Why diversification is a big challenge for business owners

Business owners’ greatest strengths are often their greatest weaknesses as well. The determination, willingness to take risks and relentless pursuit of a goal may be desirable characteristics for building a business, but not necessarily suited to sound investment planning.

Inevitably, business owners must take risks when they launch their companies. They may have sacrificed a secure income and taken on responsibility for both their own investment in the company and the wealth of others who have entrusted them with money as loans or investment. They are facing tough odds – while estimates vary, around 80% of new businesses fail within 18 months – and they usually have to surmount significant obstacles.

The qualities required make for great entrepreneurs, but may not be ideal for taking a balanced view of wealth planning. First is the focus on a single goal. Business owners tend to hold their wealth in just one or two assets – usually their business and their home(s). From one perspective, this makes sense. Why devote your life to your business if you’re not willing to ‘eat your own lunch’? Business owners often believe they can achieve a far better return on investment than any wealth manager.

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

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

These are valuable instincts without which entrepreneurs would be less successful in their primary activity, but it can be worth taking other steps to protect both the business and the 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 business may find itself subject to forces beyond its control, from central bank interest rate policy to disruptive technological innovation.

There are also liquidity considerations. A company owner that needs money at short notice cannot always sell a portion of the business rapidly. 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 isn’t liable to be compromised by personal financial considerations.

Lifestyle will also play a role. Company owners who have worked extremely long hours over several decades to build a sustainable business may feel that they want to start enjoying some of the wealth they have created. This will prompt a shift in focus from wealth creation to wealth preservation, which may necessitate a change in financial planning strategy.

Diversifying a business

A key aspect of protecting entrepreneurial wealth is found in good business practice. While many entrepreneurs may be seduced, to some extent, by the prospect of a multi-million-euro sale of their start-up to a big group with deep pockets, in reality this type of speedy realisation of the business’s value is rare, and usually requires a remarkable proprietary technological innovation, or ideal timing. Even with a thriving business, exiting is unlikely to be this easy. To survive, businesses have to be built to last, rather than for short-term gains.

Building for the long term rather than that elusive rapid flip calls for diversity of clients, of revenues and of funding, all vital to longer-term survival and growth. For example, many owners keep ploughing their own capital or those of friends and family into their business.

Often entrepreneurs are highly resistant to ceding any kind of control to external shareholders or funding providers, but bringing in alternative funding can be an important discipline for businesses, as well as the added benefit of an injection of new ideas. It can also be important if one funding source dries up for some reason – weak cash flow is usually the fatal blow for smaller enterprises.

Similarly, aiming to have as broad as possible a diversity of clients, and therefore of revenues, should be sound business practice. This is not always possible, but it should be a consistent ambition.

Personal portfolio diversification

Perhaps more important than business diversification is personal wealth diversification. Where businesses are dependent on the charisma and drive of a single individual, it is vulnerable if that individual has health problems, is struggling with family or marital issues, or has other distractions. Even the most dedicated business owner cannot always prepare for every risk, especially in their own lives.

It makes sense for business owners to hold some wealth outside their business, and in assets that are unrelated to their main source of income.

With this in mind, it makes sense for business owners to hold some wealth outside their business, and in assets that are unrelated to their main source of income. Technology entrepreneurs, for example, may be inclined to select a range of technology stocks for their private investments. While it can make sense to invest in what you know, it also makes sense to hold some assets in investments that are outside your main sector.

A significant amount of an entrepreneur’s financial and emotional capital is already tied up in the particular sector in which the business is active. If that sector experiences difficult conditions, they have no back-up. Some entrepreneurs may relish the motivation of an all-or-nothing investment, but it should not be the default option for those with financial responsibilities and an eye to the future. Business owners should be ready to move away from what they know and place assets in areas that are not subject to the same business conditions. If their company hits a rough patch, they should have other investments that may be doing better.

This applies to geographic diversification as well as sectors. If much of an entrepreneur’s business is based in a single jurisdiction, it can make sense to look at investments elsewhere. The UK’s Brexit conundrum has shown how quickly companies dependent on a single country can become vulnerable to sudden political upheaval.

Developing a diversification plan

While the exact mix of cash, bonds, stock market investments, real estate and other assets may be different for every entrepreneur and depend on individual circumstances, age, preferences and risk tolerance, the starting point for diversification is the same. If the business ran into a major financial 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, dependent on economic conditions and tying up the bulk of an individual’s wealth, they should not be taking similar risks elsewhere – the portfolio should be balanced with lower-risk assets that are less vulnerable to the economic climate.

The solution will often need to comprise not just investments but insurance, such as key man risk and illness cover.

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

The asset mix for entrepreneurs may well not be the same as for other investors. They must consider the business, as it is in many cases the owner’s largest asset. They should consider the prospect of a future sale or all or part of the company, which can influence tax, succession and inheritance planning.

While having all their eggs in one basket, as entrepreneurs tend to do, can be highly motivating, it can be extremely painful when things go wrong. Taking steps to diversify can ensure that entrepreneurs have a solid foundation to fall back on during difficult times.