“Business opportunities are like buses, there’s always another one coming.”
I have run the gamut of investing successes and failures. I’ve had some pretty hairy failures in investing (spec home building, option spread trading) to reasonable success (value cost averaging in index funds and rental real estate investing) to a big hit (co-founding and selling a company). Even though I’m a serial entrepreneur (this is company number five that I have founded, and I’ve worked longer for myself than I have for someone else), I generally like to think of myself as more financially conservative than the average person. In most cases, it doesn’t take much of a loss for me to crinkle my nose and try something else.
Yet, every time I think of ways for my clients to get ahead, I come back to the same set of recommendations and assumptions. I could be clouded in my thinking because I did manage to hit a home run (or at least a long triple) with entrepreneurship, but, for people who have the constitution to do it and the luck to get some traction, starting up a small business is, in my mind, a great way to get ahead.
However, before I get too far into explaining my (obvious) bias towards entrepreneurship, I need to explain a term for readers who might not be familiar with it. The term is called alpha.
Alphas and the Stock Market
Alpha is an investing term that means your investment return on a risk-adjusted basis. If everyone has the same amount of risk, then alpha would explain individuals’ deviations from the average.
The most common usage of alpha is looking at mutual funds. Mutual funds have a benchmark for overall risk – the stock market itself. Investment professionals use volatility as a measure of how much risk you’re taking. That volatility is called beta. So, if you’re in a fund which is twice as volatile as the overall market, your beta is 2, and you should receive twice the return of the overall market to account for that risk. Alpha is a measurement of how far you’ve deviated from that expected return.
The reality with stock market investing is that, if you’re willing to go after very risky options strategies or you’re going to try to catch a penny stock on its way up, and you put all of your money into the investment and get it right, then you could get incredible returns. You’d also probably be exceptionally lucky. There are people who, for example, invested in Apple at its IPO and are sitting on 15,000+% ROIs…for that investment. How many of them risked it all on that investment to get the super outsized returns? Every time you diversify your investments in your chase for improved alpha, you have to get just that much more in returns from a single investment, assuming the rest perform on par with the market or the expected return, to change your life.
While alpha is measured in the stock market, the concept can apply across a broad range of investments.
Let’s take a commonly used example: using a mortgage to buy rental real estate.
The Alpha of Real Estate
Lots of rental real estate investors take out mortgages on their investment properties, and I do not. Because the tax system allows for deductions of mortgage interest, the expected return on a mortgaged rental property, all things being equal, should be higher than one that is purchased outright. I’ll walk you through an example.
Houses A-F are all on the same street and all worth $100,000. They will rent for $1,000 a month, and, since this is imaginary world, they don’t need any maintenance or have other issues, and there are no property taxes (hah!).
Investor 1 and Investor 2 have $100,000 in cash. They are both in a 25% tax bracket, which means that depreciation recapture will net out depreciation taken.
Investor 1 is risk averse and pays cash for House A. He gets $12,000 in income in the year. One year and two days later, he sells house A for $110,000. He has $9,000 in after-tax ordinary income, and $8,000 in after tax capital gains (assuming a capital gains rate of 20%). His return on his investment is 17%.
Investor 2 has a higher risk appetite and doesn’t mind getting mortgages if he can put 20% down on the property. Since they’re rental properties, he doesn’t quite get the sweetheart mortgage deal, but he gets 5% on a 30 year mortgage. He buys houses B through F for $100,000 each, getting an $80,000 mortgage on each of them.
He gets the same rents and makes the same sale. At the time of the sale, his mortgage for each property is $78,819.65, and he’s paid $3,973.17 in interest on each mortgage.
His taxable income on each house was $8,026.83 since he got to write the mortgage off. His cash flow was $7,200.47 per house, although the amount which accounts for the difference went towards principal on the loan.
So, Investor 2 paid $2,006.71 per house in income taxes, compared to investor 1, who paid $3,000. He pays the same capital gains tax on the sale, and when he sells, he gets $31,180.35 back in cash per house.
Let’s look at the results.
- Invested $100,000
- Received $9,000 in after tax income from rents ($12,000 in income minus $3,000 in tax)
- Received $8,000 in after tax capital gains from sale ($10,000 gain minus $2,000 in tax)
- Net profit: $17,000
- ROI: 17%
- Has $117,000 to reinvest
- Invested $100,000
- Received $24,198.85 in after-tax cash flow from rents
- Reduced principal by $5,901.75
- Received $40,000.00 in after-tax capital gains from sales
- ROI: 70.1%
- Has $170,100.60 to reinvest
Looks like Investor 2 wins by a landslide, right?
Not so fast.
The maximum amount of money that Investor 1 could theoretically lose is $100,000. The maximum amount of money that Investor 2 could theoretically lose is $873,028 (his $100,000 investment plus the $773,028 in mortgage payments over a 30 year time period if the house never rented and became worthless and the investor never had an opportunity to capitalize on the tax loss).
