Introduction
Raising capital as a startup matures can help unlock liquid wealth for founders whether it be through a dividend recapitalization or a secondary sale.
Founders are left with the decision about what to do with the capital. We’ve generally thought it is a three-part conversation: celebrate (even a small celebration of reaching milestones can be impactful), pay down debt (whether it be car loans, mortgages, or other debt to free up cash flow), and/or invest it.
Today, let’s focus on the most talked about aspect of it, investing some or all of the capital.
Personal Financial Planning
It is important for founders to develop a financial plan and have an investment policy.
The plan would tackle cash flow through the next capital raise, financial independence modeling, a savings strategy for goals like kids’ college and other cash flow intense items, insurance, and most definitely income tax and estate planning. These all tie into developing a thorough investment policy built to get the founder and his/her family to the next stage of the business.
Let’s not get carried away though as the capital received from the dividend recap or the founder selling some shares still isn’t the greatest source of your wealth. Your shares in the company still likely hold the title of largest wealth component.
Investment Policy
Let’s look at an example. Assume you receive $1 million by selling some founder shares and leave $10 million in the business. The private equity group(s) would like to see the company 8 – 10x over the next 5 – 7 years so it will get you to a total equity stake in the company of $80 – $100 million (assuming no further dilution).
Equity Investment Portfolio
So, what impact does the investment policy have? If we stick with a liquid portfolio (no private assets), the historical rate of return of the S&P 500 is roughly 10% per year. Assuming it takes 7 years to get the desired company exit, the $1 million would roughly double – providing you with a portfolio worth approximately $2 million.
That’s a nice portfolio for many people and nothing to be upset about. However, it pales in comparison to the wealth you hope to create within the business over the same period.
Balanced Investment Portfolio
For reference, a balanced portfolio consisting of 60% equity and 40% fixed income would historically generate approximately an 8% annual rate of return – creating close to $1.7 million at the end of 7 years.
During the Great Recession in 2007-2009 a 100% equity portfolio likely would have been down approximately 50% or more from peak to trough while a portfolio including fixed income could have muted the returns to likely being down as little as 20-25% over the same period. In essence, do we want to play more defense than offense with the capital you’ve just taken off the table.
Portfolio Construction Considerations
Is the salary sustainable under most business conditions? If not, do we want to have a more conservative investment policy so less money is ‘at risk’. Are kids going to college in the interim? Is a spouse going to stay home so you need the portfolio to generate some income. All these concepts and strategies get flushed out in the financial planning process, which ultimately delivers an appropriate investment policy.
A solid financial plan doesn’t have to be overly cumbersome and time-consuming, but should include:
· Liquidity – for founders who likely haven’t had too much cash, having something liquid to tap into for any reason is a good thing.
· Safety – the company’s growth prospects are great but there is no guarantee it reaches its goals – or even survives the next 5-7 years. As such, taking the money and being conservative can alleviate some stress.
· Diversification – similar to the safety component above but worth mentioning that creating diversification is helpful. Concentrated positions are a great way to create AND destroy wealth. Being able to add a diversified portfolio to your net worth will lower the return but will begin to lessen the risk of concentrated wealth.
· Other financial goals – this could be allowing a spouse who may have been working to allow the founder to take a lower salary to step away. It could mean buying a new house, second home, new car or any other item.
· Subsidize income – in some rare instances, we still look to the portfolio to provide distributions to the founder to help the family live while the business continues to grow.
· Pay down debt – paying down debt frees up cash to be spent (or saved) and provides the family with greater disposable income.
Taxes
Additional things you want to do are annual tax projections (personal) as you want a better read on income taxes as taxes are an additional expense. How tight is the cash flow currently and what’s the impact of the investment policy on annual income taxes?
Estate Planning
And then ultimately you need to revisit the right estate planning strategy for you and your family. There is so much to think about from this perspective. Your own financial assets versus assets you have set aside for kids (this could be still under your control via a 529 or it could be through one of many trusts structures).
Do you want to maximize the wealth you leave to children/grandchildren? If so, planning now before the net worth potentially explodes can allow you to freeze your taxable estate – pushing growth to trusts and other structures you can still benefit from but are outside of your estate. Or are you more inclined to leave them something but want them to create their own wealth.
Even those differing views can lead you to different investment policies now – and especially into the future.
Summary
As you can see, an investment policy tailored to the family’s needs is a fundamental pillar of any successful financial plan. It serves as a roadmap, guiding the family’s financial decisions and helping them achieve their long-term objectives.
In essence, the portfolio should be set up to be a complement to what you have built through the company. It likely should be simple, liquid, and used as a tool to educate about portfolio construction post exit.
Keeping it simple then allows the actual work to begin. You build the company. The financial plan works around you and the family.
It’s updated and modified at least annually to reflect the natural changes that ebb and flow during life.
This includes an active income tax, estate document and insurance strategy that can be layered on over-time as the business grows.
William Bissett is the owner of and an Investment Advisor Representative of Portus Wealth Advisors, a Registered Investment Adviser. Registration does not imply a certain level of skill or training. Opinions expressed on this program do not necessarily reflect those of Portus Wealth Advisors. The topics discussed and opinions given are not intended to address the specific needs of any listener.
Portus Wealth Advisors does not offer legal or tax advice, listeners are encouraged to discuss their financial needs with the appropriate professional regarding your individual circumstance.
Investments described herein may be speculative and may involve a substantial risk of loss. Interests may be offered only to persons who qualify as accredited investors under applicable state and federal regulation or an eligible employee of the management company. There generally is no public market for the Interests. Prospective investors should particularly note that many factors affect performance, including changes in market conditions and interest rates, and other economic, political or financial developments. Past performance is not, and should not be construed as, indicative of future results.