The pandemic reminded entrepreneurs of the risks associated with owning a business. Although government closure of businesses wasn’t on our radar over the past year, it has given us heightened awareness of potential pitfalls.
When I help business owners with financial planning, this idea of risk mitigation seems to be top-of-mind (and I don’t mean owning bonds in your portfolio instead of stocks). Business owners simply have more risk, from increased liability to the fact that their income and net worth are tied to the success of their trade.
Every business owner should have a plan to address two risks:
1. The risk of being too concentrated.
Diversification is meant to reduce your exposure to risk. A business owner’s balance sheet is typically composed of four things:
- Human capital: your ability to work and generate an income.
- Your business: if your business is an asset that can be sold.
- Financial assets: things like stocks, bonds, and bank accounts.
- Primary residence: the value of your house minus your mortgage.
Everyone, regardless of owning a business or not, needs to understand that our human capital diminishes over time. In the future, your ability to work and earn an income will reduce and eventually disappear.
As a result, your human capital needs to be replaced. Since pensions are rare, most invest in things like their 401(k) with the goal of building a nest egg that can generate income when they retire.
What if your business is your retirement?
You have the benefit of building wealth in your business. If all goes according to plan, your business will continue to increase in value, replacing your diminishing human capital as you age. When you are ready to retire, you can sell your business and invest the proceeds in financial assets, thereby having assets to generate an income in retirement. The chart below illustrates this.
But what about a business whose value does not materialize as planned?
This is the risk of owning a single business. Just because you own a business does not mean someone is willing to write you a check when you are ready to sell.
Failing to diversify throughout your working years leaves you with few assets with which to generate a retirement income. In the chart below, the majority of your wealth at retirement is in your primary residence, with very little ownership of financial assets.
Some businesses don’t have much value because the worth is in you as the owner. Some service businesses will not produce an asset that is able to be sold. Still others are threatened by future changes in technology.
What risk is there to the future value of your business?
I own financial service companies, which means I have increased risk to technology, government policies, and changes in regulation. Yes, my companies are currently increasing in value. However, I know this is not guaranteed to continue, regardless of my best efforts. This is why I must work to diversify.
What does diversification look like for me? At this point, it doesn’t mean selling away portions of my business interests, although this could be an option in the future.
Currently, I need to plan on taking part of my cash flows and investing them in assets that will grow and generate an income for me in the future. This could be a mix of stocks, real estate, and insurance. If I’m able to sell my business at retirement, my efforts at diversifying further increased my financial success. However, if my business failed to provide an asset for me to sell, I’ve saved myself from financial disaster.
In this example, the value of your business and human capital still accounts for a majority of your balance sheet (roughly 70%) at age 55. What’s important is you are also taking care to increase your non-business assets. Just like the first example, your business is sold at retirement and exchanged for financial assets.
2. The risk of catastrophic loss.
Diversification is meant to reduce risk, insurance provides protection against losses.
Of course, insurance can’t protect from every loss. But there are certain risks that can easily be transferred to an insurance company that every business owner should consider.
- Professional Liability: for businesses with professional exposure like insurance agents, CPA’s, and investment advisers.
- Property: protects your equipment and property (think fire, theft, etc.).
- General Liability: covers bodily injury and damage caused by the business.
- Cyber Liability: protects your business from losses due to cyber-crimes.
- Disability Income: replaces your income if you are disabled due to illness or injury.
- Life: provides a lump sum to a beneficiary if you pass away.
As you can see, there is no shortage of available insurance products. How do you weigh the cost versus the potential benefit?
First, consider the potential loss.
Second, ask yourself these questions—in this order:
- Effect on you: could I, my business, or my family recover if I experienced this loss?
- Price tag: is the cost to insure the risk small compared to the potential monetary loss?
- Probability: what are the chances that I could actually experience this loss?
I find people start with the chances of loss and don’t consider the price relative to the potential monetary loss. This is an important distinction because some risks, like premature death or disability, are low-probability events to begin with. Only evaluating the chances of something happening is not prudent.
If the low-probability event is also catastrophic, meaning the financial ramifications spell disaster for you or your business, what price are you willing to pay to insure against this risk? Now the price tag becomes smaller, relative to the potential loss.
How much is your future income worth? For a 35-year-old, it could be in the millions of dollars. A sudden disability could mean you lose your ability to work. If you could insure $5 million of future income for $200 per month, why not?
What about your partners?
If you’re in business with one or more partners, disability and life insurance can be crucial to protect your share of the business due to your untimely death or disability.
A buy/sell agreement should be drafted that reassigns each partner’s share of the business if he/she passes away or cannot continue in business because of a disability. Most often, the other partner(s) buys out the deceased or disabled partner’s share. Usually insurance is used for this. Each partner buys a life insurance policy on the other partner(s). If a partner passes away, the death benefit is paid out, giving the surviving partner(s) the funds to buy out the deceased partner’s spouse or estate.
Similarly, a buy/sell disability policy enables the partner(s) to purchase the disabled partner’s share of the business through a lump sum made available by the insurance company.
A financial plan for business owners
Being a business owner is immensely rewarding. It can be financially lucrative, though it’s not without risks. The good news is, removing or mitigating these risks can transform your mindset. If you no longer worry about these things, you can thrive as an entrepreneur.
Want to know more about financial planning for business owners? Schedule a time to talk with a Stewardship Financial advisor