s value as well. Depending on their industry and the size of their business, every dollar of profit not recorded on the bottom line can result in three to seven dollars loss of enterprise value, a.k.a., sale price. For example, the loss of even ten thousand dollars on the bottom line could result in a reduction in sale price of thirty thousand to seventy thousand dollars or more. This can add up quickly.
This can take substantial time to correct. A potential buyer will seek a business opportunity that has clean financials and tax returns, which demonstrate sustainable, repeatable profits with healthy trends, not just for one year, but for at least a historical three-year period.
In closing, a pretty famous cliché, “nothing lasts forever” can sometimes be applied to business profits as well. We know everything works in cycles. Owners should resist the urge to spend more as their business makes more, which can help protect them in the event of a rainy day. They will also benefit from a healthy company bottom line when the time arrives that they want to leave their company or cash out providing them with the ability to fund their future lifestyle. In addition, they can benefit by diversifying their assets, investing wisely outside the business, and leaving sufficient capital in the business for possible lean times. This reduces their personal risk as well as business risk.
There is no substitution for taking the time to plan and prepare for an eventual business transition. All owners will leave their business one day, planned or unplanned. Their business is most likely their largest illiquid asset, and the eventual liquidity event will potentially be the largest financial transaction of their life, yet most spend little if any time preparing or planning for this event, leaving everything to chance. With the correct planning and preparation owners can control their outcome.