Entrepreneur Aligned Liquid Capital II Entrepreneur Aligned Liquid Capital II

Business Planning

Liquidity Equals Freedom

By Jarrod Musick, Client Wealth Strategist, CFP®

Bankruptcy isn’t the same as running out of assets. Rather, it is running out of liquidity. Liquid assets are the oxygen that your company breathes, and I’ve spent a decade helping business owners understand liquidity needs.

As I write, we are seeing equity markets, cryptocurrencies and many individual real estate markets at or near all-time highs. Your Twitter feeds are likely full of stories about how yet another person turned their $50,000 into $15 million last year by using “X, Y or Z” strategy. You likely have a friend who bought bitcoin at $3,300 and wants to tell you all about it now that it trades at $33,000. What about the beach house you could have bought for $1.5 million last year that just sold for $2.7 million this year?

Every time asset prices move up fast we feel like we have missed out. Our immediate reaction is a bit of self loathing and admonishment, because we feel like we “knew this would happen but didn’t act”. To make sure we don’t have these feelings again, we promise ourselves to take action next time and not stand on the sidelines. If you are at this point now, let us pause, take a breath and discuss things.

Missing Out Versus Avoiding Risk

Firstly, maybe you did miss out. Maybe you had a really good insight and didn’t act on it. Maybe you got busy with other aspects of your business and didn’t take chances on asymmetric bets. Each of these maybes could be valid points for you, and if so, should prompt a re-thinking of your investment strategy going forward. What they should not be are opportunities to throw money at something now for the sake of taking action. A cool head and a good plan always win the day, so go back to your strategy.

Secondly, seeking asymmetric bets is the name of the game. As Mark Twain is reputed to have said, “History doesn’t repeat itself, but it often rhymes.” If history rhymes, think about the elements of it that you have seen recently, and ask yourself what similar opportunities in the future are good. Asymmetric bets, when done well, always have a capped downside, are an opportunity for massive payoff in the future (10 times the return or greater) and are small enough that each individual failure has almost no impact on your total finances.

Thirdly, and most importantly, ask yourself if you actually have the capital to make the bets you wish you could. As entrepreneurs, we put a premium on liquid reserves in order to back our business ventures. In our previous article, we analyzed business reserve calculations and three different asset tiers. In reflecting on that exercise, how much did you actually have in the first tier based on those calculations? What amounts do you need to support your business and personal needs? If the answer is that you had “just enough or not enough”, stop kicking yourself over missing out. You likely didn’t know the right move to make, because as investors, none of us actually do. We think the probability of success looks good, but we are never certain. If you can’t be absolutely sure, you can’t treat anything as a safe bet and therefore can’t risk money that you can’t lose. It’s that simple.

Liquidity Exercise

Did I convince you yet, or do you still seek the hundreds of thousands of dollars that you don’t have because you didn’t invest? If you still need to be convinced, let’s do an exercise.

  1. What is your company’s growth rate? You can use one-year trailing, three-year trailing or forward expectations based on what you feel best represents your specific company.
  2. What is your Tier I reserve total and how does that compare to your need? Every company and personal financial life has different reserve level needs. Let’s assume that two months of business expenses is working capital and that you would likely want another two to four months as reserves. Assume that your owner distributions and salary also went to zero for a year. How much would you need for your personal life?
  3. What is your current equity value in your business? Use your most recent valuation if you have one, or a discounted cash flow model if you don’t.

For our example company, let us use the following scenario.

Penny owns Target Achievement, a technology consulting company. Target Achievement has been growing quickly and they expect a 17% forward growth rate over the next year. The company has expenses of $250,000 per month and Penny has personal expenses of $15,000 per month. Penny wants to have a four-month total business reserve (two months of working capital and two months of pure reserves). Target Achievement had a valuation done three months ago and has an equity value of $8 million.

Penny needs $1 million of liquid reserves for Target Achievement and $180,000 of reserves for herself. Let’s assume the worst case scenario, where she earns 0% and this all sits in cash. She could likely earn 2-3% without much volatility, which would cover inflation plus a bit extra. To keep this simple, let’s say she sits it all in a checking account and earns zero interest. At a 10% rate of return, she could be missing out on $118,000 by holding that much in cash, and perhaps a great deal more, if she had picked the right high flying investment for the year.

Let’s not forget about that equity value for Target Achievement that this money backs up. Assuming that her anticipated 17% growth rate proportionally grows the equity value, her $8 million valuation turns into $9.36 million. She would need to have a 115% return on her cash to generate the same return as just letting her business equity compound. Keep in mind that this assumes that investments grow and that the business continues to grow. What happens if the business takes a 30% revenue hit? What if Target Achievement is in the wholesale restaurant equipment business and COVID-19 hits? Would that extra $1.18 million allow them to survive and thrive again after their less financially savvy competitors exit the market?

The returns on your business will almost always outpace the returns outside your business over the long term. The role of liquidity is to make sure that you get to stay in the game to see those returns come true.

Summary

The next time you feel like you have missed out or should have done something differently, check on your liquidity first. It is the backstop for your business and your business is the biggest key to your total financial success.

Important note and disclosure: This article is intended to be informational in nature; it should not be used as the basis for investment decisions. You should seek the advice of an investment professional who understands your particular situation before making any decisions. Investments are subject to risks, including loss of principal. Past returns are not indicative of future results.


Jarrod Musick

CFP®

Posted: 01/11/2021

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