There is quite a buzz going on in Trenton, NJ today as lawmakers finally look to determine their course of action regarding the estate tax repeal in light of the proposed gas tax hike. […]
Singles and Doubles
With Special Dividends
It’s easy to focus on the big “liquidity event” with business owner clients. But just like baseball it’s the singles and doubles that win the game. For owners it starts with a dividend program.
Building AUM via Special Dividends
As a financial planner or wealth manager, you may be looking for effective ways to gather more assets under management (AUM). If you work with business owners, you can help them increase their return on cash balances and increase your AUM at the same time. Implementing a Special Dividend program enables the business owner to grow wealth outside of the business (and diversify). Use these tips to find more assets to manage by working with business owners.
The process of building company assets
The process of building a company’s asset balance starts with raising capital for the business, either by issuing stock (equity) or debt. Equity includes capital contributions by the owner, which may be cash or other assets contributed to the business. Companies use capital to purchase assets, and assets are used to generate revenue and profits. If a business retains earnings, those profits can be used to purchase more assets. So, a company that consistently generates a profit has two basic choices: pay profits to the owners or reinvest profits in the business.
Growing up as a company
Many business owners take a conservative approach as they start the company, and that may mean carrying large cash balances and avoiding debt. This is the approach that gets a new firm to profitability, but this may not be the best strategy for an established company that generates consistent sales and earnings. Established, “grown up” companies must realize that cash is an asset, and all assets need to be assessed on the rate of return they earn for the business or for the owners personally.
Assume, for example, that Reliable Plumbing provides residential plumbing services and generates $5 million in revenue. The company makes a big investment in trucks and equipment, since plumbers use those assets to perform plumbing work and generate revenue. Jane, the owner, has grown the business by operating profitably and reinvesting earnings into the business. In recent years, the firm has generated a 10% profit, or $500,000. The company has a $250,000 cash balance, which is 2.5% of the company’s $10 million in total assets.
Increasing the rate of return
Excess cash sitting on the books doesn’t help the firm generate revenue, or produce a competitive rate of return (or any return at all for that matter) for the owner. While Reliable Plumbing needs cash to operate, Jane needs to be aware that the rate of return on the cash balance is nearly zero. Jane needs to implement a Special Dividend Program. If Jane doesn’t need the cash to purchase more assets, she can distribute cash to herself and to any other owners. The owners can invest the cash balance in securities and earn a higher rate of return.
Assessing cash needs
Jane should analyze her cash needs each quarter, and decide if her firm is generating excess cash that should be distributed to owners. If Reliable Plumbing is generating $5 million a year in revenue, the company is producing over $400,000 in revenue a month, and must cover the costs to produce that revenue. Fortunately, nearly all of the company’s customers pay by credit card and the firm has virtually no receivables. Since cash is collected so quickly, Jane decides that a $100,000 cash balance is sufficient, and that the remaining $150,000 balance should be distributed to owners via a special dividend. She can do this analysis on her own, or find a professional to assist in the analysis.
Adding value to your Client
As a financial planner or wealth manager, you can add value by introducing this strategy to invest excess cash and produce a higher return. You can add to your AUM, and your clients will benefit financially.
This discussion frequently comes up in our valuation engagements. A frequent finding is that business owners are uncertain of how to calculate working capital requirements, and further more risk averse when it comes to making these decisions. We often lay out the cold hard facts: being risk averse is one thing, but failing to achieve returns on cash is another
The bottom line is that the owner needs to start thinking like an investor- both in their portfolio and in their operating company. Let’s help start those discussions.
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How can Quantive Help?
One technique that we find successful is to start discussions on valuation during your Quarterly Review with clients. Starting the conversation helps link the value of the business to decisions in the overall portfolio.
The outcome: we’re often helping you hit singles and doubles… and the client accumulate wealth outside of the operating company.
Our Recent Writing on Valuation and Financial Planning
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Our colleague Jessica Timmerman wrote about this issue of changes for “discounts” in FLPs and other family partnership vehicles recently… and now the old Gray Lady has weighed in as well. The Times […]