Minding the Storekeeper: What Small Business Owners Need to Know about Retirement Planning
According to a recent report from the US Small Business Administration (SBA), small businesses—generally, those employing 500 people or fewer—generate about 44% of the US GDP. Clearly, small businesses—including the 19% of small businesses classified as family businesses—are a dominant force in the US economy.
It’s fair to say that owners of small businesses spend the majority of their time intensely focused on running their businesses. That makes sense because, for most, a large proportion of their wealth is tied up in the business. This can present some significant challenges, especially when it comes to retirement planning for the small business owner. In fact, if you ask many small business owners about their retirement plans, they might say something like, “My business is my retirement plan.” Not surprisingly, a 2017 study by CNBC and the Financial Planning Association found that 78% of small business owners intended to finance their retirement lifestyle with the proceeds from selling their businesses. And for family businesses, the problem can be even more acute, as some 47% of family business owners expect to retire within the next five years, but do not have a successor lined up to take over the reins. (This could help to account for the fact that only about 30% of family businesses survive the transition from the first generation of ownership to the second).
The Importance of Planning for Business Owners
So what can owners of small businesses do to diversify their wealth? And for those founding entrepreneurs looking towards retirement, what’s the best way to plan for a secure lifestyle without selling their business lock, stock, and barrel?
You probably won’t be surprised to learn that the keyword in this section is “plan.” And that plan starts by thoroughly understanding where you are today: for business owners a critical first step is to know exactly how much your business is worth as part of your total personal balance sheet. This is especially important for family businesses, where the wish to provide every possible advantage to a daughter or son taking over the business can compete with the financial needs of the seller who is trying to fund a secure retirement. For example, while it may benefit the founder to receive top dollar when selling the business, the successor owner, who is often in the position of incurring debt to finance the purchase, would benefit from a lower price. In this and other similar situations where the needs of seller and buyer can have an inherent and potential conflict, having a professional valuation of the business can provide some much-needed objectivity and a fair value that gives everybody a solid foundation upon which to discuss a succession plan.
Develop a Strategy to Diversify
Next, business owners need to take steps to mitigate concentration risk. Just as you would be ill-advised to invest every penny of your savings in a single stock, your entire financial future shouldn’t rest solely on the value of your business. As a business owner, you probably have grown accustomed to equating the health of your business with the health of your personal finances. However, as you plan for your future, it is important to begin systematically allocating a portion of the earnings from your business into a well-diversified portfolio of investments that is matched to your current and future financial needs in retirement.
For many business owners, we recommend setting up a cash flow system to cover the following five key areas:
Funds to cover your current living and lifestyle needs;
Reserve for making tax payments;
Funds to cover any large discretionary expenses or goals (i.e. family vacation, home maintenance, buying a home, etc.);
Contributing to a solo 401k or SEP IRA;
A systematic plan to invest any surplus cash to further help you reach your retirement goals.
As we know from the power of compounding, the earlier you can start this process, the better (in other words, you should not start building your retirement nest egg when you are five years from retirement). A financial advisor can be worth their weight in gold by providing you with the proper guidance in creating and implementing a system like the one mentioned above while developing a well-balanced portfolio that aligns with your retirement goals.
Life After the Business
As discussed above, it is vital for small business owners to have a solid succession plan in place. Too many founders simply assume that “the kids or a key employee will take over someday” but fail to sufficiently involve “the next generation” early enough to prepare them for an orderly handoff when the time comes. There are many factors to address in a succession plan, such as decisions affecting the operating agreement, guidance on corporate governance and day-to-day leadership, proper capitalization of the business, as well as the owner’s retirement, and succession plans. Having these conversations well in advance with assistance and counsel from your tax, legal, and financial advisors will help to ensure a smooth transition.
If you’re like most small business owners, your business is your life. But the day will probably come when you will want to spend your time in other ways. Careful advance financial planning can help to make that transition much less stressful. At Quantum Financial Advisors, we collaborate with our clients to help them find the right solutions that match their unique needs. To learn more, click here to read our article, “Beyond the Red Envelope: Multi-Generational Wealth Transfer Strategies.”
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