Every time a business generates an extra $1 of profit, the business owner has a choice—leave that money in the business to reinvest or take it out to spend or enhance personal net worth. Most business owners don’t consciously think about this; instead, the entrepreneurial habit is often to reinvest heavily in the business. While reinvesting can be beneficial, especially in the early stages of a business, holding the majority of personal net worth in the business at the time of exit can present challenges. Here are six important reasons why owners should consider taking appropriate distribution dollars along the way before exiting.
1. Risk Reduction
We all know the dangers of putting all your eggs in one basket, and business owners are no exception. Warren Buffet once observed, “You can get rich by only investing in one stock, but you can’t stay rich that way.” When all personal wealth is tied up in the business, there’s not only a risk from concentration but also the threat of exposure to business creditors. Taking money out of the business before exit can mitigate these risks.
2. Reduces Current Income Taxes
There are several ways owners can withdraw money from the business while also reducing current income taxes. Strategies such as retirement plans and captive insurance companies can potentially allow owners to build tax-advantaged wealth outside the business, enhancing long-term financial security.
3. Increases Exit Options
When owners primarily reinvest in the business, they often need a substantial cash infusion at exit. This need for cash can limit creativity in exit strategies, such as transferring ownership to family members or selling to employees, who may lack the financial resources to buy the business. By taking distributions from the business along the way, owners preserve a broader range of exit options.
4. Increases Control Over the Exit Timing
Owners with a high percentage of their net worth tied up in the business often feel pressured to cash out. Taking distributions over time reduces this dependency, allowing owners to choose when they want to exit based on personal goals rather than financial necessity.
5. Increases Control Over the Exit Terms
The more an owner relies on business equity at exit, the greater the need for upfront cash in any sale. This reliance can restrict flexibility in deal terms, such as installment sales and stock swaps, which provide tax advantages. Receiving money over time enables owners to explore more favorable terms that align with long-term financial planning.
6. Reduces Co-Owner Conflict
When a business has multiple owners, conflicting exit goals are almost inevitable. One owner might want to sell, while another hopes to pass the business on to family. Reinvesting all profits back into the business can create tension among owners with differing objectives. Taking money out periodically reduces these conflicts, fostering better alignment of goals.
Final Thoughts: Planning for a Balanced Approach
Owners and their advisors should use sound financial forecasting to determine how much cash is necessary for the business’s growth. Any excess cash should be considered for distribution, allowing owners to diversify their net worth and minimize challenges at exit. Remember, if you later realize you took out too much cash, you can always reinvest it back into the business.
For more information on creating an exit strategy on your terms, contact us at info@flvcp.com.
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