Why diversification is a big challenge for business owners

Business owners’ greatest strengths can also be their greatest weaknesses. The determination, willingness to take risks, and single-minded pursuit of a goal that can make for highly desirable characteristics when building a business may not necessarily be well suited to sound investment planning.

Inevitably, entrepreneurs must take risks when they launch a company. They may have sacrificed a secure income and taken on responsibility for both their own investment in the company and the assets of others who have entrusted them with loans or equity investment. They face daunting odds – estimates vary, but around 80% of new businesses are estimated to fail within 18 months – and they usually have to surmount significant obstacles.

The qualities required make for great entrepreneurs, but may not be as well suited to taking a balanced view of wealth planning. Take the focus on a single goal, for example. The wealth of business owners tends to be concentrated in just one or two assets – usually their business and their home and property. From a focus perspective, this makes sense. Why devote your life to your business if you’re not fully committed to it? Business owners often believe they can achieve a far better return on investment than any wealth manager – and some of them are right.

Business owners may also be over-confident. This can lead them to underestimate risk and fail to see value in diversification.

Excess confidence, underestimation of risk

Business owners may also be over-confident – after all, they need to defy the odds to build a business. This can lead them to underestimate risk and fail to see value in diversification, whether in their business, or in their portfolio of investments and other assets.

These are valuable instincts without which entrepreneurs might well not succeed in their primary activity. However, it can be advisable to consider other steps to protect both the business and its owner’s personal wealth. Part of this is just down to common sense. Businesses are always at the mercy of market conditions. Sectors can be cyclical, and even the strongest company may be vulnerable to economic forces beyond its control, from central bank interest rate policy to disruptive technological innovation.

There are also liquidity considerations. A company owner who needs money at short notice may not be able to sell part of the business rapidly to raise liquidity; bringing in new sources of funding takes time. It makes sense to have alternative options available through personal wealth planning to ensure that the business is not at risk of being compromised by personal finance considerations.

Lifestyle will also play a role. Company owners who have worked extremely long hours for many years to build a viable business may wish to start enjoying some of the wealth they have created. This would prompt a shift in focus from wealth creation to wealth preservation, and might necessitate a change in financial planning strategy.

Building a business to last

A key aspect of protecting entrepreneurial wealth is found in good business practice. While many entrepreneurs may dream of the prospect of a multi-million-euro sale of their start-up to a big group with deep pockets, in reality such a speedy realisation of a business’s value is rare, and usually requires a remarkable proprietary technological innovation, or perfect timing in terms of market trends. Crystallising the value of even a thriving business is rarely so easy. To survive, businesses must be built to last, rather than for short-term gain.

Prioritising the long term rather than that elusive quick flip demands diversity of clients, of revenue and of funding, all vital to long-term survival and growth. For example, many entrepreneurs keep on investing their own capital or that of friends and family into their business.

Frequently business owners are highly resistant to the idea of ceding any kind of control to external shareholders or other providers of funding, but bringing in external capital can be an important discipline for businesses, and sometimes also brings the added benefit of an injection of new ideas. It can also be important if one funding source dries up for some reason – inadequate cash flow is often a fatal blow for smaller enterprises.

In the same way, seeking to attract a broad and diverse range of clients, and therefore of revenue, should be sound business practice. Depending on the nature of the business and its field of activity, this may not always be possible, but it should always be the company’s ambition.

Ensuring a balanced personal portfolio

Perhaps even more important than diversification of business funding and revenue is diversification of an entrepreneur’s personal wealth. When a business is dependent on the charisma and drive of a single individual, it is vulnerable to any health problems, family or marital issues, or other distractions facing its key man or woman. Even the most dedicated business owner cannot prepare for every risk, especially unforeseen events in their own lives.

Business owners should hold some wealth outside their business, in assets that are unrelated to their main source of income.

If possible, business owners should therefore hold some wealth outside their business, in assets that are unrelated to their main source of income. Technology entrepreneurs, for example, may be prone to select technology stocks for their private investments. While it is logical to invest in what you know, true diversification should mean holding some investments that are distinct from and uncorrelated with your main occupation.

A significant amount of an entrepreneur’s financial and emotional capital is already tied up in the sector in which their business operates. If that industry experiences difficult conditions, there may be no plan B. Some entrepreneurs may relish the motivation of an all-or-nothing focus, but it should not be the default option for those with financial responsibilities and an eye on the future.

Business owners should be ready to move away from what they know and invest in assets in areas that are not the product of, or subject to, the same business conditions. If their company experiences a rough patch, they should have the comfort of other investments that may be performing better.

This applies to geographic as well as sector diversification. If much of an entrepreneur’s business is based in a single country, they should consider investments elsewhere. The impact of the UK’s withdrawal from the European Union and the outbreak of war in Ukraine have demonstrated the risks entailed by companies dependent on a single country or a particular market relationship in the event of unexpected political upheaval.

Developing a diversification plan

While the exact mix of cash, bonds, equity investments, real estate and other assets is liable to be different for every entrepreneur and depend on their personal circumstances, age, preferences and risk tolerance, the starting point for diversification is the same. If the business ran into a major problem – an economic recession, a natural disaster such as fire or flood, or an illness keeping the owner from work for an extended period of time – could their business and personal finances stay afloat?

If the business is a high-risk asset, highly dependent on economic conditions and encompassing the bulk of an individual’s wealth, they should not be taking the same level of risk elsewhere. Their portfolio should be balanced with lower-risk assets that are less impacted by the prevailing economic climate.

The solution will often involve not just investments but insurance, such as key person risk and illness cover.

A diversification plan requires analysis of every consideration, from an individual’s spending habits and family commitments to retirement provision. The solution will often involve not just investments but insurance, such as key person risk and illness cover.

The asset mix for entrepreneurs will in many cases differ from those of other investors. They need to take into account a business, which is typically the owner’s largest asset. They should consider the prospect of a future sale of all or part of the business, which can influence tax, succession and inheritance planning.

Having all their eggs in one basket, as many entrepreneurs tend to do, can be highly motivating, but it can be extremely painful if things go wrong. Taking steps to embrace diversification at all levels can give business owners a more solid foundation on which they can fall back if more difficult times emerge.