It's easier to find an entrepreneur who can build an Inc. 500 company than one whose family's financial future is planned and secure. But that's hardly a surprise, since business owners shouldn't think about their money the way everyone else is told to
So often the impressive company builders we meet have paid precious little attention to their personal finances. Most are justifiably sheepish as they admit that their families' financial futures rank low on their agendas. But while many entrepreneurs like to think that their successful businesses will ensure a comfortable tomorrow, reason forces them to acknowledge that it's wise to make contingency plans.
As a company owner and builder, your financial status is distinctive. Your company probably ties up all your assets and attention right now, but it also represents all your prospects for one day accumulating substantial wealth. Here, Inc. offers a strategic blueprint designed specifically for the needs of entrepreneurs. And to elevate the notion of financial planning beyond the abstract, we invited an expert to dissect and redirect the finances of Mark Moerdler and Galina Datskovsky, an entrepreneurial couple with plenty of questions about how to translate their company's fast growth into the achievement of their family's financial ambitions. Their situation and the advice offered by Stephen Adams, an experienced investment adviser, may help you chart your own course.
The couple: Galina Datskovsky, 29, and Mark Moerdler, 34, started dating when they were computer-science graduate students at New York City's Columbia University. They married in 1985 and founded their company, MDY Advanced Technologies Inc., in 1988. The couple now has a newborn baby, Esther, and a three-year-old daughter, Zahava, and often works 18-hour days, six days a week. Moerdler started his first entrepreneurial venture while still an undergraduate. Datskovsky, who emigrated from Russia with her parents when she was 11 years old, is driven by the memory of "going to the grocery store and not having enough money to buy food."
The company: Having grown to 1992 sales of $3.5 million, MDY Advanced Technologies, in Fair Lawn, N.J., placed 150th in the 1993 Inc. 500. The company is carrying no long-term debt. With 21 full-time and part-time employees, MDY designs complex computer networks and industry-targeted software and provides disaster-recovery computer services. Moerdler projects 1994 sales of $10 million, but Datskovsky, more conservative by nature, thinks $7 million is likelier. Either way, the company is well on the fast track.
The expert: Stephen Adams, age 48, is a managing director at Van Kasper & Co., a San Francisco-based investment-advisory firm owned by its 40 partners, including Adams. The firm's clients and investments are in fast-growing, emerging businesses -- many in high-tech industries. From his vantage point of more than 20 years' experience as a business owner and investment adviser, Adams contends that "people in the investment business should run their own companies so they can appreciate profits and the bottom line."
The status quo: MDY is wholly owned by Datskovsky (51%) and Moerdler (49%). Since its first year, the business has generated strong profits, which the couple reinvests in the company. Because MDY is an S corporation, all net income is considered the owners' taxable income. So even though MDY paid the couple salaries totaling more than $170,000 last year, Moerdler and Datskovsky were obligated to pay income tax on considerably more than that, ending up with a combined take-home income of about $120,000. Still, they hesitate to give themselves raises because MDY's credit line is woefully low.
Aside from income taxes, their biggest personal expenses are a home mortgage ($20,670 yearly, with an 8.25% fixed mortgage and $234,000 outstanding, with 29 years remaining), child care for the kids ($10,400), private-school tuition for their older daughter ($5,000), and their one indulgence, four vacation getaways each year ($15,000).
Datskovsky and Moerdler both carry life-insurance policies worth about $1 million each: Datskovsky, a term-life policy; Moerdler, a term-life policy and a whole-life investment-oriented policy. The policies cost them more than $3,500 a year.
Out of a discretionary income that Moerdler calculates to be around $25,000, the couple has managed to save about $10,000 for future college costs, nearly $15,000 in individual retirement accounts, and for emergencies, a few thousand dollars in a short-term investment account.
The meeting: One frigid week this past January, Adams flew East for a no-holds-barred financial-planning session at MDY's suburban New Jersey headquarters. For nearly five hours the conversation ranged from Moerdler and Datskovsky's personal and business goals to their fantasies about one day going public to their frustrations with the tax system and their bank. They were dissatisfied, they confessed, with their "haphazard" approach to saving and investing, as well as with their inability to find high-quality investment advice.
