The art of taking money out of your company is a hard one and a question I get asked the most about. There are so many mixed feelings and even some guilt for putting money into your pocket. You should though and I’ll tell you why. As long as the company is profitable and paying its bills, don’t feel guilty. Yes, you should build up a reserve for emergencies. Yes, there are times you need to prepare for future investment in either infrastructure or R&D (to name a few). These can be planned for. I have seen a few companies take this too far though. It becomes a compulsion toward doing the right thing that drains the mental energy of the founder and sometimes has the opposite effect of peace of mind.
Set up a plan for those needs and save for them. When you reach that goal don’t always continue to move the bar. Here are a couple of reasons why:
Companies run by founders that have all their eggs in one basket are not often the best strategic leaders. Their family financial well-being is so locked into that of the company that it can make the owner avoid necessary and useful risks that will further the company. It’s a very interesting dynamic that I not only have witnessed many times but have lived myself. With that said, hired, professional CEOs don’t have this same extra baggage. They can focus on the strategy of the company with more clarity than founder/owner CEOs. Recognize this potential shortcoming and help alleviate it by moving some money out of the company into a more diversified portfolio for your family. Recognize that you have done that and don’t lose as much sleep making those tough company decisions. Yes, they are still really hard decisions but at least you can discount the extra weight of your family’s security a bit. And you need to be your best CEO.
There are many other reasons to be prepared for doing this. For example, you or a partner may need liquidity for some life event. This happens frequently for companies that are around for years and their founders have all their net worth buried in the company. Most companies I see are not single founder, single owner companies. They are founded and owned by partners. It’s normal for partners to have life happen at different speeds than each other. What happens when one of the partners needs or wants liquidity and the remainders don’t? Be prepared for this. Have a plan for how you will get the capital to make it happen without hurting the operation or value of the company. Side note, hopefully, your buy/sell agreement has some outlines or framework for treating this type of situation. People almost always start on the same page but it’s REALLY hard to stay there for years.
So how do you get capital? There are so many options. These options vary greatly, partially by just how much you need. Rather than talk pure dollars, I’ve broken down the conversation into a relative grouping. What is small and big will depend on your company, but hopefully, this shows a few of the options.
Tiny Money – Assuming your company is profitable and paying its bills well, make a plan to extract some of the annual cash flow out. Yes, have a plan for emergency money. Yes, save money for future investments. But get over the guilt of taking a little extra money out. The further diversification of your family nest egg will make you a better leader. Better than continuing to build a cash fortress inside the company. Most company structures are highly taxed entities. LLCs and S-corps are pure pass-through entities. I am assuming you are already taking enough cash out of the company to pay those quarterly estimates. Use that quarterly rhythm to take a little extra. You and your partners can discuss and agree on how much. It’s not likely near 100% of the profit, but hopefully materially above the 45% needed to pay taxes. IMPORTANT: remember, this isn’t you being a bad CEO. This is you allowing yourself to be a better one. So, stop feeling guilty.
Small Money: The next step above tiny starts to hit the equity pie some. Examples of this might be: one partner has an event coming and needs more cash for it. Maybe a home purchase or college, etc. That partner is willing to liquidate some of their equity to make that happen (because they have so many eggs in one basket). The best sources for this capital are internal. Perhaps one of the other partners has some liquidity and is willing to buy some of those shares. A slightly more complex version of this might be where the company itself has the liquidity and can buy back those shares out of existing capital.
If the capital doesn’t exist in either of those internal sources you can consider an outsider. Hopefully someone you know. At this level of money, we are probably talking about an individual, not an institution. There are many people out there who do angel investments. This is a lower risk, lower reward version of that type of venture. They can be hard to find, especially since you may not want many people knowing this is happening. However, it is still an option.
A third option, related to the first, is debt. I’m not a big fan of taking on this kind of debt. It tends to be more expensive and puts the company more at risk. The company could borrow money to buy back equity.
One important note on small and medium equity-based money: Minority share purchases will carry a discount below the actual enterprise value. Since they don’t control the company, they carry additional risk for the buyer. Research “Minority Discount” for more understanding of this concept.
Medium Money: This example is much bigger than small money. Duh. It’s still a minority share of the company but could be a much larger amount if needed. Two of the most common needs for this type of capital are a full buyout of a partner or all the partners de-risking their financial portfolio. This is an estimated 25% of the company. A significant new partner, but still not a majority control position. This is likely an institution. It’s hard, but not impossible, to find individuals who are willing or able to invest that much cash. Good sources of these institutions are Private Equity funds that allow for minority investments or family offices that know your space. Often these two types of investors are looking for control positions, but some will entertain minority stakes. As your new partner, be aware that while they don’t control the company, they will require a contract that provides them a great deal of rights to the big decisions of the company in the future. They will likely have a say on events such as selling the company or taking out large debt, etc.
Big Money: This is typically a majority, but not all, equity stake. There may come a time when you’re not ready to hang it up as an owner, but are looking to take significant capital out of the company. This likely means you sell 51% to 90% of the company to an outside entity. The two most likely sources of this capital are Private Equity funds and increasingly family office capital. In this case, you are often still operating the company, but doing so with a new partner, ideally one that brings all types of new good things to the table. You become a minority partner of theirs, with other future liquidity events driven mostly by them. I’ve written about this scenario a bunch before. Take a look at the “When is an Exit not an Exit” blog for more details. This is a major inflection point for both you and the company but is not the end. Often, it is a new beginning with much upside. This event may be driven by many different scenarios: You want to level up and need help. You have reached the point where you decide to take significant capital out but are not ready to leave the company, etc.
Though this is usually an external provider of capital, there are inside options for this inside the company. Larger partner buyouts, management buyouts, and ESOPs are examples. These can be quite complex, but do exist.
All in Money: The whole enchilada. This option refers to selling 100% of your equity to another party. The three most likely candidates for this are: A strategic bigger company buying to merge your company. A private equity fund or family office group-buying 100%. This option, while complicated, is just what it sounds like. It can be done for a lot of different reasons. At the end of the day, virtually no defense companies are handed down to future generations of the owners so this is in every one of those company’s future. You may or may not stay on in an operational capacity but you no longer have an equity stake. This is such a diverse and complex option that I am going to talk the least about it. It needs a whole other blog or conversation.
As I mentioned above, the valuation of equity at each of these stages changes, with the highest initial value the “All in” option.
Bottom line, if you are a healthy company that has made it past that “are we going to survive and make payroll” stage, have a plan to take some chips off the table. It will benefit everyone. You will sleep better. You will be better at strategic thinking, not muddying the strategy with your family’s financial worries. Your company will benefit by having a leader focusing only on its needs with no conflicts of interest.
As always, contact us to talk more about these scenarios. A short blurb like this can only go into so much detail. Contact us here.