Knowing your company’s value is not enough. Owners also need to know what drives their business value and how this impacts their investment strategies.
The Traditional Balanced Portfolio
If you have a retirement or some other investment account, you are probably familiar with the 60/40 asset allocation. Frequently shown as a pie chart, this balanced holding is made up of 60% stocks and 40% bonds—a fairly standard diversification strategy.
This blend is not, of course, meant for everyone. Some investors will increase their percentage of stocks in the hope of obtaining higher returns. Others will do the opposite, adding more bonds in the hope of preserving what they have already acquired.
Regardless of how the assets are allocated, the simple pie chart continues to be a tool used for financial planning. It is easy draw on the back of a napkin, easy to understand and easily adapts to include new assets such as real estate, gold or alternative investments.
But as it is traditionally used, is it an effective tool for everyone?
Including the Value of a Business
For those who own a business or professional practice, the chart is frequently missing the biggest piece of your financial pie—the company’s value. This makes it hard to adequately plan your financial future. It also presents a distorted picture of your total wealth and a false confidence in your investment strategy.
Let’s assume you have $1 million in your retirement account and after completing a risk tolerance review you decided that a 60/40 balanced portfolio would be best for you and your spouse. Each year you reviewed your investments and, if needed, re-balanced your investments in order to maintain your preferred blend of stocks and bonds.
In addition to your investment account, you own a business, MyCo Inc., that has an estimated private equity value (what a buyer would reasonably be expected to pay) of $1 million. In many ways, MyCo acts like the stock market with revenues going up when the economy is strong and down when it is weak. Overall, it’s a stock and not a bond; a private placement and not a private note. (For related reading, see: Valuing Private Companies.)
Since your business is an investable asset and not just a source of income, your exposure to risk could be more than what you had planned. Instead of holding $1 million in a 60/40 balanced portfolio you actually have $2 million in an 80/20 aggressive portfolio that is considered to carry more risk than you had intended.
Looking at your business or professional practice as an investment and including it in your pie chart does not change your financial situation. Instead, it provides a more accurate view of your investments so that you can create an overall strategy that is more aligned with what you had planned. At first, then, you might be tempted to sell off some of your stocks and replace them with bonds so that your total portfolio would be more aligned with your original plans. (For more from this author, see: Keeping Your Business Investment on Track.)
But before you do, you should consider factors used to estimate the value of your business.
What Determines the Value of Your Business?
A common method to determine the value of a small business is to combine or add its net tangible assets to its intangible goodwill (aka blue sky). For our purpose, we’ll define tangible assets as the machinery, equipment and other real property a buyer could and would readily buy.
By adjusting the book value of these real assets, you gain a reasonable understanding of what the business or practice could be sold for in an emergency. Since this adjusted value is relatively stable, it functions more like a bond than a stock.
On the other hand, the intangible value—the company’s blue sky—can change greatly. Intangible value is harder to determine because it is, well, intangible! If the business has been around for some time it might have internal procedures, customer lists, employee knowledge, reputation and other assets that have value. But unlike the wholesale price of equipment, a company’s intangible value can change quickly. (For related reading, see: Intangible Assets Provide Real Value to Stocks.)
We recently witnessed this when a local restaurant chain was sued after a customer contracted E. coli. Almost overnight, the event tarnished the company’s reputation, an intangible asset. Even so, the wholesale value of its equipment, its tangible assets, were likely unchanged.
Let’s go back to our example. MyCo, Inc. is a small manufacturing company. The wholesale value of its equipment, computers and other assets are just under $800,000. This figure represents the tangible value of the business, 80% of the company’s total value. The remaining $200,000 is made up of MyCo’s intangible assets—its customer lists, reputation, distribution networks, etc.
Since real or tangible assets are considered to be relatively stable, we will add these to the bond side of our portfolio and add the intangible assets to the stock portion. Now our overall investment portfolio looks completely opposite from what we had first considered. Instead of holding a balanced portfolio consisting of 60% stocks and 40% bonds, we have a conservative combined portfolio of 40% stocks and 60% bonds. In this case, the owner might want to increase the percentage of stocks held in the retirement account to be more closely aligned to their original intent.
As you can see, it is important for owners to understand the place their business or practice has in their overall portfolio. Financial advisors should include the private equity value of a client's company in their initial review and then monitor its value as a part of their wealth planning. Not only does this provide owners with a more accurate view of their net worth, but it helps them stay on track with the investment and diversification strategies they believe are important to their long-term financial goals.
(For more from this author, see: If Your Business Doesn't Sell, Can You Still Retire?)
DISCLAIMER: This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. Past performance of all investments do not guarantee future results.