By SJS Investment Services Founder & CEO Scott Savage.
Andrew Carnegie – steel tycoon, philanthropist, and one of the wealthiest businessmen of the 19th century – once commented about creating wealth:[1]
“Put all of your eggs in one basket, and then watch that basket.”
Does that advice surprise you? Many SJS clients have generated their wealth through concentrated bets that began as small investments - often creating their own businesses - and grew over time.[2]
As these investments increase in value, some clients no longer want their individual business concentration risk, and instead want to diversify their investments in order to preserve their wealth for the long-term. They are willing to pay the necessary taxes associated with realizing capital gains from selling a portion of their business.[3]
Conversely, others want strategies that help them generate cash without selling their business - in order to maintain ownership, keep voting authority, avoid associated taxes from selling, or just to wait to implement their estate plan.[4]
My Dad used to tell me, “Scott, there are two ways to get to the top of an oak tree. One, you can climb it. Or two, you can sit on an acorn and wait!”
As business owners, if we sit around waiting for something good to happen to us, we may be in for a long wait! The “trick” that most successful business owners know is we have to get out of our comfort zones and make something happen. So, I offer two cash-generating ideas in lieu of selling your business or investments that have gone way up in value.
Securities-Based Lines of Credit
Securities-based lines of credits (SBLOC), also known as securities-based loans, are becoming an increasingly popular go-to option to allow business owners to generate cash without selling their businesses.[4] When a business owner says they are “recapitalizing” their business, they may be referring to SBLOCs.
Negotiated directly with a bank or other lending institution, SBLOCs are highly customizable; depending on the lender, you can receive an SBLOC up to 50% of the value of your collateral, which is typically valued based on a third-party evaluator. Investments that can serve as collateral include a private business, public stock, and certain derivative holdings.[5]
Depending on the specific terms, potential benefits of SBLOCs include receiving cash without giving up voting authority in your business, lower interest rates than other types of loans, flexible repayment schedules, avoiding capital gains taxes that would result from selling appreciated assets, and not showing up on credit reports.[4] If you work for a publicly-traded company and are required to disclose your holdings, then you may be required to disclose the collateralized loans against that particular security. However, most other loans collateralized against other assets often do not need to be disclosed.[4]
As with any customized loan arrangement, it is critical to thoroughly understand the details ahead of time. The SEC released an Investor Alert in 2015 to help people considering SBLOC loans better evaluate specific details, particularly emphasizing ten questions to ask before taking out an SBLOC:[6]
Many regional and major banks offer SBLOCs. If you are comfortable taking on a loan, paying interest, and using your business or investments as collateral, then an SBLOC may be a good option for you.
Covered Call
If you own large amounts of a publicly-traded stock, you can potentially generate cash by selling a call option on that stock (also known as a covered call). A call option is a derivative contract that enables the holder of the call option to purchase the underlying security at a pre-specified price. By selling a call option, you receive an upfront premium, but if the call option holder decides to exercise the call option, then you may be required to provide the call option holder with the underlying stock, or pay the difference in value between the call option strike price and the current value of the underlying stock.[7] Therefore, a covered call limits your downside as well as limits your upside of your underlying stock holding.
Covered calls are generally only available for larger public stocks. Since call options are relatively expensive to create and trade, they are usually used by larger investors. Because call options typically expire within one year, you would need to sell a call option at least once per year, or use another strategy to generate recurring cash. Additionally, any net income from the covered call as of the call option’s expiration date is subject to the appropriate capital gains (usually short-term) taxes.[8]
Because you may be required to deliver the underlying stock to the counterparty, as well as the complexity and taxes associated with selling call options, we generally advise for investors to only consider covered calls if they need money in the short-term, don’t have other simpler sources of financing, and would be agreeable to selling the security if it reaches an acceptable price.
Conclusion
There are many ways to generate cash without selling your business, each coming with its own benefits and tradeoffs. SJS has over 26 years of experience helping business owners and high net-worth individuals implement these strategies. If you want to discuss whether any of these strategies are appropriate for you and how you could implement them, please feel free to reach out to us.
Important Disclosure Information & Sources:
[1] “Put All Your Eggs in One Basket, and Then Watch That Basket“. Quote Investigator, 16-Feb-2017, quoteinvestigator.com.
[2] “How People Get Rich Now“. Paul Graham, Apr-2021, paulgraham.com.
[3] “Ways to Cash Out of Your Business”. Laura Lorber, 11-Sep-2008, wsj.com.
[4] “Buy, Borrow, Die: How Rich Americans Live Off Their Paper Wealth”. Rachel Louise Ensign and Richard Rubin, 13-Jul-2021, wsj.com.
[5] “Securities-Based Lending“. Lucas Downey, 26-Aug-2020, investopedia.com.
[6]“Investor Alert: Securities-Backed Lines of Credit“. U.S. Securities and Exchange Commission, 21-Dec-2015, sec.gov.
[7] “The Basics of Covered Calls“. Alan Farley, 20-Apr-2021, investopedia.com.
[8] “Tax implications of covered calls“. The Options Institute At CBOE®, 2013, fidelity.com.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this report that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Advisory services are provided by SJS Investment Services, a registered investment advisor (RIA) with the SEC. Registration does not imply a certain level of skill or training. SJS Investment Services does not provide legal or tax advice. Please consult your legal or tax professionals for specific advice. This material has been prepared for informational purposes only.
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