The reality is that the probability of either investor losing all of the money is extremely slim. Real estate almost never goes down to zero value unless you get the opportunity to buy land in the middle of the Love Canal. I have had a close to -200% ROI on land where I had a mortgage and got stuck with the land and had to keep feeding the mortgage rather than choosing to default. So, it’s not impossible for you to be caught in a really nasty real estate deal, despite what HGTV tells you.
Yes, certainly, the opportunity for higher returns is possible using leverage, but nobody ever seems to want to talk about the dark side, the potential for loss.
When it works, real estate is great. I’m a huge fan of rental properties as part of a well-diversified investment strategy for the right people. I do it myself, so I practice what I preach. However, when it goes bad, it can be disastrous.
The problem with the high alpha chase in real estate is that it’s capital intensive. Yes, you can use leverage to decrease up front capital requirements, but it’s still capital intensive. It just depends on who’s providing the capital. It’s quite possible to leave yourself with very little margin for error if you’re not adequately capitalized, and suddenly, a 3 month vacancy or a roof replacement can have you dancing on, if not falling over, the edge. If you have enough money (e.g., you don’t have a mortgage you have to keep feeding), then you can weather those events fairly well.
This leads me into entrepreneurship.
The Alpha of Entrepreneurship
I’m a big supporter, as I’ve said before, of starting your own side gig and trying to make something of it, particularly if you keep your capital investment low as you vet your ideas and determine the viability of what you’re trying to do.
The Potential for Extra Income
The first, and most obvious, reason that someone would want to try to start up a business is to earn extra income. This could be a little bit of side income to pay down debt or to fund the IRA, or it could grow to the point where it supplants your regular income from a job. Unless you’re moving directly from a full-time job into some sort of consulting position where you already have clients lined up and ready to go, don’t expect this to happen from day one. In fact, even if you’re eventually successful, it can be a long time before you get paid (you can read about my story in my guest post on the Military Retirement and Financial Independence website).
If you can grow your side gig into a truly sustainable business, then you’re also benefitting from taking control of your own destiny. No matter how well you do your job, you don’t control everything about your job security. While that remains true when you’re an entrepreneur, you do make more of the calls than you do when you’re working for someone else. Research also shows that this control will make you happier.
Additional Retirement Contribution Possibilities
Most people who have a job are limited in their retirement contribution possibilities. In 2013, they can contribute to their IRAs ($5,500 per person under age 50 and $6,500 for those over 50) and, if they’re fortunate, they have a company 401(k) plan. Each individual can contribute up to a maximum of $17,500 to a 401(k). If you’re age 50 or over, you can contribute a catch-up contribution of $5,500. If they’re really fortunate, there’s a generous employer contribution, which could get them up to $51,000, or $56,000 if they’re age 50 or over.
In reality, few employers will contribute up to the employee’s limit through the use of matching contributions, non-elective contributions (other amounts the employer decides to give you in your 401(k)), and allocations of forfeitures (unvested money returned to the general pool).
If you have a successful business of your own, then your business can make up that shortfall. You could also elect to start a SIMPLE plan, which has a $12,000 a year contribution limit in 2013, or a SEP plan, which has a limit of the lesser of:
- 25% of your compensation, or
If you employ your spouse or your kids, then your business can fund their retirement plans as well.
You have to be successful as a business owner to be able to take advantage of all of the opportunities, but even if you’re mildly profitable, you can still fund extra retirement accounts that you might not have been able to solely as an employee.
The biggest tax advantage of owning your own business is that you get to use what are called “above the line” deductions. An above the line deduction is one that allows you to reduce your gross income. It’s the difference between pre-tax dollars and after tax dollars.
Let’s say, for example, that you own a small business which uses a cell phone which costs $100 a month. If you were to pay for the cell phone normally, if you had an effective tax rate of 25%, then you’d have to earn $133.33 per month to pay for that phone, since $33.33 would be taken out in taxes. However, with a small business using the phone as part of an ordinary and necessary expense, then you only need $100 in income to pay for the phone.
When done correctly, you can write off many items, such as:
- Depreciation on part of your house through a home office
- Travel as a part of your business
- Cell phone
- Business entertainment
This isn’t an exhaustive list by any means, but, rather, just a sample to give you an idea of what’s possible.
If you structure the business properly, it’s possible to shield some of your income from self-employment tax and route it into dividends, which could also be tax advantaged for you.
Naturally, when filing taxes and taking these deductions, you’ll want to engage the counsel of an experienced and competent CPA.
Moreover, it’s important that you not let tax savings drive what you do in your business, because the primary goal is to make money. The tax piece should be an added benefit, but it’s not the main reason you go into business.
