Many successful entrepreneurs have all their wealth tied up in their business. This probably make senses at a time when they are building the company’s activities and have ultimate control over its destiny. But is that still true once they have stepped back from active involvement in its operations to a lesser or greater extent?
Investment theory lays down that it is poor practice to keep all your financial assets in a single company. Businesses may find themselves subject to unexpected pressure, from new competitors or disruptive technology to extraordinary events such as the Covid-19 pandemic.
It is a huge risk to have all your wealth tied up in just one business, whatever your attachment to it. Instead, investment gurus recommend that you should diversify your holdings across a range of companies, sectors and geographic regions. That way, if something goes wrong with a particular investment, its impact will be less than life-changing.
However, this is not the way most entrepreneurial business owners work. Their wealth is likely to be mostly or completely tied up in their business, over which they have a great deal of control and can, to some degree, determine its success or failure. Many business owners are far more comfortable with this type of risk than they are with, for example, stock market investment, where there is risk but they have no control.
A question of control
The problem tends to become more acute when a business owner decides to step away from the company that they have built up and therefore no longer enjoys that control, or it is significantly reduced. Should they continue to have a substantial proportion of their wealth tied up in a company where, like a stock market investment, they cannot influence the outcome? There’s also the question of whether the executives now running the business want to manage it for a single or dominant large shareholder.
How involved do you want to be in the company after you give up its day-to-day running?
There are a number of questions that entrepreneurs in this position should ask themselves. Perhaps the most important is how involved they want to be in the company after they give up its day-to-day running.
Do they want to be an employee, a consultant, chairman or a director, or have other specific responsibilities? This may affect any decision on selling all or part of their ownership interest. Will any new owners wish to use the expertise of the founder, or might they decide to take the business in a new direction?
Linked to that is the question of whether the founder wants to keep benefiting financially from the business, or decides they would be better off using the proceeds of a sale to redeploy their wealth into a portfolio that can provide an income. If the business is in a high-risk sector, would they rather diversify their assets? Or do they have the ambition to invest in building a new venture?
Influence versus diversification
There are advantages and disadvantages to selling a large stake in the business. The arguments for keeping it are that you built it and understand it – you know the risks and will have more influence than you would if you were investing in a portfolio of publicly-traded investments. You are likely to have a say, even an informal one, over key appointments and strategic decisions, and will understand the products and the market, the risks and potential rewards.
However, the critical stumbling block is that your investments will not be diversified. Business owners generally take a lot of risk in the process of building up their wealth. In most cases, once they have stepped back from the business, they are likely to prefer to enjoy their wealth rather than worry about it.
Stepping back completely is always difficult and becomes even harder if you retain a large financial stake.
But stepping back completely is always difficult and becomes even harder if you retain a large financial stake. There is a risk that you will remain closely focused on the business and decision-making, risking friction with the new management team.
Equally, the business may not be able to provide you with the type of income you prefer. The returns from small businesses in the form of dividends may be lumpy and unpredictable, and successful entrepreneurs may prefer access to a steady income stream to support themselves and their families.
Taking it gradually
That said, it is difficult to move away from a business that has been part of your life for many years. There’s no requirement to do it all in one go. Owners can sell part of the equity but retain a shareholding that they gradually sell down over time as they grow more comfortable with alternative deployment of their wealth (buyers may prefer it, too, since it means the outgoing owner keeps a stake in the company’s ongoing success).
That gives time to founders to gradually shape their investment portfolio around priority areas in which they are most interested, or to build up their expertise in other sectors. There is a key role in such a process for a good investment manager, whether on a discretionary basis or not, who can design a portfolio in tune with the client’s areas of interest and knowledge.
A lot will depend on the way in which the business is transferred and the expectations around that on all sides. If a company’s founder continues to hold an influential position, such as non-executive chairman, they may be expected to keep a financial interest in the business (other investors may get nervous if they see a key insider reducing their exposure significantly).
If you choose to limit involvement to an advisory role, the incentive to retain a controlling or other significant stake in the business diminishes.
However, if you choose to limit involvement to an advisory role, the incentive to retain a controlling or other significant stake in the business diminishes.
Choose your purchaser
If you want to retain a residual stake and some influence in the business, it would be better to transfer shares to successors within the business or an employee ownership trust, rather than, for example, a private equity or venture capital firm, which may insist on running the company as they see fit, even though they might be ready to pay a higher price. If the business is being passed to family members, the founder should be clear about the parameters of their involvement.
There are other ways of blurring the lines. The founder of a business could opt to retain ownership of the premises from which it operates and negotiate a leasing agreement. This could provide a steady income stream that is not wholly dependent upon on the performance of the business.
It is always difficult to step away from a company you have spent much of your life building, but it is risky to keep a significant financial stake without meaningful control over the direction of the business, and, in the long term, it may be inadvisable. But there are a range of options that business owners can consider before they decide whether and how to leave the company they created.
The arguments for keeping a business that you built it and understand include that you know the risks and will have more influence on its performance than on a portfolio of publicly-traded investments, but the key risk is an ongoing lack of diversification.