Getting to the Equity in Your Business

hourglassToday’s newsletter is written to address an important topic in planning for an owner’s transition, namely, ‘how to get to the equity in your business?’  We’ll look at how business owners view their companies and then offer some planning-base suggestions as to how to draw the equity out of your business over time, assuming that you are not selling to an outsider.  We hope that this newsletter content inspires you to begin planning for how you too will get to the equity in your business.

Getting to Income vs. Equity

There are two very different aspects to getting the money out of your business.  On the first hand, there is the income that you draw from the business in terms of salary, personal/business expenses, and bonuses that you pay to yourself and/or retirement plan savings. All of this constitutes money that’s coming to you from the cash flow of the business going towards the lifestyle that you have built for yourself.  The second and potentially much more important aspect, is getting to the equity – the illiquid part – of your business.  The equity is your ‘owner’s value’, the reward for growing your enterprise and taking the risk as a shareholder and investor.

Leading with Personal Planning, Measuring the Value Gap

As a part of the process of tapping into your equity value, it is helpful to first know your Value Gap – i.e. how much money you need to extract from the business in order to maintain your lifestyle without the business.  The chart below helps to illustrate this point.

We see that Bill Brown has $1,000,000 saved for retirement but needs $7,000,000 to maintain his lifestyle.  Bill’s Value Gap is $6,000,000.  The question becomes, ‘How can Bill get to the equity in his business in order to close this Value Gap?’

Value Gap

Like most business owners, Bill is focused on running and growing his business.  Bill has some money saved for retirement.  However, as we can see, it is nearly impossible for Bill to extract enough ‘income’ from his business, at his age, to meet his personal financial goals – Bill needs to get to the equity in his business.  The question that Bill is looking to answer is, ‘how can I plan to tap into my business equity, over a long enough time period, to draw it out to meet my personal goals (without hurting my company’s cash flow)?’

The Many Paths to Harvesting Equity Value

The first step is to realize that there are many ways to get to the equity in your business.  You can find a buyer, groom a successor, or even create a buyer for the shares of your company’s stock.  The most important part of this planning process is to recognize that any one of these options requires a process.
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Are You Building Equity or Income in Your Business

Many business owners run their businesses based on their current lifestyle needs. However, when you begin to consider who will own your business after you, i.e. your exit from your business, you need to ask yourself whether you are focused on creating a stream of personal income from your business, or whether you are actually building equity, i.e. ‘value’ within the business. The difference between these two opposing perspectives will reveal itself when your turn comes to exit your business and may have a large impact on your ability to transition your company.planning

Is Your Business a Job or An Investment?

An owner who builds their business with a primary focus on personal income, for the most part, has a job. An owner who builds their business by making decisions that are likely to increase their equity value has an investment. One day someone other than you will be running your business. Will that successor be purchasing a job from you or an enterprise?

Your eventual buyer or successor will likely be interested in knowing about the equity that you have built, not about the income that you have achieved within your business. And, as an owner who is considering a future exit, you want to speak in terms of equity and not just in terms of income.

You see, income can vary according to the personal needs of the owner-operator. However, equity can be expanded and value can be driven into your business once your focus moves to an ‘equity driven’ model.

The Building of Equity Value

Technically, ‘equity’ is a Balance Sheet term which is equal to your assets less liabilities; this equation reveals your owner’s equity. However, we are not discussing the financial reporting within your business, we are discussing the manner in which you make operational decisions to increase the value of your business.

Let’s look at an example to make the point. Jim owns a distribution company and spends most of his time focusing on building strategic relationships to increase sales, as well as increasing the capacity of his business to distribute more products. He does most of this work alone, without an empowered or incentivized management team. Sounds simple enough. However, Jim’s mindset is towards conducting these activities so that he can take a larger salary and bonus at the end of the year. Again, to most reading this newsletter, that sounds like a very reasonable objective. But there is a problem, a very predictable and obvious problem once Jim is aware of it.

The problem is that Jim is not spending any time considering who would be doing his ‘job’ at the company in his absence. While it is true that the company can run for a week or two as Jim takes his vacations. Or perhaps the business could even sustain for a few months if Jim were to want time off or had a physical problem that prevented him from working – these instances alone would not materially affect Jim’s income. However, Jim is not protecting the equity in his business with his decision making process. Jim’s equity, and hence his illiquid business wealth, is at risk because Jim has not focused on his business as an investment.
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