There are active markets for liquid securities. These markets comprise a substantial portion of the wealth of America. There are also assets that, by their very nature, are illiquid in that they have no well-developed markets. Examples might include commercial real estate, developmental land, timber, other real estate assets, oil rights and many others.

The example for discussion today, however, is your illiquid (pre-liquid) investment in your closely held or family business.

Pre-Liquid Wealth

At the outset, let me say that there are markets for entire companies. If you own a successful private business, in all likelihood, it can be sold. The question in most cases is not whether a business can be sold, but at what price? With appropriate preparation, most businesses can be sold within a period of six to eighteen months.  I have been involved in the sale of many companies. Sometimes things go smoothly and sometimes they do not. There are a lot of moving parts to the sale of a business. I am not advocating that you sell your business. What I am advocating is that you need to manage, or get help managing, the wealth in your business just like you have others manage your liquid investments.

Most private businesses, by the time they reach a minimum value threshold of $3 to $5 million on the very lower end and up to the hundreds of millions or even billions from there, have two or more owners. There is great discussion of family businesses in the financial press; however, most businesses with multiple shareholders have at least some owners unrelated to any founder or her family. That’s why I always refer to private businesses as closely held and family businesses.

If you think about the wealth cycle, wealth tied up in private business tends to be illiquid. However, I like to use the term pre-liquid to describe private company wealth. There is generally a thought that at some point, your investment in a private business will be liquefied. That can occur through a sale of your business. But you can also develop liquidity from your business while still owning it.

The Ownership Transfer Matrix

One fact before we proceed. You will sell your business or your interest in it. You will do so voluntarily or involuntarily and you will sell all or a portion of your business. If you hold onto your business interest until you die, you will “sell” your interest to your estate. The following graphic, which we call the “Ownership Transfer Matrix,” depicts what I’m talking about.

The bottom line about the Ownership Transfer Matrix is that there is no way out of the boxes. Some of the things that can happen are really bad from the viewpoint of your personal wealth, your family’s well-being, and your own peace of mind and enjoyment of life. So you might as well be sure that you move around in the boxes of the Ownership Transfer Matrix on a voluntary basis to the extent you can, based on your plan.

Diversification Can Be Difficult

Let’s return to Mr. Jones, the business owner with $5 million in liquid assets from an earlier post. While talking with him, we learn that he also owns a controlling interest (two-thirds) in a successful company and that interest has just been appraised as having a fair market value of $20 million. As a result, the asset allocation chart we saw in the previous post (Chart 1 below) is highly misleading regarding the actual level of diversification in Mr. Jones’ total investment portfolio.

Chart 1

Instead, the actual asset allocation chart (Chart 2) looks like following, and does not reflect much diversification at all.

Chart 2

Mr. Jones likely did not tell his financial planner about the appraisal of his business. Or if he did, perhaps the planner thought there was little he could do about the situation and so chose to ignore it. That may be okay for Mr. Jones’ financial planner, but it is not okay for Mr. Jones.

There is a philosophy regarding concentration of risk first attributed to Andrew Carnegie that can be summarized as:

Put all of your eggs in one basket – and then watch that basket!

However, there is another philosophy, attributed to an unnamed investment adviser by Steve Parrish writing for Forbes.com:

Concentrate to create; diversify to protect.

The advice of Andrew Carnegie to the contrary, it is a good idea, over time, to attempt to diversify closely held wealth. It may be necessary to concentrate to create wealth, or to put all your eggs into one proverbial basket for a while. However, at some point, as wealth grows, it does become wise to diversify to protect. Bad things happen to even really good companies.

We will talk about methods of diversifying closely held wealth  as we continue.

The bottom line for Mr. Jones is that his overall wealth is not well-diversified. We don’t know at this point if Mr. Jones is concerned about his lack of diversification or oblivious to any potential problems that might arise. But remember the purpose of diversification is to spread risk. Mr. Jones is highly concentrated in his business, Jones Manufacturing, LLC.

The One Percent Solution

Assume that the management fee on for Mr. Jones’ liquid portfolio averages is about 75 basis points. That means that Mr. Jones is paying $37,500 per year in management fees on his $5 million portfolio. Management fees are typically paid quarterly and, in many cases, in advance.

What is the “management fee” for Mr. Jones’ $20 million investment in his closely held business? Almost certainly, no management fee at all is being paid on this $20 million portion of his wealth.

Assuming a “management fee” of 75 basis points applied to the pre-liquid wealth of $20 million, the resulting budget for wealth management would be $150,000.  In fact, Mr. Jones, if he is currently thinking like some business owners I know, might consider expenses related to wealth management of even $37,500 per year to be either unnecessary, exorbitant, or both. What I know from more than 30 years of working with business owners is that while they may not like the idea of paying “management fees” to manage the wealth in their businesses, they need to do so.

Thus, we have introduced The One Percent Solution in simple form. Allocate 1% (or some %) of the value of your closely held business to create the budget for wealth management activities. We’ll work with the concept in more detail as we proceed, but there it is, a simple idea that can change your wealth profile, your risk profile, and your life, and all for the better.

I hope this little book will help change the thinking of not only business owners, but wealth managers, financial planners and other business advisers as well, by introducing the concept of The One Percent Solution – a new and powerful way to think about managing wealth tied up in illiquid investments in closely held and family businesses. With this concept:

• Wealth managers can begin to talk to business owners about managing all of their wealth, thereby enhancing their relevance to private business clients.
• Financial planners can begin to talk to their clients about the necessary budgets for longer-term planning, buy-sell agreements, and life insurance to fund stock purchases in the event of unexpected deaths.
• Attorneys can begin to talk about regular reviews of corporate planning documents as well as the status of wills, personal planning, succession planning and more.
• Accountants can begin to talk to private corporate clients about buy-sell agreements, other corporate planning and personal planning, as well.

Importantly, business owners can begin to think, realistically, about managing all of their wealth, both liquid and pre-liquid.

Conclusion

If you are a business owner, my hope is that you will never think (or act) the same way about the portion of your wealth in your closely held or family business.

If you are an adviser to business owners, my hope is that you will never let your clients bifurcate their wealth management planning into active management of liquid assets and ignoring, for the most part, the wealth tied up in their closely held and family businesses.

As always, please let me know by commenting below if you have thoughts or suggestions as we proceed to discuss various aspects of The One Percent Solution. Call me at 901-685-2120, or email me if you’d like to discuss any of these important issues in confidence.