Adams: Given your ages, I compliment you on what you've managed to accomplish so far. Your insurance coverage is on target. But I think Galina's term coverage is the better choice. You shouldn't confuse insurance with investments. Insurance should exist in a family's portfolio as a way of buying, as cheaply as possible, the protection of income replacement. That's term coverage.
And even though you haven't been systematic about it, you have tried to prepare yourselves for the future. Most entrepreneurs don't have the time to work on personal financial planning and don't like to give up control. So it's hard for them to invest in something that someone else is running.
Moerdler: Our problem is that we're not sure how to plan or even what direction to take. Everyone and his brother try to give us financial advice because they're trying to sell us something.
Datskovsky: Yes, and how do we find a financial adviser we can trust? For short-term investments, our insurance broker recommended a mutual fund. But I'm not comfortable with it.
Adams: I think you need to make your own financial plan and look at it once a year to make sure you're staying on course. Since you're both young, I think you're doing the right thing with your salaries. You should be growing your company -- it has the best reward/risk ratio. And since you are in control of the company, there are choices for you to make that would immediately improve your personal financial situation. For example, as long as your company doesn't have a tax-deferred retirement plan, one money-saving tactic you might want to consider is having just one of you earn your combined salaries and the other work for free. That would save you about $10,000 in FICA taxes.
Moerdler: What difference would a retirement plan make? Do you recommend that instead?
Adams: You should consider setting up a 401(k) plan. Of course, then it would be in your best interest to forget about combining your two salaries into one to reduce your FICA taxes. Only paid employees can participate in a company's retirement plan. Each of you could contribute up to $9,420 -- while deducting it from your taxable incomes. Furthermore, the savings in the 401(k) are bulletproof in the sense that if MDY ever runs into financial trouble, your savings there will not be considered an asset of the company.
Moerdler: We've talked about setting something up for our retirement savings. But, as you see, we haven't done anything yet.
Datskovsky: Part of it is the time. It's not something we have the time to do. We have saved some money in IRAs, though.
Adams: Yes, but your IRAs are all in bank certificates of deposit and scattered in too many accounts. You should consolidate them into a single investment account. It will be easier to make money, in part because your fees will be lower. And in a corporate retirement account, like a 401(k), you could allocate savings among at least three different investment options while keeping the funds in a single place. Meanwhile, stop funding the IRAs, at least for now. IRAs are meaningless from a tax standpoint because you don't get a deduction. You're building assets, but. . . .
Moerdler: We'd be better off putting the same funds into a 401(k)? From what you're saying, it seems as though that's our safest, cleanest bet.
Adams: Absolutely. It's the first way you should save. I'd start your 401(k) with a mutual-fund group mixing your investments -- 60% or 70% in a conservative common-stock fund, 10% to 20% in a more aggressive growth-oriented fund, and the balance in a diversified international fund. Reinvest your dividends. MDY can enhance those savings, too, by matching, at some level, all employees' contributions.
Datskovsky: But what's going to happen to MDY's cash flow if we commit the company to match some portion of 401(k) contributions?
Adams: Your corporation doesn't have to match contributions until you feel it can afford to. But when MDY does begin to match, that will be more tax-free money out of the corporation and into your own retirement savings.
Datskovsky: How much money do you think we should be able to set aside?
Adams: By my calculations, you ought to have about $35,000 that you can direct into savings and investments. Currently, your short-term emergency savings account is too small -- less than one month's living expenses. People generally need three to six months' worth in a cash-reserve money-market fund. I suggest that your immediate priority be to accumulate $25,000 in such an account. Anything you save beyond that should go into your 401(k) plan, up to the $9,420 limit per person per year.
Moerdler: What is the right amount to save for college? Every time we look, the prices are higher than the last time we looked.
Datskovsky: It's very scary.
