Just because it is a nice problem to have, does not make it unimportant, says Jeremy Lang, regional general manager of Business Partners Limited. The answer to the question can make a huge difference to the wealth and future security that a business owner manages to achieve.
It is important to realise that there is no rule of thumb like “take out 20% and reinvest the rest” to guide a business owner in answering the question, says Jeremy. Every business is unique, and the right answer also depends on the risk appetite and investment strategy of the business owner.
There is only one rule that applies to every business owner when it comes to this question: you must have a well-defined and thought-through growth strategy which is underpinned by sound financial planning.
Then you are able to consider carefully the advantages and disadvantages of either reinvesting or extracting profits for your particular business.
The advantages of extracting profit and saving it elsewhere
Running a business, even though it might be profitable, is still exposed to elements of risk. Investing some of your profits outside of your business can take some of the sting out of the risk if the investment is safe and flexible.
Putting it into a money market account, for example, is both safe and flexible - you can access the funds with relative ease should you need it. In contrast, a new machine for the business cannot be liquidated easily if you suddenly needed cash, says Jeremy.
A strong argument in favour of extracting at least some profit is the old principle of not having all your eggs in one basket. It is good to diversify by investing in a range of asset classes wider than just one business.
Some savings outside of your business gives you a more stable retirement asset, rather than relying only on the sale of your business one day, which is inherently a more uncertain affair.
The disadvantages of extracting profit
Investing surplus money outside your business may be safer, but with lower risk comes lower returns. The wealth-creation potential of your money in safer investment vehicles is generally lower than keeping it in the business, depending of levels of profitability.
Even the difference between investing your money in a money-market account on the one hand and the stock exchange on the other is substantial, with potentially a much higher return on the stock exchange.
Once you have extracted the money from your business and you suddenly need a cash injection to expand, you may have to go out to look for debt finance or equity investors. Apart from the costs, these can come with conditions that impede your freedom to make decisions on your own.
The cost of the debt must be carefully calculated and weighed against the return on the investment elsewhere. The debt option does not always have to be cheaper to make it the right choice. Diversity might be enough of an advantage to rule in favour of debt even though it may be more expensive. Consideration must also be given to current levels of debt versus equity currently in the business and how much more debt the business is able to comfortably afford.
The advantages of reinvesting in your business
Putting your money back into your business will most probably give you a higher return than keeping it in a money-market account, depending on levels of profitability.
Furthermore, the very fact that you reinvest fuels the growth of your business, provided you do so in a well planned and executed strategy, therefore strengthening your potential for a higher return.
The act of reinvesting your money into your business shows good faith and confidence in your business when you approach investors and financiers, who see it as a sign of the commitment and belief of business owners in their ventures.
Reinvesting in your business also carries some tax benefits such as qualifying marketing expenses and wear and tear allowances, amongst others.
The disadvantages of reinvesting in your business
Business is always risky, and your reinvestments carry no guaranteed returns. If that major marketing campaign does not work, you would have been better off saving your money elsewhere, even in the money market.
Planning for the sale of your business one day is a completely legitimate retirement strategy, but there is a big danger of overestimating its value. Business owners tend to be emotionally attached to their businesses and know what hard work went into building it. The result is that they tend to overestimate its value. This can lead to overinvesting in the business to the detriment of a more diversified retirement portfolio.
When considering the questions of reinvesting versus extracting profits, business owners each have to weigh up their own circumstances, says Jeremy.
They must make sure to take into account their own personal risk appetite and investment strategy.
In an important business decision like this one, it is always a good idea to seek the help of a finance professional, a business adviser or an accountant to help you determine the best strategy, says Jeremy.