The Sweet Spot
Wealth is significant financial capability sustainable at a low level of risk. It is a desirable condition, and that condition is a primary goal of business activity. What distinguishes a business that creates wealth for its owners from other businesses? Wealth is created when a business owner holding sufficient non-liquid business assets at risk to the business market transfers those assets (including a system of profit-making) in exchange for liquid assets only subject to investment risk (much lower risk than a business risk).
An owner can derive wealth from the operation of a business if the business generates enough liquid assets to be extracted from the business, set aside to be maintained at low risk, and over time create wealth. However, given the competitive environment of most businesses, it is unlikely that a business will create profit over time without the requirement of significant reinvestment of capital by its owners to maintain the viability of the business.
Once a business system has created procedures resulting in profitable operation, there will be a subsequent challenge in the marketplace, and the dynamic nature of the competitive market will have its effect. This is an important element of business risk.
Another significant element of business risk is that the owner, at any time, may be forced to transfer the business ownership interest due to death or other contingencies. A buy-sell agreement among the owners reduces the risk of the extreme adverse consequences of a contingency forced sale. However, a sale to other business owners will not be a sale for the maximum possible value because insiders will not pay a maximum price. At some price point, an insider will decide to start a competitive business rather than purchase part of an existing business at a premium.
The wealth building sale is the sale to a capable party from outside the business who is willing to pay full value for the functioning system of profit creation that is the principal asset of the business. For this to occur, the business must be perceived by that buyer to be a system capable of functioning into the future without the continuing involvement of the current owners. A buyer capable of purchasing for a maximum price will often be sophisticated and carefully inspect the profit-making system being purchased. That system must be credible, documented, and not dependent on current owners.
The longer a business operates profitably, the more likely it will be challenged by competition which will force a reinvestment to maintain the profitability of the business. Also, a contingency event forcing a transfer of business interest could occur at any time. There is a sweet spot, a place where the business is operating profitably without significant competitive challenge, that is the time to sell to an outsider for maximum value.
This sweet spot is also the time that the flow of profit is most seductive to the owners, encouraging continued ownership since the system of profit creation is in place and no challenges have yet appeared. It is difficult for the owners to see past current cash flow to the inevitable challenge of competition and the requirement to invest more capital in the business.
Business owners who experience wealth-building events, resist the temptation to hold the business past the sweet spot and act to obtain maximum value for the business from a buyer outside the business. This transfer of non-liquid business assets at business risk for liquid assets to be held at investment risk is a way business ownership creates wealth.
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