Following a series of posts introducing aspects of what I call The One Percent Solution for Managing Pre-Liquid Wealth, it is now time to elaborate on exactly how The One Percent Solution should work in practice. This concept is based on the premise that owners of closely held businesses should treat their ownership interests as important investments. So now, we get to the heart of the simple concept of The One Percent Solution.
First, however, we need to understand what The One Percent Solution is not. This concept has little at all to do with managing your business. Owners and managers must always manage businesses. Businesses models involve the production of goods or products, the delivery of services, the distribution of materials or goods between manufacturers and retailers, the delivery of goods and services through internet-based vehicles, and many more.
And businesses create wealth. Business schools talk about management and supply chains and marketing and many other aspects of businesses. Business schools, however, do very little to teach how to manage the wealth created by closely held and private businesses.
So how can business owners begin to better manage the wealth in their businesses? Now we can examine The One Percent Solution.
The One Percent Solution
What is the solution to financing the expenditures necessary to manage the wealth tied up in closely held and family businesses? The solution is so obvious that we overlook it, thinking that such activities either are too expensive, too time-consuming, or worse, not a high priority.
For business owners, the solution lies in the decision to treat their ownership interests as investments. The process begins with The One Percent Solution for Managing Pre-Liquid Wealth.
The One Percent Solution suggests allocating a percentage of value for the illiquid assets under management to provide the budget necessary to manage wealth. There is no formula for the precise percentage of conceptual value for the management fee. I am promoting the concept and not any particular percentage.
If the wealth were liquid, that budget would be one percent of assets under management, plus or minus, depending on the asset category of investment. For pre-liquid wealth, we suggest starting with a budget for investment management on the order of 100 basis points (1%) or so of value. If, after planning is instituted, the budget can be lowered on an ongoing basis, that is fine. And the fee would scale down as a percentage of value (AUM) as value increases. There is only so much “management” that will make sense at any point in time.
The last column in the table above calculates the “management fee” as a percentage of assumed pre-tax earnings. This is to highlight that management activities are not free and that there are real expenses associated with managing pre-liquid wealth. Focus on the middle line in the table where pre-tax income is $10.0 million. If the appropriate valuation multiple is 6x, the business is worth $60 million. We have assumed that the appropriate “management fee” is 50 basis points of this value, or $300 thousand. That turns out to be 3.0% of reported earnings. The table shows illustrative examples for both higher- and lower-earnings companies.
Let’s look at how this One Percent Solution budget might be employed and obtain a glimpse of what it might accomplish in the wealth management process.
One Percent Solution Activities
What would your One Percent Solution budget be spent on? There are a number of possibilities:
Wealth Manager Compensation. The wealth manager who introduces One Percent Solution concepts to business owners may seek compensation based on a percentage of the value of the business, or based on specific fees. Wealth managers include financial planners, attorneys, accountants and other consultants who work with business owners to help manage their wealth. You will pay some of these professionals at their regular hourly billing rates, but that’s all part of your One Percent Solution budget for managing illiquid wealth.
Annual Appraisals and Monitoring of Performance. Liquid assets are valued every day, and portfolio performance reports are made at least quarterly for most portfolios. Annual valuation is the best way of tracking investment performance over time, and for reporting to shareholders about a company’s return performance relative to itself and to other asset categories.
I have been advocating the benefits of annual, or at least periodic, appraisal of businesses for more many years. When I speak to business owners I sometimes joke and say that in the early years, I encouraged annual appraisal because it would be good for my business! Now, after many years of working with private businesses, I unabashedly make the recommendation because it is good for their businesses and your business as well. We now provide annual appraisals for more than 100 companies. Some of these companies have been clients for 25 or more years. There is clearly value in the process.
Buy-Sell Agreement Pricing. Annual valuations can also establish the value for buy-sell agreements. They are so important that I have written a print book and an Amazon Kindle book about these critical and oft-ignored business agreements. In fact, the valuation process I most often recommend is that a single appraiser be agreed upon and employed to provide an initial valuation for buy-sell agreements, and then that the appraiser will provide annual revaluations to revalue the price for the buy-sell agreement. Note that the annual appraisal for purposes of your buy-sell agreement would serve multiple purposes. (See www.buysellagreementsonline.com)
Annual or Periodic Review of Corporate Documents.
Life Insurance Funding. The budget could certainly include the cost of life insurance purchased on the lives of key shareholders to fund stock purchases from deceased owners in accordance with buy-sell agreement provisions. The annual valuation can establish the amount of life insurance needed, and be a prompt for necessary adjustments to the amounts purchased as value changes over time.
