PerspectivesArticles to cut through the confusion of Financial Planning for Business Owners
Foundations – why planning is important for business owners
As I was driving through my neighborhood recently, I rounded a corner to see a large back-hoe tearing into what was left of a house. I’ve always wanted to watch that process as I find it fascinating, but I seem to always miss the big day. Once the demolition is completed and the dump trucks have left, nothing but a dirt lot remains. Then, within a few weeks or months (depending upon permits and so-forth), new work begins according to a plan that has been set out, measured and approved. In all cases, it’s the foundation of the structure that is laid first.
Today I want to focus our attention on the important issues that as the owner of a successful business, you must make time to consider and address in order to build your business on a solid foundation that will provide not only an income for you and your family, but also the potential to produce multi-generational family wealth.
First things first
A foundation is something that generally you don’t see. After it’s finished, no one really thinks about that part of the project; but even years later if something goes wrong, then everyone thinks about it!
I asked Mark Luciano – one of the founders of a local construction company; (www.basementstore.ca) to answer some questions and give us a grasp of this vital yet often overlooked aspect of construction.
IWM: What is the most important thing a contractor must do when building a foundation?
Mark: The most important as always is prep. Good soil density is critical. All foundation work from a deck pillar to a house foundation must be on undisturbed soil and it must be below the frost line (48″)
Where to Focus?
A solid foundation is also critical in business, and there are different foundations to be laid. There’s the financial foundation; a human capital foundation, and most importantly the personal financial success of the owner must be considered; for a business that functions for everyone but the entrepreneur and fails to create additional family wealth is really just a job with lots of stress.
So, as an owner-operator you need to consider where you are in the life cycle of your business; prepare and build your foundation(s) with care and intentionality.
Like the construction of a home, one thing builds on another and there is an order to the way things must be done. In a home, drywall is not helpful until framing, HVAC, electrical and plumbing are completed.
For the private business owner-operator, there are 6 Critical Themes that are truly foundational and as a business owner, you must consider and plan for them if you are to reap the most benefit from your entrepreneurial efforts over the years. This planning may be done in stages, although for many – little to no holistic planning gets done until you’re approaching a situation or stage that needs attention, (often at maturity and transition), and in that case, it’s appropriate to look at all 6 Themes at one time.
To keep with the analogy of construction as it relates to business growth, however, the planning could be done in stages according to the phase of development that the business is moving through. In a moment we’ll explore the questions that guide the conversation for each of the 6 Critical Themes. They will provide food for thought and form the basis of an effective and holistic planning process.
For our unfolding construction analogy, let’s explore where the pitfalls might be. Here’s the next question I asked Mark…
IWM: When it comes to the foundation, what are some things that can go wrong?
Mark: Placing a footing on disturbed [loose] soil will cause settling and if you’re not below the frost line then there is a risk of uplift or heaving.
Let’s consider where there might be ‘loose soil’ in your business. What does that look like for you? Here are some typical examples:
- Overly simple corporate structures
- Hundreds of thousands of unnecessary TAX upon sale or the owner’s death
- Poorly worded or non-existent shareholder agreements, leaving you open to litigation
- No pre-arranged funding to enact a shareholder agreement buy-out upon death or disability
- Improper set up of life insurance for the owners causing the death benefits to become TAXABLE
- The potential for family conflict brewing under the surface. Family issues that are not discussed
- No Wills, or grossly outdated Wills; poorly worded Wills which actually create tax problems
- No 2nd Will for the business and other assets to reduce exposure to estate administration tax
- The business is exposed to loss should one of the key managers be unable to work; whether temporarily due to illness or injury, or permanently due to sudden death
- Lack of a formal plan to maximize the wealth of the business and protect it for the family
- No investment plan for Retained Earnings – holding too much cash or real estate
Often as business owners, we don’t know what questions to ask and further, the right planning topics depend largely upon where you are in the business’ growth curve. It’s challenging to know where the problem areas might be, because as we have witnessed in our work with clients; as owner-operators, you’ve taken care of some of these issues; you’ve done a lot of good things and made progress in planning. A truly holistic process will affirm the good things that have been completed and find gaps that would expose you to loss or missed opportunity.
So let’s consider this foundational planning so important to your business’ ongoing success and ultimately the creating and monetizing of a lifetime of hard work.
The Startup Phase (typically year 2 – 5)
For the new business – once you’ve made it through the first few years and you are confident of your business and you’re on your way – the first two of the 6 Critical Themes should be planned out at this point:
1. MINimize Financial Risk
- How long would the business continue to grow without you?
- More than one shareholder family involved? Do you have a formal agreement? Is it signed? Have you arranged for the delivery of cash through insurance should an active owner become sick, injured or die so that the remaining owner can buy the shares?
- How long could you, as an owner-operator continue to draw an income if you couldn’t work due to an illness or injury?
- Have you arranged for tax-free cash to come into the business when the owner is diagnosed with a serious illness?
