Family businesses can be incredible wealth generators that create a strong sense of legacy and accomplishment. With a never-ending desire to constantly improve, it is easy for entrepreneurs to fall into the trap of solely reinvesting in the business (their “baby”). Understandably, the net worth of typical entrepreneurs is highly concentrated in the value of their businesses. This concentrated position can create significant risks for the owner’s personal financial plan as it relates to the cash flow of the business and the timing and terms of a potential sale, which may never actually occur.
Specifically, according to the 2023 National State of Owner Readiness Report by the Exit Planning Institute, the business represents approximately 80% of a typical entrepreneur’s personal net worth. While capturing value via a transaction is a gold star achievement for many founders, the reality is that most businesses never sell. Instead, only about 20-30% of businesses that go to market execute a transaction.
Considering who the desired buyer is can also drive further complications. According to the 2023 National State of Owner Readiness Report, 60% of first-generation business owners favor an internal exit option. Further, 82% of second-generation business owners favor an internal exit. If a business is sold to the next generation, the top dollar potential valuation of the business may not be exchanged due to affordability and estate planning considerations for the younger generations. However, this mindset can put the current owners in a difficult position from a cash flow perspective post-sale.
Given that (1) not all businesses are well-positioned for eventual sale and (2) many business owners desire to pass on the business to their children, the diversification of total net worth is a strategy that can increase financial flexibility for both entrepreneurs and their families.
What are we trying to accomplish?
Questions I pose to business owners during planning meetings include the following:
- Is there a chance that your children will take over the family business?
- What is the desired timeline to execute this transition?
- Are you trying to essentially gift your children the shares in the business or take a very low payment, if any?
- Are you willing and able to continue working in the business for a certain number of years post-transition?
- Are there estate tax considerations in play (total net worth more than $30 million for married filing jointly and more than $15 million for individuals in 2026)?
How Can I Best Prepare for a Transition of the Business to Ensure that I am Financially Sound?
Oftentimes, when there is a desire to pass on the business to the next generation, the presumption is that the current owner will not receive top dollar for the business. This creates issues post-transition as the cash flows of the business generally cannot solely support the lifestyles of both Generation 1 and Generation 2. Therefore, once this goal is identified, I work diligently with Generation 1 to identify:
(1) What is the liquid net worth necessary to not be reliant on a cash out of the business?
(2) What are the annual savings required to hit that liquid net worth goal by the desired transition time?
Target Savings Rate
When meeting with clients, I focus immensely on the concept of a savings rate, rather than a specific dollar amount. In general, for clients aspiring to retire by age 60, an approximate 20% savings rate is required. The savings rate is determined based on the contributions to investment plans divided by the gross income. The inverse of the savings rate is the spending rate. A client saving 20% of their income is only spending 80% of their income annually. Over time, the 20% savings will build a liquid portfolio that can maintain the current lifestyle, generally around age 60. However, a client with only a 5% savings rate reflects a 95% spending rate. Therefore, the liquid portfolio will likely not be able to maintain the current lifestyle if employment ceases at age 60. Consider Individual A, earning $100,000, who contributes $20,000 annually to a 401(k). Individual A reflects an 80% spending rate. Consider Individual B, earning $1,000,000, who also contributes $20,000 annually to a 401(k). Individual B reflects a 98% spending rate. Therefore, Individual B will likely not be able to retire at age 60 and maintain the $980,000, annualized lifestyle given the low savings rate.
Even if entrepreneurs do not intend to pass the business on to Generation 2 at little to no buyout, building a robust liquid portfolio through consistent savings will provide business owners with increased flexibility. Has there recently been a significant change in the economy? No problem – the business owner can afford to push off the sale another few years due to the support of the liquid portfolio. Has the owner suffered a significant medical condition? No problem – the owner can afford to pivot and sell the business earlier than intended, even at potentially a lower than desired valuation, due to the liquidity available to support the family. In financial planning, any strategic move that will help promote flexibility and increase the viable options available is generally ideal. Entrepreneurs have enough unknown factors to consider. Our planning focuses on what we can control.
Allocation Considerations
Business owners inherently have a high allocation to private investments within their industry. Accordingly, some business owners may consider being overweight to fixed income (particularly municipal bonds for favorable tax treatment) in the liquid portfolio to yield the desired weighted average allocation across all assets. Similarly, some business owners may not be interested in private investments or a significant allocation to equities in their industry in the liquid portfolio. Both the liquid and non-liquid holistic net worth are key to establishing a strategic allocation.
Investment Account Considerations
Business owners have unique retirement savings tools that may result in additional contribution capabilities compared to standard W-2 employees. Specifically, two commonly utilized plans include SEP IRAs and Solo 401(k)s. Solo 401(k)s are like traditional 401(k) plans but are specifically tailored to business owners with no employees (other than a spouse). For 2025, employees can defer up to $23,500 of earned income into a traditional 401(k) plan. As the employer, participants below age 50 may contribute up to an additional $46,500 (capped at 25% of total income earned) for a total of $70,000 in annual contributions. Likewise, maximum contributions to a SEP IRA are up to $70,000 for participants under 50 (also capped at 25% of total employee compensation). Depending on the number of employees, the ease of setup, and whether the owner is willing to fund contributions for staff, retirement plans can be an effective way to reduce taxes and build savings.
As a complement to retirement contributions, entrepreneurs may also want to build immediately accessible liquidity in a brokerage account to promote flexibility. These funds can be utilized at any time without penalty and are subject to a favorable capital gains tax structure for distributions. Both retirement accounts and taxable accounts offer different pros/cons from a tax and accessibility perspective. Building wealth in both types of accounts enables flexibility.
Life and Disability Insurance Considerations
Especially for single-earning households, life and disability insurance can be a critical component of a financial plan. Life insurance can be viewed as a mechanism to replace the savings that would have been built over time if the deceased hadn’t passed. Similarly, disability insurance provides cash flow through a set age to replace lost income. Further, life insurance may be contemplated in certain business contingency plans. Specifically, if Owner A passes, the policy may pay out to Owner B to fund the buyout of Owner A’s estate. Careful planning must be considered for these contingency plans, including the review of the valuation of the business relative to the insurance proceeds available over time.
Trust and Estate Considerations
According to the same Exit Planning Institute Report, only 30% of business owners have an updated estate plan, and only 24% have a will. Given that a business is an illiquid asset typically without distinct beneficiaries listed, having a comprehensive estate plan incorporating the business is essential. Additionally, for married filing jointly families with a net worth of more than $30 million, there may be strategic transition structures available that would help limit estate tax consequences.
Key Takeaways
When selling a business, so many questions that cannot be controlled can arise. What will the health of the economy be like at the time of the sale? Will the next generation be willing and capable of running the business? Would it be advantageous to push off the sale for a few years? Will there be any health situations that complicate the sale? Unfortunately, no one can control the unknown factors. Instead, one can only control one's own behavior. By focusing on building significant liquid net worth outside of a business, protecting the family with appropriate life and disability policies, and planning ahead with a comprehensive estate strategy, a business owner will be in a strong position to allow for flexibility in their decision-making.