Entrepreneur’s Wealth Digest
What do we mean when we talk about risk management?
As entrepreneurs, our financial lives are more complex and can have more risk factors. Our jobs as entrepreneurs are to make sure that our businesses and personal lives have no singular failure points. There can be no areas where a specific error causes everything else to fail. Some of the biggest risks we face are around the two broad terms of “business continuity” and “liability risk”. How do we define those specific risks and what can be done to manage them?
Business continuity is defined as “the ability of your business to continue operating regardless of what calamity befalls you while also ensuring that your owner equity value is protected”. If you die, are disabled, become divorced or have someone sue you, what happens to your business and equity? Each of these scenarios presents a different type of risk, and I describe them later in this article.
Liability risk is split into two categories: the potential liability you run into with your business activity and the liability you run into as someone with more personal wealth outside the business. On the business side, your liability is based on the unique aspects of your business. Could someone get hurt by your product? What if the guidance you give them with your service is wrong? What if one of your workers is seriously injured while doing their job? I cover how this impacts your personal planning below. I also cover steps to take if liability arises, because you now have more personal wealth and become a bigger target for potential lawsuits.
Transferability of equity
How transferable is your equity, and how explicit are the rules for that transfer? Those two questions are the core components of your business continuity plan. Transferability of equity is a combination of several factors.
What is your organizational structure, and what are the rules of your governing documents for transferring equity? Those two questions are increasingly relevant, as your ownership group expands in size.
If you own 100% of a single member limited liability company (LLC), transferability is likely to be uncomplicated. If you own 45% of an S corporation, where specific requirements must be met to sell equity outside the existing owners, your transferability is much lower and more complicated. Read your ownership governing documents to understand what you can and cannot execute independently.
Are your governing documents specific about how a transfer must be valued and executed? Do other owners have an option to purchase your equity before you sell externally or not? If you do sell, are there drag-along provisions stating that the other owners must sell their equity at the same time and price? What about valuation? Is there a clear methodology for valuing an internal transaction? What about seller-carried notes? Do internal buyers have an option to purchase your equity on a seller carried note?
The answers to each of these questions help you understand where your rules are clear and where they are ambiguous. The greater the clarity, the easier it is to be able to value your equity and how it will transfer in a triggering event. Let us look at our triggering events and how we can mitigate risk in each case
If you pass away unexpectedly, how will your equity be valued? Is there a clear valuation methodology in your documents? Who will it sell to? Is there a buy/sell provision in place with a specific buyer or buyers? If not, who is responsible for taking the company to the market and completing a deal, and how are they compensated for doing so? Is there a funding mechanism for the buyout such as life insurance? What about cash flow for your family during the period between your death and the sale of the company? Each of these are important questions to ask, and if your documents are not structured to support the transaction, you need to work with your attorney to restructure them.
What if you become permanently disabled and will not be able to return to your former role? Do your documents set you up to be a passive owner, or do they require a sale? If you are a passive owner, how will future profits be distributed? Can your power of attorney conduct a sale on your behalf if you lack the mental capacity to act? As with death, a permanent disability represents a permanent change, and your documents need to fully reflect what you want to happen if that event comes to pass.
In most cases, both the owner and the business have no interest in an ex-spouse becoming an owner in the business in the event of a divorce. Do your documents prohibit a spouse from acquiring ownership in the event of a divorce? How will the owner equity be valued for the divorce settlement, and what are the payment terms allowed? These should be unique to each couple and organization and should support the continued operation of the business during and after the divorce.
This risk area is not necessarily connected to the business and its equity value, but it is often heightened by the existence of a successful business. As wealth increases, you become a bigger target for litigation. Think about a small car accident between a Honda Civic and a Toyota 4Runner. The driver of the 4Runner is at fault and the driver of the Civic has a mild, sore neck. The diver of the Civic is likely to file an insurance claim and seek necessary treatment for their neck but nothing more.
Now, imagine that instead of a Toyota 4Runner, the at-fault driver is in a brand new Range Rover and wearing an expensive watch. Will that accident victim perhaps want to head to the hospital for an extra evaluation or think more closely about how much emotional trauma the accident caused them? This example is an oversimplification, but illustrates the point that when you have more, you have more to lose.
Think about how much additional risk your business activities create for potential liability and how well your business and personal wealth are legally separated. Are you carrying business insurance for errors and omissions? Do you have business liability coverage in place? Do you have a personal umbrella policy? What are the coverage limits for that policy and your auto and home insurance policies? Working with a good insurance broker can help you review your liability risks in the aggregate and see what coverage amounts you need. Your attorney can help you understand your legal structures and how to best protect your personal wealth from any business liability losses.
Your business creates opportunities and wealth. Make sure you have a vision for how to protect yourself and your family regardless of what happens. Our job as entrepreneurs is to ensure that we and our businesses succeed and that means ensuring there are no single points of failure.
If you have a question or simply want to talk through your financial planning, we are here to help.
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DISCLOSURE: Jarrod Musick is an officer of Destiny Capital and Entrepreneur Aligned, a DBA of Destiny Capital. This article is for informational purposes only and should not be relied upon as a basis for your investment, business, or personal financial decisions. We recommend consulting with your wealth advisor, CPA/tax advisor and/or attorney, as applicable to your situation, prior to implementing any new tax, legal, or investment strategy.
Jarrod was born into financial planning and solving financial problems. With his financial advisor father Steve telling stories about finance around the dinner table from an early age, the idea that everyone has a different financial situation was always there. After an early professional career spent in nonprofit and government, Jarrod came back to his roots helping people plan and invest in 2011. Since then, he has worked with individual clients, led internal teams and ultimately became partner and the CEO of Destiny Capital in 2017. With a passion for helping entrepreneurs change the world, Jarrod ultimately oversaw the creation of Entrepreneur Aligned in 2020. With both Destiny Capital and Entrepreneur Aligned, Jarrod leads teams that help people live lives of abundance where money is simply a tool to let everyone be a positive force for the world around them. When he isn’t working with the talented teams for EA and DC you can find him chasing his twins, wily trout or a podium spot at an OCR race.