Selling Your Company
This one is the big kahuna. While there are a few business owners who plan on intergenerational wealth transfers through passing the business on, most of them would just as soon either have something which provides them with a steady stream of money or sell it.
When my co-founders and I had our first business strategy offsite, we thought that we’d eventually grow the company to the point where it would throw off enough in dividend revenue and distributions for us to live on quite happily.
While I can’t disclose the terms of my sale, I can say that it was the sale which enabled me to achieve financial independence.
In 2010, BuyBizSell reported 4,568 sales of companies, and there are many others (such as my transaction) which don’t get reported, so my guess is that it’s somewhere near double that number, maybe 10,000 a year. According to the Kauffman Foundation, in 2010, there were 565,000 businesses started. This means that there’s roughly a 1 in 50 chance that a business you start will sell. The chances of the business failing within 5 years, comparatively, are 1 in 2. So, if you survive, your odds of selling jump all the way to 1 in 25. BOOM!
Obviously, the range of terms and conditions of buyouts vary widely, but the BuyBizSell report previously cited revealed the average sale price of a company in 2010 (a down year) was $150,000. If you stick by my rules and you can get an average sales price if you can sell, you have a 1,500% ROI. Of course, there are no guarantees, but there are also no guarantees in anything else in life, either.
There are stories of entrepreneurs who started up a company, sank everything they had into it, maxed out the credit cards, and then watched it all go down the drain in a blaze of glory. They shared Herbert Hoover’s view that prosperity was right around the corner.
If you are wise about your investments, though, and properly insured, then the downside risk is limited to the capital that you actually put into the company. There is no mortgage which you still have to account for even if you don’t have tenants. There’s no margin call threshold like leveraged stock investors have. There’s no drastic downside chasm like the writers of naked call options. You can quit, wind up, and be done if it doesn’t work out. The potentially bigger loss will be of time, but you will also be gaining experience and knowledge, even if your business doesn’t work.
Let’s take the example of Flypt, which wound down in 2012. The founder of Flypt, Nick Barron, was very wise in how he funded his company. As he told me in our interview, he had a “Flypt blow fund,” where he had a certain amount set aside every month that he would invest in Flypt to see if he could get traction. He didn’t get sucked into believing his own story to the point where he took unnecessary financial risks. The company didn’t succeed, Nick kept his shirt, and his loss was limited to the amount of capital he’d invested in starting Flypt (which I’d guess was fairly low).
While I’d love to see all of my clients start companies, grow them wildly, and then sell them for gazillions, that’s simply not a realistic goal. I’m aware that the numbers simply do not support my desires and that few startups reach the promised land of an acquisition, or, similarly, grow to the point that they are large and acquisitive themselves.
Instead, while I say to set the goal to be acquired or grow big, if we go out with that mindset, then Monkey Brain will derail the entrepreneurship process. You have to set intermediate milestones and alternative goals so that you don’t perceive what is, in reality, a success as a failure. Here are the milestones I suggest:
- Get revenue. The first step in business is to get someone to pay you for whatever it is that you are offering. One cent is a huge barrier, and getting people to part with money will be a step in showing the viability of your business.
- Earn a side income. Many side gigs never get beyond getting a few hundred dollars a month to pay various bills or to invest more or to increase the standard of living for their owners. That’s OK. You’re still doing better than a lot of people, and you’ve created a real option for potentially growing in the future.
- Earn a real salary. If your business is throwing off enough excess capital that you can afford to pay yourself a real salary, that’s an enormous step. I’m sure that there are psychologists who can explain what’s happening inside our heads when it happens, but I can tell you from personal experience that there is a massive psychological lift the first time you actually get your own real paycheck from your own company. Even if you had to take a pay cut, the mental freedom associated with paying yourself for your work is exceptionally liberating and it’s really hard to put a true measure on that value.
- Grow the business to either sell or to treat it as a cash cow. While only about 1.8% of businesses get sold in a given year, I’d be willing to stake a claim that there are also that many which pretty much run themselves and require very little intervention on the part of the owner while generating cash flow for the owner. At that point, you have achieved true freedom.
Entrepreneurship is not for everyone. It’s probably for more people than the number of people who think that it’s for them simply because of the limiting scripts that Monkey Brain keeps throwing at them. It is, in my mind, though, the highest alpha investment that people can make, as it has the highest upside opportunity if everything goes right. 41% of the world’s millionaires are entrepreneurs, after all.
That’s not to say that other investments aren’t good, either. I am all in favor of diversification of investments and of investment classes. Having a solid, steady foundation of investments allows you to take risks and take shots, and I, personally, think that small business has the best potential for driving a very high ROI. It’s not for everyone, and starting a business is no guarantee of success, but when it works well, it’s very good.
What do you think? Would you rather invest in real estate? Options? Margin accounts? Start up your own business? Tell us your thoughts in the comments below!