Adams: You have to estimate your future needs. But the amount you save also depends on what you'll be able to afford. Here's a trick: Zahava will be 18 in the year 2008. So you should check the listings for zero-coupon bonds in the Wall Street Journal. You'll see that a zero-coupon bond that will be worth $1,000 in the year 2008 is currently selling for $381. So, if you figure you're going to need $50,000 to pay for her first year of college in 2008, then you'd need to spend about $19,050 today to buy a bond to cover that.
Moerdler: But what if we can't afford that? What if we can pay just $5,000 a year?
Adams: Then you do that and keep layering on more and more, year after year, until you've got enough to cover your costs. Right now, though, you wouldn't want to buy zeros because their yields aren't high enough. You can still use them as a conservative benchmark. If you'd need to spend $19,050 in zeros, then you could invest somewhat less in a long-term growth-stock mutual fund.
You should try to allot 3% to 4% of your combined income annually for college savings. At your current salaries, that would amount to $5,400 to $7,200. Assuming 9% interest from a good growth-oriented-stock mutual fund, you would achieve your education goals for both your daughters.
Datskovsky: What you've suggested so far -- building cash reserves, establishing a 401(k) plan, and continuing to save for college -- will more than eat up the money you think we could set aside. In fact, I don't think we'd both be able to contribute all the eligible $9,420 to a 401(k). I don't think we should give ourselves raises yet.
Moerdler: We could manage raises in a few years if we maintain MDY's growth rate and profitability. And of course we need to renegotiate the company's credit line. Will we be able to make more aggressive investments soon?
Adams: Once you've accomplished those three immediate goals and have extra funds to invest, I think you should buy municipal bonds. Tax-free bonds and long-term-growth stocks are the only investments that make sense in the current tax environment.
Moerdler: I think we're getting rate-pillaged and plundered in what you call the "current tax environment." So tax-free bonds sound good -- but not really aggressive.
Adams: You've already got a growth-company investment -- your own business. So to me it's natural that in the next two to three years you should get into municipal bonds. First, invest in a closed-end mutual fund that has a specific purpose, like investing in New Jersey bonds. A closed-end fund brings few surprises, since its portfolio is fixed just once, unlike an open-end fund's portfolio, which is continually adjusted. Look again in the Wall Street Journal for a closed-end fund that is trading below its net asset value.
Moerdler: How much and for how long do you think we'll be aiming to invest in the closed-end fund?
Adams: Once you've put in $25,000 to $30,000, it's time to diversify a little -- not by selling what you've got but by purchasing individual municipal bonds. Then you, not a portfolio manager, control the bonds you buy. You can stagger their maturities according to your own financial needs. Also, you save yourself the management fees.
Moerdler: I'm wondering when we can consider investing in the stock market?
Adams: I think people should wait until they've invested, say, $50,000 to $100,000 in munis before they diverge from that path. By that point, your investment profile will be solid. The money you'll have in munis is safe and liquid. Your pension funds, through your 401(k), will be mainly in the stock market, growing at tax-deferred rates. And your own company offers the best prospect for capital growth. In three to five years, if you've been able to double your salaries, you could look at the stock market. By then, you'll have about $50,000 invested in municipal bonds, which will probably be earning $2,500 a year in interest. You can invest that $2,500, and eventually, you'll be able to invest as much as you want.
Datskovsky: Do you think, when we get to that stage, that we should invest in companies that are not in our industry? Some people say that would keep us from getting hurt twice if economic conditions affect computer businesses.
Adams: I believe it's best to invest in what you know. And in your case, there are so many fast-growing companies that represent different segments of the technology industries. That's the world you know best.
Datskovsky: How should we evaluate a company's stock?
Adams: I advise people to buy a company's stock as though they were going to buy the company. Analyze the company's financial statements to figure out, at whatever the stock price is, if you'd be stealing the company, if you're paying a fair price, or if the stock is priced too high. Consider the company's revenues, assets, and profits -- historic and projected -- and take a look at cash flow, debt, and other key numbers.
