Successful small business owners can be among a financial advisor's best clients. Not only do these professionals often enjoy high incomes that fund sizeable personal investment portfolios, they also may rely on their advisor to provide other investment-related services, such as retirement plan advice.
While a small business owner's personal holdings and business assets often are separated by the legal walls of the business's limited-liability status, there is no doubt that owners often think of their personal and business wealth as one big pool.
This mindset, and the potential for a large personal property or casualty loss to prompt a business owner to tap company assets, creates the potential for an unexpected change of circumstances to a client's wealth — and to an advisor's assets under management.
Consider the example of Brian Herndon, a fictional but typical 58 year-old entrepreneur who owns a successful metal fabricating business in suburban Chicago.
A candle left burning on a counter in the Herndon's recently renovated kitchen for some reason emitted an ember that caused a hanging potholder to catch fire. The fire spread quickly and destroyed the kitchen's custom cabinetry, high-end appliances and flooring. Damages totaled $350,000.
Unfortunately, the Herndon family hadn't updated their homeowners insurance after completing the kitchen renovation, leaving their coverage inadequate and saddling them with $150,000 in expenses they had to cover out of pocket.
Like many small business owners, the vast bulk of Mr. Herndon's wealth was tied up in his business. The Herndons' personal financial wealth was relatively small and held in qualified retirement accounts, which Mr. Herndon and wife didn't want to tap to avoid paying the 10% early withdrawal penalty.
Instead, he decided to borrow cash from the business to cover the expense — also a complicated maneuver that should be undertaken only with the help of a tax expert to avoid IRS penalties.
Borrowing funds from the business proved costly in its own way. It depleted working capital, which the business had to borrow from its bank. That not only raised costs and reduced margins, but also lowered the value of the business, which Mr. Herndon was hoping to sell when he reached 60.
