Who doesn't love factoids.  In the 12/21/15 edition of Barron's, a study by PwC and UBS found that in 20 years only 126 of the 1995 billionaires (289) remained on the list.  Business failures and family dilution were among the reasons provided. Did the heirs destroy or divest the asset that created the wealth?

No doubt gratification versus growth is a real business owner paradox.  When we hear most businesses have $1 million or lower annual revenues, what do we think?  First, you don't bank sales.  You bank net proceeds.  Then we wonder why after a few or many years these businesses never really grew.

While most prefer "baby" I will refer to these businesses as "the beast".  Why?  Because most parents would never consider raising a malnourished child, but many owners will take cash needed to grow a business to pay for their own wants.  (Notice I didn't say "needs".)  So toiling 60 and 70 hours isn't enough to grow a business.  It needs adequate cash ("capital") or it starves.  Capital can be obtained from the profits of the business or borrowed or invested funds.

A tell-tale problem is when a line of credit (debt) is tapped because revenues, collections or profits dip and the owner still wants (or needs) compensation even when the funds from the beast's operations or reserves (piggy bank) aren't there.  These behaviors are quite common and often explain why most companies can't be sold as they are essentially a "job" created for the founder and the "baby" is only beautiful until it isn't ("the beast!"). Few buyers want it.

Less common is after years of toil, the business generates more sales and profits.  The owner craves a reward for the sacrifice (and too many PB&J sandwiches), so seeks compensation a little too much too soon.  This partial abstinence may allow the company to reach $5 million or even $10 million in sales; however, most companies hit this growth ceiling due to both financial and human capital reasons too many to address in this post.  My Wiley book "EVE" addresses these issues ad nausea in a reasonably entertaining way.

Let's pull out the calculator and perform a VERY simplistic scenario.  Assume no inflation. Owner "A" decides to over-compensate both salary and distributions and in 20 years with the following results:  The business "needed" $200,000 to fund "typical" 4% per annum industry and market level growth and could have achieved 10% growth if $500,000 had been wisely reinvested in the company. 

Let's say the business was worth $5 million and paid the owner $250,000 per year, but the owner took another $500,000, so growth is an anemic 2% per year.  If the owner is operating a "lifestyle business" versus reinvesting the extra $500,000 in marketable securities or investment real estate each year in a personal account, then the "extra" amount received equates to 20 years times $500,000 (maybe more and maybe less - this is for illustration purposes) or $10,000,000 for gratification plus the $5,000,000 in company value plus the 2% compounding for the 20 years (an extra $2,430,000) or $17,430,000.  The $7,430,000 company and some nice toys are to show for the 20 years of effort.

Owner "B" defers gratification preferring growth.  This owner enjoyed a 10% year-over-year compounded growth and as a result had $33,700,000 value to show for 20 years (and likely has other investments) while still maintaining an upper-middle class lifestyle.  It is clear the benefit of compounding provides almost double the economic benefit when considering Owner A's gratification.

Now that $33,700,000 figure is relevant as it constitutes what is referred to as Ultra-High Net Worth (UHNW).  According to Wealth-X, there are about 70,000 individuals in the United States who are UHNW.  Most are facing the scenarios in this post.  My function as a Strategic Value Architect is to ensure they or those wishing to join their ranks achieve the highest possible enterprise value while also considering philanthropy and tax minimization.

So, what has this to do with the "Shirtsleeves to shirtsleeves" challenge?  In our example, Owner B was 30 when the business was worth $5,000,000 and 50 when it was worth $33,700,000.  Care to guess what age 65 would look like at this rate?  If you said a $142,000,000 value is likely you'd be correct.

Now assume the business stayed in the family and the same business growth (from expanded offerings and markets) was sustained with each of three adult children having an one-third interestAssume magnificent tax planning and each child is a triplet and has the same deferred gratification principles as the founder and spouse.  Their one third interest is valued at $47,333,3333 ($142,000,000/3) when they were 40 and the founder was 65.  They operate the business for a generation or 20 years. If you guessed that each equity interest owned was worth ~$200,000,000 when they reached 60 you'd be correct.

What would happen if the founder's advisors had suggested not maintaining concentrated risk (keeping in mind their wealth was created by doing just that). Will the family benefit from control if they sell 100% of the equity?  Does the family need the liquidity?  What are their other options to include family legacy or hiring professional management for the company?  How would the financial institutions manage the proceeds from a sale?  Would they be more risk adverse?  Would they select a passive portfolio? Would it achieve the levels of yield and growth (total return) that would allow the family to maintain their existing lifestyle(s) or would principal erode as the founder and spouse spent it?

I intentionally eliminated the specific annual spend of the family members; however, wanted to illustrate that even with the "dilution" by having three children receive the valuable asset(s)/interests the worth was "greater" than when it was received by almost four-fold, 20-years later.  This ought to raise the question of whether risk aversion and not necessarily risk alone may, in part, contribute to the decline in wealth from generation to generation.  In fact, even a reasonably responsible beneficiary could prevent the erosion of the principal while keeping the business asset by maintaining a minority or majority equity stake if family members may not wish to operate the company.  This may be seen as a "messy" option by some firms looking to administer family wealth.

The conversation ought to focus on whose risk optics and who has skin in the game and how do all of these parties get compensated.  That is why liquidity, legacy, leverage and learning must be part of transition event planning.  This requires an independent perspective with the wherewithal to ensure advisors and families are aligned when such important decisions are made without inadvertently placing biases or short-sightedness into the mix.  Consider the additional "mess" of a disruptive event like death, disability, divorce or dispute.

My financial peers may admonish me.  They will argue "reversion to the mean," which suggests most investments at some time will not continue to perform in the top-tier of their peer groups due to a myriad of issues.  This is true as a general statement, but the very premise of a 9- or 10-figure company suggest families can succeed in beating the odds with organic growth and M&A.

The issue of stewardship versus cashing in might be settled in practice, but not in theory.  I leave this to the post reader and welcome your thoughts.  If you liked what I had to say here, please share with your followers and feel free to read these other thought-provoking posts.

Why I Wrote Equity Value Enhancement ("EVE")

What top 1% of advisors and entrepreneurs know

What is your risk vs. opportunity optics?

Keep some powder dry ("liquidity") for 2016

Brooklyn-born, USMC Tank Officer & PhD Writes Wiley "EVE" Book


Posted on February 2, 2016 .