Datskovsky: Everything you've recommended sounds reasonable and promising, but tell me, where do we find the time to do all this?
Adams: Financial security is important to everyone. If you don't address it, it becomes a nagging problem that wastes your time. But simply by coming up with a financial plan -- even if it's only three or four lines long -- you'll have something to work toward. You'll find people who will work with you. And eventually, you'll manage your finances yourself, with the help of good advisers. Soon you'll outgrow some of those advisers -- given the kind of growth your company is achieving.
But the first step is setting goals. Then you'll have started, and you'll be light-years ahead of everyone else.
DIVERSIFY YOUR RISK
This is not sacrilege: the essential first step for entrepreneurial company owners who want to build wealth and financial security is acknowledging the need to divert their assets from their companies.
That may sound blasphemous, but we're not suggesting you withdraw everything from your business. We do say that it makes no sense to keep all your eggs in one basket -- even when that basket is the company to which you devote your life. When your company can pay you an adequate salary, that's the time for you to diversify by spreading your financial risk to increase your payoff potential.
According to the strictest investment criteria, entrepreneurs are locked into the worst of all worlds. Their companies are illiquid, high-risk, long-term investments ready to swallow every drop of cash their owners can find. Long-term investments should be the safest and the most predictable. High-risk or illiquid investments are meant for risking only small, controlled sums you can easily afford to lose.
Convinced now? Here's how to start:
Pay yourself a decent salary. Most new businesses can't support much in the way of salaries, and their founders wind up struggling along on take-home pay that leaves no room for outside savings. And it can get worse. When cash-flow crises loom, owners often skip paychecks entirely.
Here's a better approach: as soon as your company generates the revenues to cover it, pay yourself a salary that permits you to fund an emergency money-market account to the tune of three to six months' worth of living expenses. That fund will protect you should you face high medical bills or other unexpected personal expenses. Give yourself raises as sales and profits increase, and use extra cash to expand into other investment areas.
Be disciplined. Don't touch your emergency nest egg or your kids' college savings accounts at the first sign of business trouble. You should guard your personal investment portfolio with as much determination as you protect your investment in your company.
Safeguard the financial investments you put into your company. If a cash crisis requires you to forgo a paycheck or to plow in additional funds, keep detailed records that show you extended the company a loan, payable with interest as soon as cash flow revives. Keep the transaction official: sign a promissory note. Grim as it is to contemplate the prospect of bankruptcy, that procedure will at least ensure you some degree of compensation as a secured creditor.
Protect personal assets from your company's bankers and other creditors. Most business owners are forced to secure their credit lines and other loans with collateral. Too often, that amounts to the equity in your house or car. So channel as much of your income as possible into legally protected personal assets such as a 401(k) plan and college savings accounts in your children's names.
If you -- like MDY's Galina Datskovsky -- despair of finding a financial expert who isn't motivated by visions of big sales, you might consider a consultation with a fee-only financial planner who sells no investment products and earns no commission income. For a list of fee-only planners in your area, contact the National Association of Personal Financial Advisors (708-537-7722).
PREPARE YOUR ESTATE
This piece of the financial-planning puzzle is no fun. But failure to prepare for the inevitable leaves an entrepreneur's beneficiaries facing estate taxes that can be as high as 60% -- with no alternatives beyond selling or dismantling the business simply to pay off the tax man.
"I hear all kinds of excuses from business owners who don't want to get involved in estate planning," confides Joshua Rubenstein, a partner in the estate and trust department of New York City law firm Rosenman & Colin. "They tell me their companies are new, they're start-ups, they're not worth anything -- or that the company is too big and too valuable and it's too late to accomplish anything. But both attitudes are wrong. Wherever you are in your company's growth, the best time to start planning is right now."
