Financial Risks Every Business Owner Should Know

How Business Owners Can Manage Financial Risks

Running a business involves managing many moving parts, and while the rewards can be great, so are the risks. Many business owners are so focused on day-to-day operations that they overlook the potential financial risks and the threat they pose to their financial security. Without a proper risk management strategy in place, these threats could jeopardize not just the business, but your personal wealth and long-term financial goals.

In this post, we’ll explore five major financial risks that business owners face and provide actionable solutions to mitigate them.

1. Tax Risks: The Threat of Increasing Future Tax Rates

Risk Overview:
Taxes are typically the largest single expense for business owners. Future tax rates are expected to rise sharply due to the expiration of the Tax Cuts and Jobs Act in 2025 and the growing national debt. This poses a significant risk for business owners relying solely on tax-deferred accounts like 401(k)s or IRAs, as higher tax rates on withdrawals could significantly reduce their retirement savings. While these accounts allow for tax deferral during the growth phase, withdrawals are subject to income tax at the rates in place at the time of distribution. If tax rates rise, the amount available for retirement may be drastically reduced.

Risk Management Strategy:

Prepare for Increased Tax Rates: Educate yourself and prepare for the increased taxes.
Diversify Savings Vehicles: Relying too heavily on tax-deferred accounts can leave business owners vulnerable to rising tax rates in retirement. Instead, balance your retirement savings across a mix of taxable, tax-deferred, and tax-free accounts, such as Cash Value Life Insurance and Roth IRAs or Roth 401(k)s. With tax-free accounts, qualified withdrawals in retirement are tax-free, providing a hedge against future tax rate increases.
Maximize Tax-Efficient Investments: Consider investments like municipal bonds, which generate tax-exempt income, or cash value life insurance, which can offer tax-deferred growth and tax-free access to funds in certain situations.

Solution:
Work with a financial professionals to structure a plan designed to balance tax risk by incorporating tax-free and tax-deferred strategies. This way, you can manage your current tax liabilities and future tax liabilities in both high and low tax rate environments. This leads to tax efficiency and paying the least amount of taxes over the course of your lifetime.

2. Not Having a Business Continuation Plan in Case of Death or Incapacity

Risk Overview:
One of the biggest threats to the longevity of a business is the lack of a clear continuation or succession plan. If a business owner passes away unexpectedly or becomes incapacitated, the company may face chaos, leading to financial instability or even closure.

Risk Management Strategy:

Create a Business Continuation Plan: A comprehensive business continuation plan should clearly outline how the business will be managed or transferred in the event of your death or incapacity. This includes designating successors, outlining management responsibilities, and providing clear financial instructions.
Buy-Sell Agreements: A buy-sell agreement is a legally binding agreement between business partners or co-owners that dictates what happens to an owner’s share of the business in the event of death, disability, or retirement. These agreements ensure that the business can continue without disruption and that heirs receive fair compensation for their share.
Life and Disability Insurance: Funding the buy-sell agreement with life insurance ensures that funds are available to purchase the deceased owner’s shares, allowing the business to transition smoothly.

Solution:
Establish a business continuation plan and implement a buy-sell agreement funded by life insurance and disability insurance. This will ensure that the business remains operational and financially stable even in the face of unexpected events. Also, create management systems that allow your business to operate without you being present. This may be hard at first, but this can pay huge dividends for you in the future. It not only decreases your financial risk, it makes the business more appealing to future buyers, and creates more time for you and your family.

3. Financial Risk of Economic Downturns and Market Volatility

Risk Overview:
Businesses are often vulnerable to broader economic downturns and market volatility. Whether it’s a recession, supply chain disruption, or changes in consumer demand, economic shifts can severely impact a company’s profitability. You’ve probably already felt the impact of this financial risk with the massive rise in inflation over the past few years.

Risk Management Strategy:

Build Cash Reserves: Cash reserves serve as a buffer during tough economic times. Business owners should aim to have enough liquidity to cover at least six months of operating expenses. Using cash value life insurance and money market accounts are a great places to safely store cash reserves to earn interest and still be liquid enough to get your money quickly.
Diversify Revenue Streams: Relying on a single source of income can increase the impact of economic downturns. Explore ways to diversify revenue streams through new products, services, or markets. Make sure your revenue is not completely dependent upon the economic cycle.
Manage Debt Levels: High debt can be a significant burden during periods of reduced revenue. Ensure that your debt levels are manageable and seek ways to refinance or reduce interest costs during economic booms to prepare for potential downturns.

Solution:
Prepare for economic volatility by building cash reserves, diversifying income streams, and keeping debt under control. This financial stability will allow your business to weather market shifts and economic uncertainty.

4. Legal and Regulatory Risks

Risk Overview:
Businesses face a range of legal and regulatory risks, including lawsuits, regulatory changes, compliance issues, and intellectual property disputes. Failing to manage these risks could result in costly litigation, penalties, or even business closure.

Risk Management Strategy:

Proper Business Structure: Make sure you have an LLC, S-Corp, or C-Corp in place to separate your business interests from you personal wealth. Not only can this help with taxes, it will protect your personal assets from your business liabilities.
Ensure Compliance with Laws: Stay updated on federal, state, and local regulations that affect your industry. This may include tax laws, labor regulations, and environmental guidelines. Work with legal counsel to ensure compliance.
Purchase Liability Insurance: General liability, product liability, and professional liability insurance policies can protect your business from lawsuits and claims. Having the right coverage ensures that your business is not financially crippled by a legal dispute.
Protect Intellectual Property: If your business relies on proprietary technology or intellectual property, make sure it is legally protected through trademarks, patents, or copyrights. Enforce these protections to avoid costly legal battles.

Solution:
Invest in liability insurance, consult with legal professionals regularly, and ensure compliance with relevant regulations. These proactive steps will protect your business from potentially damaging legal and regulatory challenges.

5. Lack of a Comprehensive Retirement and Exit Plan for the Business Owner

Risk Overview:
Many business owners focus on growing their company but fail to plan for their own retirement. Without a comprehensive retirement plan, they risk becoming financially dependent on the sale of the business or other uncertain income sources in retirement. Additionally, many business owners make the mistake of assuming that their business will be their primary source of retirement income, only to face difficulty selling or passing on the business.

Risk Management Strategy:

Separate Personal and Business Finances: Ensure that you are saving and investing for retirement outside of the business. Don’t rely solely on the value of your company to fund your retirement.
Set Up a Retirement Plan: Business owners can benefit from setting up tax-advantaged retirement accounts, such as Roth IRAs, Cash Value Life Insurance, SEP IRAs, SIMPLE IRAs, or 401(k) plans, for both themselves and their employees. These plans allow for tax-deferred growth and can help attract and retain employees.
Plan for the Sale or Transfer of the Business: If you intend to sell the business to fund your retirement, start planning early. Have a business valuation done and establish an exit strategy that ensures you get the most value from the sale.

Solution:
Meet with a financial professional to create a retirement plan that includes both personal investments and a business exit strategy. By planning ahead, you’ll ensure a financially secure retirement, regardless of the business’s future.

Conclusion

Managing financial risks is a crucial part of business ownership. While risks are inevitable, they don’t have to derail your business or your financial goals. By proactively addressing potential threats, such as tax risks, the lack of a business continuation plan, economic downturns, legal issues, and retirement planning, business owners can safeguard both their company and personal wealth.

Remember, the key to successful risk management is planning. With the right strategies and tools in place, you can protect your business from financial threats and ensure long-term success.