Let me make the following point about life insurance and buy-sell agreements. It is essential that the owners agree, in advance, about how life insurance proceeds will be treated for valuation purposes. It is also essential that the language in the buy-sell agreement and any related documents be consistent and clear. I know I mentioned this issue above. It is important. The life insurance issue is treated in some detail both in the print book and the Amazon Kindle book mentioned above. (See www.buysellagreementsonline.com)
Estate Planning. Tax counsel could be retained to provide ongoing advice regarding gift and estate planning issues for shareholders. Estate planning takes time. You may need to work with family or personal consultants as well to help work through family issues like which children get the stock of the business and how much, and which children get other assets. Are there enough other assets for a “fair” (you define) resolution?
Ownership Transition Planning. Not all closely held businesses are “family” businesses. It is often necessary to consider the orderly transitioning of ownership to others if a business owner is going to be able to engage in a reasonable exit at some point. Ownership is all about having value where it needs to be when it needs to be there. More than a few business owners have made undocumented promises to share ownership with key employees. If those promises have been made, they need to be delivered.
Financial Planning. Key owners and shareholders could retain personal financial advisers to assist with their personal financial planning. The annual valuation will assist financial planners in advising with respect to asset allocation decisions for non-business assets.
Audited (or Reviewed) Financial Statements. While an audit might be considered a normal business expense, many private companies do not obtain an annual audit. It is a fact that having audited financial statements can enhance the ease of marketability of a business, so part of investment management expenses could include the annual audit – or at least make it easier to make the decision to obtain an audit or review.
Annual Legal Review. It is often helpful to have legal counsel review a company’s board of directors’ minutes and other legal documents and contracts on a periodic basis. This practice helps to identify and eliminate issues that, left alone, can create potential problems in the future. The investment management budget would also include an annual review of the buy-sell agreement by legal counsel and business advisers. Numerous other corporate documents require annual or periodic review, including insurance documents and insurance coverages.
Other “Make-Ready” Projects. Most businesses can be sold – at some price. Businesses that are “ready for sale,” however, tend to sell more readily and for better prices. In fact, the next book in this series, highlighted at the end, will address this important question of readiness for sale. Business that are “ready” are more attractive to larger pools of potential buyers, and their sales processes are less frequently caught in snags from surprises with inventories, accounts receivable, fixed assets, information shortfalls, and the like. If there are known issues at a company, it can be helpful to consider funding their correction with the investment management budget.
Corporate Finance for Private Businesses. It can also cost money to explore corporate finance solutions for your private business. Your business may be a candidate to engage in a leveraged share repurchase, or a special dividend, or a leveraged dividend recapitalization, or any of several other potential avenues to create partial liquidity and diversification for its owners – without selling the business. We will spend more time investigating these possibilities in future posts.
So you see, there are many things that you can do to begin to focus on managing the pre-liquid wealth in your business.
Most business owners work in their businesses. Those who consider their ownership positions as investments will also regularly work on their businesses and retain the professional assistance needed to assist in the process.
An “Almost Free” Lunch
I mentioned above that One Percent Solution activities cost money to implement. That is true. While there’s no such thing as a free lunch, the investment management budget for closely held firms may be at least partially free.
Any dollar spent is certainly not available for distribution or reinvestment, so investment management expenses are definitely not free. However, One Percent Solution expenses become almost free when returns are enhanced to more than offset the expenses, and when dollars spent on annual valuations, life insurance policies, estate planning, financial planning, etc. are added back to earnings by buyers in the their processes of “normalizing” earnings.
In other words, while dollars spent on investment management activities do reflect real expenses, the returns on their investments may exceed the actual investments and may be capitalizable at the time of any ultimate sale of a business.
This one is easy to misunderstand, so let me give a specific example. Assume a company has $2 million in reported pre-tax income and that the appropriate market multiple is 5x. If certain “non-normal” operating expenses associated with ownership and management transitions and as outlined above are “normalized”, they will added to earning by many buyers. At the present time, this may be possible, because most companies do not spend any or much money on managing owners’ wealth, so these expenses may well be considered to be normalizing adjustments by potential buyers.
Assume in this example that One Percent Solution activities are documented to be $100 thousand. Normalized earnings are therefore $2.1 million and the business is worth $10.5 million rather than $10.0 million. But after all, what’s $500 thousand among friends? Would you rather have it or not? Maybe almost a free lunch.
The One Percent Solution for Managing Pre-Liquid Wealth is an important concept for owners of closely held and family businesses. You want to manage your business, of course. But you also need to manage the wealth that your business creates for you and your family and your fellow owners.
Consider allocating a percentage, 50 basis points (O.5%) or 100 basis points (1.0%) as the budget for beginning to manage your pre-liquid wealth. The return on your investment will undoubtedly be substantial. Your shareholders may enjoy more liquidity and diversification. Your family will have peace of mind.
If all of this seems overwhelming, start small. Begin with a review of your buy-sell agreement with legal counsel, a competent valuation adviser, your personal and corporate financial advisers, and your life insurance adviser(s). You have to start someplace.
As always, if you wish to talk with me about any business or valuation-related matters in complete confidence, give me a call (901-685-2120) or email.
Until next time,