Diversification poses a real challenge for the small business owner. The reality is, the average entrepreneur has far too much of their wealth tied up in the business, which poses a great risk financially. Although total diversification is likely improbable and unrealistic for an active entrepreneur, there are ways to reduce your concentration. Here are three financial diversification strategies for the small business owner.
Top 2 Reasons Why Business Owners Need To Diversify
According to the 2023 National State of Owner Readiness Report by the Exit Planning Institute:
- 80% of business owners have the majority of their wealth tied up in their business
- Only 20-30% of businesses that go to market actually sell
To further illustrate the importance of diversifying, just consider how the valuation might change for a small business manufacturing facemasks in early 2019 versus one or two years later. On the other hand, imagine what the DOGE cuts might mean for a consulting company whose sole client is the federal government. It is so important to focus on what you can control, as uncontrollable factors can happen at any time and work for or against you.
Like real estate, a business is an illiquid asset. Having a high savings rate, a plan in place, and outside liquidity can greatly reduce risk.
3 Practical Strategies On How to Diversify As A Business Owner
Until (or unless) you sell your business, full diversification is unlikely. But some diversification is achievable, and for the majority of business owners, it’s a worthwhile endeavor. It is important to note that not all businesses, or entrepreneurs, are alike.
Some small businesses, particularly services businesses built around the skills or reputation of the primary owner may not be salable. In those cases, it is less about managing risk until a major sudden wealth event when the business is sold. Instead, the focus is more towards utilizing profits and managing expenses to maximize liquid assets along the way.
Diversify Around Your Business
As a business owner, you already have a concentrated stock position in your own company. Since this asset is 100% equity, entrepreneurs planning to exit their business at some point may want to consider adjusting the rest of their portfolio around their major holding.
Consider tailoring the allocation of your investment accounts depending on the relative value of the business versus your other assets, your risk tolerance, etc. In some situations, it may make sense to overweight or exclusively hold less risky investments (e.g. bonds versus stocks) in brokerage or retirement accounts. United States Treasury securities are considered the safest investments. The bond market is deep, so investors may also want to consider diversifying their fixed income portfolio, for example using investment grade corporate bonds or municipal bonds.
Another way for small business owners to diversify around their business is by tailoring their equity portfolio to overweight sectors or regions that are uncorrelated with the nature of the business or exclude firms in the same sector.
Cash Management
Diversification is all about reducing risk. With cash, the biggest risk is typically the loss of purchasing power over time, as interest rates may not keep pace with inflation. For small business owners, having liquidity to get through a rough patch is an essential part of staying in business.
Business owners need to keep more cash than W-2 employees. Figuring out what that number is can be quite challenging as the issue is twofold: the company’s cash needs and your own personal reserves, which are separate.
Business cash
As entrepreneurs know, managing cash flow using only a profit and loss statement will lead to trouble. As with many things in life, timing is everything. Keeping a spreadsheet or model to forecast income and expenses, updated with actuals, can help tremendously. Don’t forget to include distributions not directly related to business expenses, such as withdrawals to pay personal quarterly tax payments or K-1 distributions, particularly if you have partners.
Every business will need a different cash buffer beyond working capital, depending on volatility of income and costs, fixed expenses, seasonality, margins, and so forth. Short-term cash reserves should be held in a interest-bearing checking or money market account. For ongoing rainy day funds or matching significant longer-term liabilities, consider other options such as the fixed income securities mentioned above or even just a high-yielding money market fund.
Personal cash
As with everything in personal finance, exactly how much cash you need is personal. Consider factors like your assets, current liquidity, household income, etc. Having enough liquidity can help business owners diversify financially and reduce the risk that short-term hurdles become real problems. As a general rule-of-thumb, consider keeping at least one year of necessary personal expenses in cash. One-income households or businesses that don’t have adequate cash reserves yet may require the business owner to stash more cash.
Diversify By Adding To Your Outside Assets
Whether or not you expect a large windfall from selling your business, one of the best ways for small business owners to diversify financially is by having a high savings rate and ongoing dedication to investing outside of the company. Remember, a lot can happen before a successful exit.
There are several ways to add to your outside assets and diversify as a business owner:
- Don’t automatically reinvest everything into the business. Pay yourself too. Don’t be afraid to take profits.
- Consider when or if it makes sense to take on a partner, outside investor, minority shareholder, or even using debt financing instead of cash on hand.
- Maximize retirement savings with a qualified retirement plan. Consider exploring plan design options and retirement savings vehicles, such as a cash balance pension plan or individual 401(k).
- Monitor your expenses – business and personal. Spending less makes it easy to save more!
The business will grow at a different rate than your personal assets. If you expect to sell at a big multiple, it is likely that your outside assets won’t ever eclipse the value of the business pre-sale. But through ongoing diversification efforts, business owners can improve their liquidity and build their contingency retirement plan, just in case.
Work On – And In – The Business
Most entrepreneurs are so consumed keeping up with the day-to-day that they lack the time for strategic planning. This includes defining their business goals, current value of the firm, ways to diversify the company’s revenue streams, and other key performance indicators (KPIs). Busy operators should consider working with business consultants that can help advise on growth, operations, and exit strategies, as well as help with ongoing accountability to ensure plans are implemented.
The word is spreading. The Exit Planning Institute’s study reports that 62% of respondents in 2023 completed a formal pretransition value enhancement or due diligence project in the last two years.
Megan Kearney, Partner at Exit Factor in Lexington, MA, regularly helps coach and support business owners in these areas. She notes that “without strategic preparation, a business is statistically unlikely to sell successfully.” Most businesses lack a dedicated business advisor, leaving a sizable advisory gap in a typical professional team which includes legal and accounting/tax on the corporate side and a wealth advisor, estate planner, and tax advisor on the personal side. Although there’s often ‘creep’ from the personal side to the business, the personal advisors are not going deep or wide into the firm’s operations, profitability, workflows, and so forth.
Building a team with a shared mission can make all the difference. Kearney notes, “Diversification is critical, building value beyond the day-to-day operations can not only expand exit options but also safeguard owners’ future wealth.”
Other Considerations
Aside from diversifying, there are a number of other planning items that entrepreneurs must consider as it relates to their company and personal situation, though a complete discussion of these issues is outside the scope of this article.
- According to the Exit Planning Institute’s study, only 30% of business owners have an updated estate plan. Less than one in four even has a will!
- Figuring out how much you’ll need in retirement and what you want to retire to
- Disability and key-man insurance
- Key deal terms and liquidity options
- Legal tools to help facilitate a smooth transition of ownership, such as buy-sell agreements and trusts
- Estate tax considerations and liquidity issues
- Understanding the transition timeline and sale process
It is easy to push these items to the bottom of the to-do list. But the reality is, exit is top of mind for most business owners. The 2023 survey reported 49% of respondents want to exit within the next five years and 75% with in 10 years. Entrepreneurs seeking to transition within five years may want to consider attending this upcoming webinar on exit planning.
Final Word On Financial Diversification For Small Business Owners
The focus of this article has been on how to diversify financially as a small business owner while running the company. But it is worth repeating the statistic on how many entrepreneurs plan to sell their business, and how few are able to. The best way to combat this risk is to start planning your exit, transition, or succession plan early. Get a valuation done, understand the market and what metrics can improve the sale price, and meet with business brokers. This will help inform your perspective on what risks you face and what approach to diversifying makes the most sense for you and your business.