The Freedom Point, 3 Things You Should Consider

“The Freedom Point,” 3 Things You Should Consider

Have you calculated how much of your net worth is connected to your company’s value?

When you started your business, it’s value was mostly likely negligible. That is if you didn’t either inherit your company or you purchased an existing company. Over time however, the proportion of your assets tied to your business have probably begun to increase.

For example, a business owner named Tim, starts his company when he’s 30 years old. He has some equity built up in his first home and a small retirement fund. So, when he starts his business, it’s not worth very much and thus does not yet factor into Tim’s net worth.

By the time Tim reaches 50 years old, he has built up $600,000 worth of equity in his home, $400,000 in his retirement fund and his business has grown and is worth $4,000,000. Now Tim’s company has increased to represent 80% of his net worth.

He knows the first rule of investing is to diversify his investments, which he does with his retirement account. Still, he failed to achieve overall diversity given the success of the business he started.

What’s more, he may have passed “The Freedom Point,” unknowingly. Which is when the net proceeds of selling his business would earn him enough money to live comfortably for the remainder of his life. Your lifestyle determines what your Freedom Point will be, if you surpass it, it may be worth considering the risk you may be taking.

The pandemic has taught us many things, one being that nothing is for sure. Your thriving business could one day turn into a struggling company in the blink of an eye. When your business makes up the majority of your net worth and selling would earn enough money for you to retire, there’s no financial reason to continue to own your business. There may be other reasons you enjoy owning your business. You may enjoy the social interactions, the creative process associated with owning your business, the challenges it may provide, however, keeping it could be unnecessarily risky.

Once you’ve reached your Freedom Point and decide you want to diversify but still don’t wat to retire, you have some options. Those include:

  • Selling a Minority Stake: Minority recapitalization is when you sell less than half of your shares. They are often sold to financial advisors such as a private equity group. Minority recapitalization allows you to continue to control your business while also diversifying your net worth.
  • Selling a Majority Stake: Majority recapitalization is when you sell more than half of your shares to an investor. Likely, the investor will ask you to continue running your business moving forward. This was you are able to diversify your wealth, keep some equity in your business if the investor sells and continue to run your business.
  • Earn-Out: When selling your company, you will most likely have to agree to some sort of transition period. A popular version of this is called and earn-out, where you agree to continue running the company as a part of the purchaser’s business for an agreed upon amount of time. The earn-out may be as little a year, or even as long as seven years, however the average is about three years. Thus, if you are already past your Freedom Point and see yourself wanting to retire in the next three to five years, an earn-out may be the way to go.

Building a successful business can be rewarding, but when your personal balance sheet does not match, it might be time to consider the risks you are taking and the options available to you.

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