Kenneth Brier, an estate-planning partner in the Boston law firm of Powers & Hall, recommends that as you form your plan you should --
Think globally. "You can't be constrained by cut-and-paste planning principles or by the notion that your personal estate and corporate estate plans are different and separate. Look for an estate planner who's willing to be innovative." When one of Brier's clients, the owner of an $18-million corporation, wanted a way to pass his business on to his children while minimizing gift and estate taxes, Brier recommended that the children set up their own company, to which their father could divert business opportunities. "We didn't pay a dime of taxes on all that transfer of value," he notes.
Plan succession or face extinction. A comprehensive succession plan should anticipate management and family controversies.
Deal with liquidity issues. "If you leave your estate with a cash drought because you haven't purchased adequate insurance, your beneficiaries will have no choice but to liquidate your company when the IRS comes calling nine months after your death."
Divide and conquer. Because the IRS treats "minority-stock transfers" favorably, you can reduce the size of your taxable estate by making gifts of stock shares while you are alive.
"Many corporate law firms do not employ trust-and-estate specialists -- and the consequences can be costly for entrepreneurs if they simply rely on the advice of a partner who remembers drafting a will back in law school," Rubenstein says. For a listing of specialists in your area, send a written request to the American College of Trust and Estate Counsel at 3415 South Sepulveda Blvd., Suite 460, Los Angeles, CA 90034; phone 310-398-1888. George C. Shattuck's useful guide, Estate Planning for Small Business Owners (Prentice Hall, 1993, $19.95) will prepare you to sit down with a qualified estate planner.
Coherence. Logic. Discipline.
Sound a little too stodgy to be the bywords of your ambitiously high-flying investment strategy?
Well, this is reality. Effective investing -- especially for the all-too-busy entrepreneur -- depends on these three essentials:
Coherence: Your investments must complement one another's risks and payoff potential.
Logic: A well-researched rationale must support each interlocking investment.
Discipline: You must adhere to your long-term goals, and you mustn't be distracted by the whims of the economic marketplace.
Your strategy ought to look like a pyramid, with your company as its base. After all, most of your money will be in your business.
You'll want to make other investments as soon as your family's take-home pay exceeds its living expenses. At first that progression will focus on securing such essentials as your retirement plan. Many experts recommend starting with mutual funds and money-market accounts with investment profiles that complement your ownership stake in your company.
It's not necessary to pay fees for a stockbroker or banker to handle those mutual-fund investments. You can find comprehensive lists of no-load -- that is, no-fee -- mutual funds in magazines such as Forbes, Money, and Smart Money.
For Moerdler and Datskovsky, who are ready to move to the second tier of their investment pyramid, short-term activities will center on funding a retirement plan, saving more aggressively for their children's college education, and boosting their emergency cash reserves.
Your second tier depends on your family profile, the stage your business is at, and your personal finances. If you've already set aside an emergency money-market account that covers three to six months' worth of living expenses, don't add to what is, after all, a relatively low-paying investment. If you don't have kids, obviously, you've saved yourself from a very large investment concern. But if you are in your forties and still haven't prepared for retirement, making up for lost time should consume most of your investment activity.
When you attain the next level of the pyramid, you'll have taken care of all the fundamentals, and you'll start putting cash into the financial markets. You'll probably want help from a stockbroker to purchase individual bonds or stocks, but find someone who shares your disciplined approach. You must not withdraw savings from your lower-tiered investments simply to fund your market plays.
As Adams advised MDY's owners, municipal bonds provide tax-free earnings, safety, liquidity, and a predictable income stream -- all features that nicely complement the investment characteristics of a fast-growth company.
When you've finally accumulated a sizable stake in municipal bonds, you will be ready to climb to the top of the investment pyramid. If you've been well disciplined, you'll be in an excellent position to branch out into such risky but potentially lucrative investments as the stock market and real estate.
Choose investments that match your expertise and attention span. Have some fun. But invest only what you can afford to lose. As Adams explains, "You don't ever want to need the money you've got in the stock market and have to go out and sell shares at a fire sale."
The American Association of Individual Investors (312-280-0170) offers resources targeted at both fledgling and sophisticated investors.