2. MAXimize Structural Security
- Are you confident that you have the right structures in place for the future growth of the business, not just for today?
- Is it time to consider a holding company for real estate or investment?
- Is your corporate structure overly simplistic? What would be the best structure for tax planning, tax reduction, etc.?
These two Critical Themes are crucial for the business that has found stability yet may not be concerned about high taxes and creating outside investments. At this stage, you’re still pouring your profits back into the business for growth and expansion. So much depends upon you as the owner-operator. You may not have complete systems and procedures in place and much of the day to day routines and guidelines are in the head(s) of the owner(s). Should there be legal issues, or an illness or untimely death in the leadership of the company at this stage – there will be significant problems that without financial liquidity may kill the business. Protecting against these nasty eventualities is actually not difficult and yet it’s so important.
The Growth Phase (typically year 5 – 30+)
Typically and hopefully this is the longest phase. There will be challenges and opportunities along the way, but this is where the magic happens. Slowly, methodically, wealth begins to be created.
Although the first two Critical Themes remain just as important as before, at this point it’s essential to add protection of a different sort. Finding ways to reduce the tax exposure and safely capture the company’s retained earnings or profit comes into view. At this stage, you’re considering investing cash into other areas: real estate, securities, a new business venture, etc.
Here are some questions around the next 2 Critical Themes to think on in this phase:
3. MINimize Tax
- Do you believe taxes are going to go up or down?
- How do you think the recent pandemic will impact your income taxes?
- Do you believe you’re optimizing ALL of your tax-reducing opportunities?
- Have you arranged your affairs to minimize tax over the LONG-TERM?
4. MAXimize Retained Earnings
- Do you ever worry that most of your net worth is locked up in the business?
- What is your plan to monetize your profits?
- What is the exit plan for your business?
- Are you making tax-efficient investments with your net profit?
As the business moves through the growth phase – potentially lasting years – as an owner you will begin to become more concerned about the amount and multiple layers of tax you pay. Taxation overreach is a huge barrier to growth, and ultimately to the creation of lasting wealth. Although you should expect excellence from your CPA firm to keep your taxes at a reasonable level each year, it is also crucial that you look at the big picture and how to keep taxes lower, on pace with all the changes that are likely to take place in your life and business. This is the time when you’re looking for investments outside the business, be it rental properties, a stock portfolio, etc. as ultimately you’re looking for ways to protect the wealth your business is creating. It is essential that your planning reflect these topics in a proactive manner.
The Maturing Phase (typically year 20+)
Often, the maturing of the business matches the maturing of the owner(s). Many business owners conceived of starting a business while working for someone else and stepped out to do so, after having what Michael Gerber in his book The E-Myth calls an ‘Entrepreneurial Seizure’. The truth is that most businesses in Canada – particularly family businesses – were started by dad, or grand-dad and were begun because the business idea solved a problem in the economy, and through hard work and diligence it became successful. The foundation was built solely upon the effort, daily customer service and problem-solving ability of the owner-operators. Only now (25-40 years later) is consideration being given to what’s next.
The last two Critical Themes relate precisely to this Maturing phase of the business life cycle.
5. MAXimize Retirement Income
- What does retirement look like for you? What will you be doing?
- What is your ‘number’? What must you get for the business in order to retire?
- Are you completely clear and comfortable with your current plan to maximize your income in retirement?
6. MAXimize Your Legacy
- How do you feel about CRA getting more than your children? Would you like more control here?
- What does your Will say? Do you have dual Wills? Are there conflicts between your Wills and other beneficiary designations? Are you sure?
- Did you know that assets in your HOLDCO could attract over 70% tax without proper planning to the contrary?
Wherever you are in the life cycle of your business today; Start-up, Growth, or Maturity; you must consider the end game. Where is this business going? What size of business do I want? How long do I want to work? What are the risks we face and how do we mitigate them where possible? Each phase of that business’ life has new and different risks and opportunities for planning.
Wrapping it up
In summary, there are a number of items that could be said to form a business’ foundational structure. I like to call them the ‘Fences and Safety-Nets’ around your hard work. Without walking through a process that deals with all 6 Critical Themes, there will be issues you may not see that could either cause added taxes, fees and other headaches; or you may miss the opportunity to grow wealth more efficiently.
How did you feel about some of the questions in the 6 Critical Themes we just walked through? Were you confident and comfortable with your answers? Were there some that caused you to wonder if you have everything in place?
The bottom line is this – in the same way that a shallow foundation or poor quality materials will definitely come back to haunt the builder of a home, failing to put in place the right foundational structures in your business could at worst cause serious tax and structural problems down the road; and at best just make it more difficult to build the wealth you planned upon for yourself and the people and causes you care about most.
Don’t put your hard work at risk. Talk to someone who specializes in helping you as an entrepreneur get the most from the lifetime of work you have invested in that business you have so proudly built. A good thing to remember is that it’s never too early and rarely too late to plan!