Managing Your Private Business as Part of Your Investment Portfolio
This article aims to help owners of small and mid-sized companies understand how to mitigate and manage the unique risks that owning a small or mid-sized company adds to your portfolio.
To begin, let us look at an example portfolio of a fictional private company owner. Our private company owner is 57 years old. She runs a manufacturing company that supplies exterior metal accessories for homes such as gutters and mailboxes to retailers and homebuilders. She started the company 16 years ago, and it has provided a good, steady stream of income. Over time, the owner has accumulated investment assets, including the land that the company sits on, the property next door, and a condominium that she rents out. During the three best years of the company, she took some excess earnings and invested in stock mutual funds, and she still holds these shares. To retire, she plans to sell the business and live off the sale and any proceeds from the real estate and mutual funds.
Our owner appears to have a pretty good plan to meet her financial goals. Nevertheless, because her largest asset is her business, she should give special attention to the following areas:
Portfolio Diversification & Concentration Risk
A diversified portfolio contains a mix of investment assets that provide an optimal return for a given amount of risk. Lower risk assets have lower volatility over time. Less volatility makes returns more predictable and allows you to better plan your financial goals. A typical diversified portfolio may look like this:
A Typical Diversified Portfolio
Our sample private company owner’s portfolio looks like this:
A Sample Private Company Owner’s Portfolio
Put simply, putting all of your eggs in one basket goes against the basic principle of diversification. A majority of this owner’s investments are in one asset, her company. Compounding the risk, our owner has significant investments in real estate. These real estate investments add to the concentration risk of this portfolio. A downturn in the real estate market will hurt both the company and these investments.
Liquidity Risk
Private companies don’t convert easily to cash. Selling a private company may take a year or more. If our example owner had to liquidate in a hurry, she might not be able to.
Small Company v. Blue Chip Companies
‘Blue Chip Companies’ are well-established, well-capitalized companies. Generally speaking, they are the least risky stock investment on the spectrum of a diversified portfolio. As the size of the company decreases, the share price tends to have greater volatility. In other words, smaller companies are riskier as an investment.
Public vs. Private
Publicly traded companies have the SEC’s oversight, periodic audits, and reporting requirements. These requirements are not present in the private markets, and buyers consider this additional risk when they value private company investments.
Value
Publicly traded companies have a market that tells you the company’s value at any time. Private companies do not have a readily available market price.
Marketability
To sell your company, you need to find a buyer. Less than 50% of small and mid-sized companies will not sell. Not finding a buyer when it’s time to retire would be the worst-case scenario for our example portfolio.
Taxes
Taxes on sales of mutual funds or stocks are relatively predictable. Typically, these investments have interest or dividend income or capital gains. The sale of a private company is more complicated. Taxes can vary significantly depending on how the deal is structured.
Mitigating These Risks In Your Portfolio and Company
Fortunately, business owners have options to reduce these risks, including:
Tax Planning
When you sell your business, the impact of taxes can be significant. As part of your financial planning, meet with a tax professional who is well versed in your industry and private company transactions.
Periodic Valuations
Private companies don’t have a market that tells them their value daily, but you can get a professional business valuation. Getting a valuation periodically is worth the investment because it will help you make sure you are on the right track to meeting your goals.
Take Some Money Off The Table
To increase your diversification, invest less in your company and more in other investments. Some of the options to do this include:
Pay Yourself More
You can pay yourself more of your company’s earnings. The form of payment can include contributions to a benefit plan, salary, bonus, distribution, etc. The goal here is to get more money out of the company so you can invest it. The method you choose has a tax impact, so it is crucial to make this part of your tax planning.
Borrow Money at a Low Rate
Borrow money for equipment, working capital, or other business areas previously paid for by re-invested capital. Borrowing money at a low-interest rate via an SBA loan or a similar low-cost loan may make sense if it allows you to diversify your portfolio.
Take on a Passive Investment
A more complicated strategy is to sell part of your business to a passive investor. Passive investors are typically private investors that are very selective about the companies they invest in. Attracting private investment will likely require help from an investment professional.
Increase the Value of Your Company
Increasing your company’s value is different from ‘getting more sales’ or ‘saving costs.’ To increase your company’s value, look at it from a buyer’s perspective. A buyer uses some form of the discounted cash flow model to estimate how much they are willing to pay for your business. Put simply, there are two main inputs into the model, cash flow and risk. Cash flow is good; risk is bad. You can find ways to increase cash flow, but doing so has diminishing returns. Reducing the risk of your business can have exponential returns while improving your cash flow.
To understand risk, recognize that a buyer wants to purchase a business with transferability, predictability, and sustainability. Your business may have provided you with a good income for many years, consistent growth, and have good employees. All of this is good but let’s look at how a buyer might evaluate your business. They will look at your business’s critical areas to see if they have transferability, predictability, and sustainability. These key areas include Planning, Leadership, Sales, Marketing, People, Operations, Finance, and Legal. So, for example, you may have sales that are increasing every year. If you are the primary salesperson and without a reliable sales team under you, can the buyer count on your sales success to continue once you are no longer at the company? Or you may have great employees, but if you don’t have formal employee agreements in place, will they stay once you sell the company?
You can see how each of these critical areas enter into the price a buyer is willing to pay for your business or how it may make them look for other opportunities. Your strategic plan should include an exit strategy that takes this into consideration.
Make Your Company Marketable
A formal valuation can tell you how much your company is worth, but if it will sell is again a function of its transferability, predictability, and sustainability. Your financial plan’s worst possible scenario is one where your business simply doesn’t find a buyer. You can plan for this now by both preparing your business and understanding the market for your business.
Investments That Help Diversification
Work with a wealth manager to help you identify investments that do not correlate with your company’s value. In our example, the company is dependent on real estate because the owner has real estate investments, and their house is a significant part of their investment. A wealth manager could help diversify this portfolio as much as possible.
Conclusion
Owners of a small or medium-sized business need to pay extra attention to how their company impacts their portfolio. By addressing its unique nature as an investment, both their company and portfolio will be more valuable.
How Highpoint CFO Can Help You
Highpoint CFO is a CFO consulting firm that helps business owners prepare their businesses for exit or transition. Whether you are thinking about exiting three years from now or fifteen years from now, as a Certified Value Growth Advisor (CVGA), we can help you understand which improvements buyers are looking for and help you make the changes needed.
This article is not investment or tax advice, and Highpoint CFO is not an investment or tax advisory firm. Contact us to learn more about how we can help you.
About Us
Highpoint CFO is a Florida-based CFO Consulting firm that serves clients throughout the US.
Scott Young is the President and Principal Consultant at Highpoint CFO. He is a CPA and Certified Merger & Acquisition Advisor (CM&AA) with over 20 years of experience in finance and accounting at industry-leading companies.
Sources and Further Reading
Concentrate on Concentration Risk | FINRA.org
Ray Dalio discusses the All-Weather Strategy.
Diversifying Well Is the Most Important Thing You Need to Do in Order to Invest Well
Borrowing Money? Investor funding? How much will it cost to fund your company’s growth?
