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The Emerging Wealthy Part 2 — Handling the Early Liquidity Event

Many millennial entrepreneurs many find themselves with unexpected liquidity following the closing of a large deal or sale of the company. How to handle this new wealth requires serious consideration.

 

 

In our last discussion of the Emerging Wealthy— we focused on what we call Stage 1 of Wealth accumulation. Stage 1 occurs when income exceeds near-term living expenses and creates a pool of capital available for investing. We concluded the article by exploring what happens when the opportunity for equity ownership occurs at this stage of capital accumulation -whether it is through becoming a partner at a law firm, co-investing in real estate deals, or through entrepreneurial ventures. We focused on how great fortunes have historically been accumulated (and sometimes lost) through concentration in an asset and / or through financial leverage.

For our discussion today, we look at what occurs after this ‘equity ownership’ position is established and it is ultimately sold.

At the outset, it is important to layout out three mental categories for wealth — what we have termed human capital, core financial capital and aspirational financial capital. At any given time, these three may be a mix of actual dollars in the bank, asset ownership and earnings potential. Here is how we define each:

  • Human capital: the embedded earnings potential of an individual. Its value is a mixture of education, drive for achievement, grit, and opportunity.
  • Core financial capital: the liquid asset the investor has and is accumulating to enable the individual to maintain their standard of living in retirement
  • Aspirational financial capital: the investments that an investor makes that have the potential for higher rates of return (and increasing one’s standard of living) but also carry greater risk

These buckets or ‘mental accounting’ are a helpful mental model for processing through how we think of and behaves regarding their wealth. Let’s consider a few examples of how this looks in practice.

For a working professional:

For an Entrepreneur:

For both options, human capital remains the dominate asset. Our first piece discussed possible next steps for the investment management of the funds of a working professional in which wealth is accumulated step by step over time.

Today, we want to focus on the entrepreneur who has the potential for a much lumpier cash flow stream vs. a doctor/lawyer/corporate executive. While the initial ‘balance sheets’ between the two are similar, for the entrepreneur, the start-up has great potential value, but very little actual realizable cash value.

Now let’s consider what happens after a transaction — say the startup gets traction and receives a buyout offer for $10MM to a larger strategic competitor.

Same Entrepreneur — Dramatically Different Mix of Assets

Suddenly after the transaction, the relationship between the 3 capitals has gotten out of balance. The entrepreneur is now overly concentrated in aspirational capital, very light in core financial capital, and still retains their human capital.

So what now? What is the right way to think of and handle this windfall in cash?


First, we would note the somewhat unique nature of this circumstance.  For the individual who founds a business and does not have liquidity until many decades in the future and then at that time takes out a sizable payday — their near-term wealth considerations look much more like our example of a working professional.

Their goal is to steadily accumulate savings in order to maintain a standard of living into retirement, while retaining optionality on the eventual value of the business they are working to build. (Also cognizant of the fact that there is significant risk that exists in retaining a concentrated position in an illiquid asset).

But for the individual who ends up with a sizable (but not massive) amount of liquidity relatively earlier in their career, they find themselves in a unique place. They are now over-weight aspirational capital (which has become liquid) but under-weight core financial capital.

For certain individuals, there is no consideration here — they keep the full balance in the ‘aspirational account’ and use it to fund their next venture / deal / buy-out / property etc. Basically it is a way to keep pressing the bet in hopes of using the larger balance sheet to hit an even bigger jackpot next time.

We would quick to offer a word of caution in this scenario. While no doubt prescient market insight and hard work were outsized contributors to the success that led to the liquidity event occurring. It is important to remember that as the SBA notes, roughly 50% of businesses fail in their first 5 years of operation. More info here. All that to say, it doesn’t seem entirely imprudent to take a little risk off the table.

In general, we think it is important to maintain some aspirational capital. The entrepreneurial chutzpah that allowed the creation of the initial liquidity event is no doubt a key part of your personality. That said, most entrepreneurs start their ventures with nothing to lose — and after a liquidity event, they do have something to lose.

The key tension to balance here is how much to keep liquid that allows you to take risk and capture the potential returns you will no doubt see in the market going forward, but not have so much capital at risk that you feel trapped and end up taking bad risks because you feel backed into a corner liquidity-wise.

So how much to take off the table and what to do with it?


We think there are three different strategies to consider in this circumstance.

The first option is to ‘endow’ your standard of living. In this instance, you would set aside an amount of liquidity that like the endowment of a university would support your standard of living in perpetuity. This option would effectively enable you to permanently retire today, and never need to add additional assets to the portfolio to cover your living expense, even after taking inflation into consideration.

The second option would be to make a lump sum payment that would cover your eventual retirement. The math behind this is fairly straightforward. You would calculate the size of the asset pool needed to fund retirement at a desired standard of living. Once the size of the pool is calculated, you would discount the value of that pool back to today’s dollars assuming a certain normalized market rate of return. So say for example, you determine that at your retirement in 30 years, you would like a $10MM portfolio. Assuming a 7% rate of return in the market over that period, you would need to deposit $1.3MM in a brokerage account today.

In effect, you are ‘buying’ today the estimated cost of your retirement tomorrow. It allows the power of compound interest to work in your favor over the long-term, and preserves ample liquidity from the liquidity event to allow for additional investment or establishment of new ventures. That said, this option does assume you continue to work to cover your living expenses.

The third and final option, you adjust the lump sum payment downward from option 2, by assuming you make additional retirement saving contributions into the future. This assumes you will continue to work and continue to make some level of retirement savings. It preserves the maximum amount of liquidity for future ventures, but also helps re-balance the equation modestly.

Conclusion


Which path of the three to choose is a function of your how much volatility you are willing to stomach en route to the next big liquidity event. In our conversations with clients who face similar circumstances, flexibility remains a primary concern. While the desire often exists to take some “chips off the table,” now knowing how to create significant wealth, there remains a desire for the liquidity necessary to deploy into another opportunity.

Regardless, a thoughtful reassessment of your current risk tolerance and the future ahead will assist in determining the right path forward. Moreover, considering all source of potential liquidity available for future opportunities will assist in making a final determination, whether it be through something like an undrawn home equity line of credit or raising outside capital.

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