Taking Some Chips off the Table: How to De-Risk and De-Lever

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One of the big reasons entrepreneurs come to us is that they’re feeling the weight of risk and liability on their shoulders more than they used to. Sometimes they just want to distribute the responsibility a bit and free up their time and energy, and other times the decision is more financial: as they get closer to retirement or their next big venture, the potential impact of small mistakes starts to feel bigger and harder to reverse.

This is a very real concern, and the stakes are high: it’s been said in middle market companies that up to 80 percent of entrepreneurs’ net worth is tied up in their relatively illiquid business. Unlike publicly traded stocks like Apple, which you can sell through a stockbroker, selling a private company is more complex and less liquid.

Still, making the choice to diversify and de-risk is just as important with your own company as it is with your other investments. As with Apple stock, it’s not wise to put all your investments in one place, because if something happens to Apple, you’re in trouble. Entrepreneurs may feel more in control of their company and therefore invulnerable, but diversifying those investments into areas like real estate, bonds, and stocks is a savvy move for financial security.

Regardless of your reasons, at a certain point you feel increasingly ready to take some chips off the table. By partially cashing out while retaining ownership or leadership, you can take some weight off your shoulders and sleep better at night, without stepping out entirely.

So how do you figure out the best path forward?

Questions to ask yourself when deciding your next steps

1. How comfortable are you with risk? Think about how much risk you’re okay with taking and how it fits with your financial goals. How would you handle losing money, and how it would affect your overall financial health?
2. How comfortable are you with debt? Look at how much debt you have now and how you’d handle more. Think about the interest rates and terms of any new debt, as well as your ability to make regular payments.
3. Are you keeping up with your competitors in terms of spending and investing in your business? Check out what your competitors are spending and investing in. See if your own spending and investment plans are enough to keep up with or beat your competitors.
4. Do you want to reduce your risk or take some profits off the table? Think about your long-term goals and whether you want to take less risk or make sure your money is safe. Weigh the pros and cons of reducing risk, like having less chance of making more money and missing out on opportunities because you’re not taking on more risk.
5. Are you moving towards something or away from something? Think about what drives you and what you want to achieve, since this kind of insight will clarify a lot of your next decisions.

What are your options for liquidity?

If you’re uncomfortable having all your eggs in one basket, you’ve got some options for seeking liquidity. Consider moves like these:

1. Transfer some risk to the bank. For example, if your company is worth $40 million, you could secure $10 to $15 million in debt against the company and pocket the liquidity.
2. Minority recapitalization, where you sell 30 percent of the equity. This way, the company doesn’t take on more debt, but you still achieve some liquidity.
3. Majority recapitalization, where you sell a controlling interest of 51 percent or more. You can still run the company and be the CEO. This is sometimes called the “second bite of the apple,” partnering with private equity and potentially selling the company four or five years later.

It’s all about weighing your options, considering your comfort level, and thinking about what you want for your business’s future. Sometimes, the best approach might be a mix of strategies.

For instance, you might bring in a CEO and take on some debt, letting them handle the financials. Or perhaps, take a minority partner on board and also hire a CEO. These moves bring in a partner in some form, who can share the burden, provide expertise, and offer support. This kind of partnership can invigorate your business and alleviate the all-too-common loneliness of leadership, allowing you to move forward with greater peace of mind.

When you’re ready to start handing over the reins without veering off the path, what kind of transfer options do you consider?

Transferring ownership without major disruption

Increasing liquidity doesn’t just affect your present financial standing as the business owner, but also sets the stage for the future transition of the business. A smooth transition not only ensures the continued success and legacy of the business but also reflects the strategic liquidity decisions made earlier.

If you’re ready to step back but don’t want to risk your business taking an unpredictable turn in your eventual absence, consider some internal transfer options:

• To another partner: Often seen as the most straightforward route, transferring ownership to an existing partner leverages the shared business vision and understanding already in place.
• To a management team: Ideal for owners looking to preserve the company’s culture and operational continuity. This method empowers those who know the business best to guide its future.
• To a family member: This approach keeps the business in the family, allowing for legacy preservation and potentially smoother transition with a deep personal connection to the company’s history and values.

Regardless of the recipient, the transfer process typically involves three key stages:

1. Establish a valuation: First and foremost, understand the worth of your business. A fair and objective valuation sets the foundation for a transparent and equitable transfer.
2. Agree to key terms: Once a valuation is established, both parties must agree on the terms of the transfer. This includes roles and responsibilities post-transfer, expectations, and any contingencies.
3. Figure out financing/mechanism of transfer: Finally, decide how the transfer will be financed or executed. Options vary widely, from direct purchase to installment payments or leveraging existing assets and earnings of the business to finance the deal.

Laying the groundwork for a transfer

To secure a fair valuation for a business transfer, engage an investment bank for a market-informed perspective and complement it with a CPA’s financial analysis. This dual approach will help you get a comprehensive valuation, reflecting both intrinsic worth and current market conditions, crucial for a successful ownership transition.

Make sure you’re clear on your net number. Knowing the gross amount you could receive from a transfer is one thing, but understanding the net amount—what you actually keep after taxes, fees, and other deductions—is crucial. This “net number” is what truly matters at the end of the day, as it represents the real value you derive from the transaction.

Know your company’s ecosystem position. Awareness of where your company stands within its industry ecosystem can significantly influence its valuation. This involves understanding not just your company’s strengths and weaknesses but also how it compares to peers, its market share, and its growth potential.

There’s a lot to mull over, but at the heart of it, the decision isn’t just about the numbers or the business—it’s about what you want for your company and, more importantly, for your life. It’s as much a personal choice as it is a financial or business one.