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Business owners must diversify

Doing so can make succession easier

By Lorie Zimmer, CPA, PFS

You may have a great business, but unless you pull money out of it and diversify into other investments, you could be dooming your family company to failure — particularly when it's time to hand the reins to your children.

"The problem is that most family business owners are so consumed with the business that it's all that matters to them," says Andrew Keyt, executive director of Loyola University Chicago Family Business Center. "It's okay to be single-minded, but you also need to diversify."

Keyt, whose not-for-profit group educates entrepreneurs running small- and medium-size companies, estimates that nine out of 10 owners of small businesses have virtually all of their net worth concentrated in those operations. "The bigger the business gets, the more likely the owners are to diversify," he says, "But it's typical that owners of successful businesses with annual revenues of $5 million or less have more than 90 percent of their wealth tied up in the business."

It's important for owners of small businesses to think about their own futures, rather than focusing exclusively on the future of their company. And that means pulling cash out of the business and investing in other assets — securities, real estate, another business, or any of a wide range of other investment opportunities.

Keyt says business owners should get in the habit of reallocating assets as soon as their businesses become profitable. Obviously, some earnings will have to be pumped back into the company to keep it growing. But without a strategy to divert some profits into other investments, you'll make it harder for your children to take over the business.

It's estimated that just 30 percent of all family businesses survive the passage to a second generation, and only 11 percent continue to exist under a third generation of owners. While estate taxes are often blamed for killing off family businesses, Keyt thinks the real culprit is controlling shareholders who fail to diversify into other assets.

If you have little liquidity outside of your business, it makes the succession to the next generation much more emotional, says Keyt. "Because the parents' financial fate is so tied up in the successful continuance of the business, the succession process is much riskier and creates a lot more tension. You're less likely to let your children take over." In contrast, parents who have a financial life outside their business will be much better prepared to let the kids start running the show.

"You need to be able to re-launch your children, just as you did when they went off to college," says Keyt. "You have to give them the freedom and control to take the business where they want it to go. And the only way you can do that successfully is by being diversified in assets outside of the company so that your financial fate is no longer dependent on how they run the company."