“You can consider your new business a success if you are in the black by the end of your third year in business.”
Owners of start-up companies probably know that statement all too well.
In fact, one of the most common reasons new start-up businesses fail is being under-capitalized. New business owners sometimes underestimate the amount of capital needed to fuel a new enterprise and may find themselves investing more of their own capital into the growing endeavor. As a result, in the early years, they may not be able to take much in the way of salary or even reimburse themselves for their investment.
Lifestyle Goes Up a Notch
Considering the struggle to get into the black, it’s not surprising that, after the business begins to produce healthy profits, these owners want to begin reaping the rewards of their sweat, sacrifice, and effort. So, as the business profits increase, many owners also increase their personal lifestyle: boats, cars, second homes, travel, and country clubs… It all just seems to come with the success of the business.
Now let’s talk family members. About this time in the life cycle of the business, additional family members may become involved in the business, and before long there may be several family members and households dependent on the business profits
Why is this dangerous?
There are several reasons. This pressure to payout cash may be draining the business of necessary capital for growth and sustainability. During our most recent recession, many owners found they had to make some very difficult choices. How long could they keep the business running during lean times and maintain the lifestyle they had grown accustomed to? How do you face the fact that you can no longer afford the luxuries the business has been paying for? What if the business can no longer pay family members who are now dependent on the business for their income? Many businesses did not survive the recession, and some owners also lost substantial personal assets as a result!
Piggy Bank Syndrome: What can you do about it?
Our process at Business Transition Academy helps owners prepare for their eventual exit from their businesses. One exercise that almost always takes owners by surprise is finding out just how much they derive from their businesses in the form of salaries, perks, and benefits. It is not uncommon for owners to want to minimize profits as a means of minimizing their tax burden and to use the business as their personal piggy bank. Soon, there is no line between their personal expenditures and the business expenses.
Recently, I spoke to a financial advisor who had just met with the son of a successful business owner. The advisor was providing financial planning services to the son and was astounded to find out that the son didn’t even have a personal bank account. He had a company debit and credit card and absolutely no idea what he spent monthly! Maybe this is an extreme case, but most owners don’t realize all of the personal items and benefits the business pays for on their behalf. This practice, which may start out relatively small and innocent, can get out of control quickly as the business grows.
When planning for your eventual transition taking stock of what the business pays for—and how those expenses will be funded is eye-opening and you may have to face tough choices:
- Do you need to stay longer to increase business value and save more money?
- Can you reduce your current spending and save more outside the business?
- Do you need to consider lowering your standard of living post-transition?
Impact on Sale Value
Draining the business of profits reduces business enterprise (sale) value. By ratcheting up discretionary spending, improving their personal lifestyle, and/or attempting to minimize their tax liability, owners end up reducing their company’s value as well! Depending on their industry and the size of their business, every dollar of profit not recorded on the bottom line can result in three to seven dollars of lost sale price. For example, the loss of even ten thousand dollars on the bottom line could result in a reduction of thirty to seventy thousand dollars or more! This can add up quickly.
This can take substantial time to correct. Potential buyers seek business opportunities that have clean financials and tax returns that show repeatable and increasing profits for at least three years.
All businesses are at risk of losing profits for any number of reasons. Owners can protect their businesses and their wealth by:
- Resisting the urge to spend more as their business makes more
- Managing company profits to demonstrate and maximize business value.
- Diversifying their assets, investing wisely outside the business, and leaving sufficient capital in the business for possible lean times.
There is no substitution for taking the time to plan and prepare for an eventual business ownership transition. All owners will leave their business one day, planned or unplanned. Their businesses are most likely their largest assets and the eventual liquidity event will be the largest financial transactions of their lives. And yet, most spend little, if any, time preparing or planning for this event, leaving everything to chance. With the correct planning and preparation, owners can avoid falling into piggy bank syndrome and improve their outcome.