PLAN FOR RETIREMENT
Typical entrepreneurs are so preoccupied with ramping up the value of their enterprises that when it comes to an essential issue like retirement planning, they're like the cobbler's children without shoes," warns Arthur Warren, a retirement-strategy specialist who owns his company, Benefits Advisors of New England, in Franklin, Mass.
If you've procrastinated on this issue, you should realize that entrepreneurs have much more control over retirement planning than most people do, since employees' options are limited by what their employers offer. Furthermore, Warren emphasizes, "given the fact that we face the highest personal marginal tax rates that have existed in the United States since the early 1980s, any pretax method of capital accumulation is something you simply have to do."
It's possible that one day you'll wind up spending part of your retirement savings on a boat or to pay for your baby's college tuition, but when you see how quickly your tax-deferred retirement-savings account grows (compared with other investments that are subject to ordinary or capital-gains taxes), you'll recognize its essential value to your overall financial plan.
Because the tax rules, administrative issues, and investment decisions involved in retirement planning are quite complicated, this is not a do-it-yourself issue. To learn more about your options, before you spend money on a consultation with a retirement planner or an accountant, you might want to boost your personal knowledge with a very good introductory videotape: Solving the Retirement Puzzle (Retirement Planning Associates, 800-546-5406, $19.95).
SELECT GOOD ADVISERS
As the owner of a business, you'll have financial advisers of all stripes hounding you with get-rich-quick schemes they've devised. Start running.
Do you need an expert? Why consult a financial planner and an insurance broker and an estate planner and a retirement planner and a stockbroker and a tax lawyer? If you have the time and the interest, you can learn a lot from investment newsletters from organizations like the American Association of Individual Investors and such publications as the Wall Street Journal, Barron's, and Forbes. You can also stay up-to-the-minute with the changing financial and economic news by using your computer to tap into a range of investor databases. Your corporate accounting and legal advisers may be able to help, too.
The adviser you select should understand your goals. "Sure, I know about a small-business owner's needs," is a statement you must challenge. Your adviser should know exactly how those needs are different from other people's. Trust your instincts. You will require special attention in order to develop a plan that is sophisticated enough to achieve personal and corporate goals.
Investigate educational credentials. These days new investment instruments flash on and off the scene. The best financial professionals know they need to continually upgrade their training to stay on top of frenetically paced market developments. Look for a professional who is well versed and uses state-of-the-art technological support to stay informed about changes.
Seek recommendations from other entrepreneurs. It's fine to ask your banker and accountant for referrals of qualified financial advisers, but you also need proof that those advisers know how to work with business owners. Check references!
INSURE YOUR FUTURE
The glue that holds your family's financial future in place is a well-conceived insurance strategy. Entrepreneurs have insurance requirements in addition to the obvious need for medical, property, and casualty coverage. Here's a checklist of the minimal coverage to ensure your family's -- and your company's -- continued financial well-being:
Personal disability insurance: It makes sense for business owners to purchase the maximum coverage -- usually 60% of salary.
Family-owned life insurance: In the event of your death, your survivors will appreciate having insurance cover estate taxes, your home mortgage, and other expenses.
Key-man insurance: Your corporation should own such a policy to help stem cash-flow losses in the event of a management transition.
Insurance to support a buy-sell agreement: If you have partners or an outside potential buyer, the partners, the buyer, or the company itself should purchase such a policy.
Long-term-care coverage: For a top-of-the-line policy, expect to pay up to $10,000 per couple. If you or your parents are well into their sixties, it could be worth the expense.
Most business owners, especially the founders of young companies, tend to skimp on insurance coverage or forgo vital policies entirely. Although MDY's owners each have nearly $1 million worth of life insurance for their family's protection, financial adviser Adams urged them to purchase an equivalent level of key-man coverage for the company. Datskovsky's parents are near retirement age, so Adams recommended a long-term-care policy as well.
As your family matures, your investment portfolio grows, and your company becomes more valuable, your insurance coverage should reflect those changes. It makes sense to involve your accountant and estate-planning lawyer in periodic reviews of your insurance package.