When did you last calculate how much of your net worth is tied to your company’s value?

When you started your business, its value was probably negligible. Unless you purchased or inherited your company, it was not worth much when you opened your doors, but over time, the proportion of your assets tied to your business may have crept up.

Imagine a hypothetical business owner named Christos, who starts his company at age 30. He is still renting but has a diversified portfolio of equities in an online trading equity retirement account worth EUR 100,000. As he has just started his business, the company is worthless, so it does not yet factor into Christos’ net worth calculation.

By the age of 50, Christos owns a home worth EUR 600,000, his equity retirement account has grown to EUR 400,000, and his business has blossomed and is now worth EUR 4,000,000. Christos’ company has crept up to represent 80% of his net worth.

Christos knows the first rule of investing is to diversify, which he is careful to do with his retirement equity account, with a blended portfolio of large and small equities as well as international and fixed income based mutual funds.

However, he has failed to prepare his business for a future exit and so in reality has not diversified his wealth. In fact, it has become more risky due to the dominance of his biggest asset – his business.

Furthermore, he may have unknowingly passed something called “The Freedom Point,” which is when the net proceeds (i.e., after taxes and expenses) of selling his business would garner enough money for him to live comfortably for the rest of his life. Your lifestyle determines your Freedom Point, but when you pass it, it’s worth considering the risk you’re taking.

If this pandemic has taught us anything, it is that nothing is for sure, and a thriving business one day can turn into a struggling company overnight. When your business makes up most of your net worth and selling it would garner enough money to retire, there is no financial reason to continue owning your business. You may enjoy the challenge, the social interactions, and the creative process of building a business, but keeping it may be unnecessarily risky.

What if I do not want to retire now?

When you’ve crested the Freedom Point and want to diversify—but still do not want to retire—you have some options:

• Sell a Minority Stake: In a minority recapitalisation, you sell less than half of your shares. Often sold to a financial investor such as a private equity group, a minority recapitalisation allows you to diversify your net worth while continuing to control your business.
• Sell a Majority Stake: In a majority recapitalisation, you sell more than half of your shares to an investor who will most likely ask you to continue to run your business for many years to come. You get to diversity your wealth, keep some equity in your business for when the investor sells, and continue to run your company.
• Earn Out: When you sell your company, you’ll likely have to agree to a transition period of sorts. One of the most popular is called an earn-out, where you agree to continue to run your company as a division of your acquirer’s business for a specified period of time. Your earn-out may be as little as a year or as long as seven, but the average is three years. Therefore, if you are past the Freedom Point and can see yourself wanting to step down in the next three to five years, an earn-out may be worth considering (Please note earn-outs can be very risky for you so only agree to one after careful consideration with legal and other counsel). 

Building a successful business is rewarding, but when your personal balance sheet gets out of whack, it may be worth considering the risk you are shouldering and the options you have for sharing some of it.

Download our free ebook below if you would like to find out more about the Freedom Point and how to calculate it. In addition, discover the value of your business at Sophiall Solution Value Builder and where you stand on the 8 key drivers of business value.