Learning a few valuable lessons is likely to be the only good to come from the collapse of Enron and the assorted investigations and lawsuits related to one of the worst incidents of executive greed in U.S. history.
For the thousands of Enron employees who have seen their retirement savings wiped out, the most brutal lesson is probably this one: don’t put all of your retirement option eggs into the company stock basket.
As Enron’s share price soared, employees poured millions set aside for retirement into company 401(k) accounts comprised entirely, in far too many instances, of Enron stock. The circumstances surrounding whether or not employees were forced to invest exclusively in company stock or not remains to be settled in court, but at the very heart of this situation is a textbook case on the importance of investment diversification.
Just the (basic) facts, ma’am
To review the basics, an investment portfolio should be broadly diversified among different industries, different size companies and different countries. Further, a portfolio should contain both stocks and bonds. When one’s investments are so arranged the risk of trouble in any one industry or any one country is minimized.
Naturally, a recessing economy lowers all boats, but a diversified portfolio won’t be depressed more than the economy as a whole.
What about small business owners? How can a small business owner diversify his portfolio when everything he owns and can beg, borrow or steal is tied up in the business? Ouch!
Starting a business — a few more basics
A business requires capital to purchase assets, finance accounts receivable and satisfy countless other needs. A person wishing to start a business must provide that capital in order to get things going.
So, where does the money come from? Generally speaking, entrepreneurial wannabes get capital from one of three sources: inheritance, savings or debt. One either inherits property or one doesn’t. Not much planning potential there. Saving enough money to start a business takes a really long time. Unfortunately, by the time one has saved sufficient capital to start a business, they may be too old to make the emotional and physical commitment required to get a successful venture in motion. If inheriting and saving are eliminated, that leaves debt, which is the route most new businesses take.
The budding entrepreneur likely doesn’t have much in the way of collateral to pledge for a business loan. The end result is that you assign everything you own to the lender in exchange for the money necessary to convert your business dream into reality.
In this case, you have to put all of your eggs in one basket — and then watch that basket very closely.
Now, in the wake of Enron and other recent financial disasters, the small business owner is being counseled to diversify his investments in order to minimize risk. With everything tied up in the business, how can one diversify? One can’t really, but the business owner is in control of the business, at least, which differentiates them from the typical Enron employee.
An orderly succession and stock redemption plan is the answer. Though it will not really do the same thing as diversification, it can protect the value of the business for the owner’s retirement or heirs.
Laying out a succession plan is stressful since all entrepreneurs believe they are bulletproof and will reign forever. Reality is another matter.
Start by asking what would happen tomorrow if you should assume room temperature today: Who would carry on the business? Would your personal estate be wiped out by business obligations? Can the business succeed without you?
Though I don’t sell life insurance (or anything else for that matter) this scenario probably calls for an insurance solution. You can purchase a life insurance policy in sufficient amount to provide your heirs the fortune they would have inherited if you had lived and eventually liquidated the business. The premiums are the cost for peace of mind that the heirs are protected regardless of what happens to you. You might even consider an irrevocable life insurance trust to move the inheritance beyond reach of your business creditors and estate taxes. You need the advice of a competent financial/legal professional to decide how to customize a plan for your situation.
Once the financial exposure is covered, the “people issue” needs attention.
Someone needs to be positioned to step in and conduct business at your death. That person needs to know what is expected of them, and the organization needs to know that a plan is in place.
It is possible that senior employees may be motivated to buy the company at your death. If so, a stock redemption plan is in order. The employees can buy life insurance on you and use the proceeds to purchase the company. It’s done all the time and one option worth investigating as you prepare a succession plan for your business.
Back to the basics
The collapse of Enron and the thousands of personal portfolios it brought down with it are tragic when we look at the many lives — the hopes, dreams and futures — that were invested in those soaring share prices. While tighter regulations of large corporations and the firms that audit them are in order, sweeping change will not accomplish as much as remembering the basics of investing, which build wealth over time — not overnight.
And, one more time now, what does a healthy portfolio begin with? Investment diversification.
It just doesn’t get much more basic.
Thought for the Moment —
How to persuade others toward your way of thinking:
1. Be clear, in your own mind, about exactly what you’re after.
2. Do your homework so that you are fully prepared to answer questions.
3. Be persistent. Don’t expect to win the first time.
4. Make friends with the person with whom you are bargaining. Cast your bargain in terms of his or her needs, advantages, and benefits.
5. Keep your sense of humor.
— Benjamin Franklin
Joe D. Jones, CPA, is publisher of the Mississippi Business Journal. Contact him at firstname.lastname@example.org.