If you own a successful business, you may wonder why you would do anything other than continually reinvest back into that business. It is most likely the best investment you have ever made!
When we think about investing, we need to take into consideration the risk/reward tradeoffs of our decisions. When we see more potential reward in an investment, we should immediately begin to identify what additional risks are coming with the chance of more reward. In a free market society, the aggregate graph of investment risk and reward is linear. The more reward we see, the more risk we should expect.
Consider the following two examples:
- Let’s say you invest all of your money into one publicly traded stock, Acme Corp. Based on your market knowledge, you can expect to realize a 10% annual rate of return on this investment. The most obvious risk you face is that Acme Corp. goes belly-up and you lose all your money. Now, that is a serious risk, but the consequences of failure stop there.
- Now let’s say you invest all of your money into your privately held business. Looking at past performance, you can expect to realize a 20% annual rate of return on that investment. However, with that higher expected return comes a higher consequence of risk. If your company goes belly up, not only do you lose your entire investment, you lose your job (and future earning power that goes with it), potentially default on outstanding loans and could even have your personal assets seized by personal guarantees you made to back up your business liabilities. In a worst-case scenario, you could even go bankrupt.
So, what does this all mean when it comes to investing for a privately-held business owner? It means you need to be intentional about hedging against the highest risk/reward asset you own, your business. In my experience, this leads to two primary considerations.
- You should most likely be holding elevated amounts of cash relative to your income as compared to a non-business owner in order to hedge against the possible liquidity need in your business. In general, the riskier your assets, the more cash you should keep on hand.
- You should view your retirement plan (401k, SIMPLE IRA, SEP IRA, etc.) as a form of ‘insurance’ to decrease your overall risk profile over time. Your retirement funds are not meant to compete with your business from a return perspective. If you run your business well, publicly traded stocks will lose that battle. Your retirement funds instead act as a hedge against your worst-case scenario risks. They also happen to provide a tax advantage, which is useful.
A well-run privately held business can provide an ROI beyond many, many other investments, and with that comes elevated risks that need to be protected against in a prudent manner. Consider that next retirement contribution your hedge.