The easiest way to become wealthy is to inherit a mountain of assets. But what about the rest of us? Look at any rich list and it’s unlikely you’ll see many employees.
Even if the person’s riches initially came from being an employee, like a sports player for example, the real wealth is usually made later. And it is usually made from assets. Things like property, equity in a business or movie franchise, song rights, or the 100% owned asset that is someone’s personal brand.
I’m not fixating on the rich list level of wealth today. I am focusing more on “every day” levels of wealth where people are financially independent without necessarily being ludicrously rich.
That is the rough level of wealth that the famous book “The Millionaire Next Door” was aimed at decoding, and it is a level of wealth dominated by business owners rather than employees. Two thirds of the households with over $1 million in net worth in the study (an amount worth $2 million in today’s dollars) made their money from business ownership as opposed to being an employee.
I’m not saying you can’t eventually obtain financial independence by earning a salary, putting some of it aside in a disciplined manner and investing it over many years. That is what I am doing at the moment and it is exactly what we want to help people do successfully. I’m just saying there are a couple of ways that owning a business has an edge over being an employee when it comes to building wealth.
First, business owners can leverage the time of other people (their employees) to make more money for them as the business owner. Employees don’t have this option. I’m sure that somebody somewhere has ChatGPT doing eight other jobs for them and is collecting nine salaries as a result. But most of us only have time to do one job for 40 or 50 hours per week.
More importantly, business owners also benefit from the building up of equity. A profitable company with established customers is an asset that can be sold to somebody else. It is also an asset that can be borrowed against, and one that can grow in value if the business grows.
Employees facilitate much of this growth and take wages, maybe even a bonus, in return. Yet unless the employee owns shares, they do not benefit from the value of the business growing. It is a bit like a renter paying off a landlords’ mortgage for them. The rent payment in this case? The employee’s time.
Of course, you can become a business owner by investing in companies on the stock market too.
Not only about the money
People aren’t only attracted to becoming a business owner because of its wealth creation potential. It might come down to wanting more control of your own destiny.
If you own the business, it is unlikely that you will turn up one day and be told you are being made redundant. As the owner, you also have the final word on things like your work schedule, location and workplace culture. Not to mention the overall strategy and direction of the business. Those things might all bring more responsibility, stress, personal downside risk and less free time. But I doubt many owners would switch.
Buying a business can also help facilitate a lifestyle change you are seeking. Two friends I met while living in New Zealand had relocated there from Australia, and both had worked in corporate jobs up until then. Most companies in the region we lived in though, are small to medium sized businesses that are owned by families. It isn’t a place to build a corporate career in the same way that big cities like Sydney, London or Auckland are.
So what did my friends do? They both bought local businesses and essentially created a job for themselves.
How to buy a small business
For those of you interested in owning a business, I have good news: there are a lot of them coming up for sale.
One consequence of Australia’s aging population is that more business owners are retiring than ever before. If the business owner’s family aren’t interested or would rather take the money, the business will often find itself being sold by a business broker.
I’ve always been interested in the idea of buying a company one day. So I thought I would ask Harley Stibbard from Vision Business Brokers to share some key mistakes to avoid when buying a business. After all, Charlie Munger always stressed that a big part of achieving success is learning from the mistakes of others and avoiding them.
Harley Stibbard, Vision Business Brokers
4 mistakes to avoid for business buyers
1. Overpaying
Private businesses usually command lower prices relative to sales and profits than public companies. There are several reasons for this. For one, there is an illiquidity discount (you can’t sell your ownership stake instantly like you can on the stock market). Many private businesses are also simply smaller and less competitively advantaged enterprises than huge-listed companies.
As a result, you may often find yourself able to buy businesses at far lower multiples of revenue or profits than you are used to seeing on the public markets. This spells potential opportunity and brings the prospect of a much shorter payback period on your initial investment. But the increased risk you are taking on to capture this opportunity only makes sense if you are paying a favourable price.
Just like with buying shares in the stock market or purchasing a house, overpaying for any asset reduces the chances that you will receive a satisfactory return.
A common source of overpaying, Harley told me, are buyers relying on forward projections that are too aggressive. Or that ignore changes in costs that are highly likely. A classic case here, he said, is not factoring in increased rent costs over time.
Harley also mentioned the danger of a buyer becoming emotionally sold on an opportunity and massaging their projections to get the result they want. A bit like me trying to justify buying a golf membership within my current financial plan.
Paying a third party – like an accountant, for example – to analyse the business and make projections can help buyers sidestep this mistake. And Harley says that buyers should always, always ask a broker what their valuation methodology was for coming up with the initial listing price.
2. Underestimating key person risk
Harley sells businesses with a transaction size between $1m and $25m. In companies of this size, the original business owner will often have been very involved with everyday operations. As a result, this person leaving the company can sometimes hit profits from both ends.
If the old owner’s personal network was a significant source of new or recurring business, their departure could eventually hit revenue. Similarly, the old owners may have benefitted from discounted deals with suppliers. If these subsequently get repriced, costs increase and profits fall.
Key person risk is also something that you need to consider when investing in public companies. Although Buffett has always said that he’d bet on the inherent quality of the business rather than the person running it.
I’d also point out something that Terry Smith has highlighted in the past – that poor results after the departure of a revered leader can often be a result of decisions that very person made during their leadership. It isn’t always the new CEO’s fault!
3. Ignoring the perils of customer concentration
When you are buying a small business, key person risk can be magnified if the business has a heavily concentrated customer base. Because if one of those clients was only hanging around because of the old owner, you can suddenly have a big hole in your projected revenue and profits.
Even if key person risk isn’t a factor, customer concentration is something to be wary of. For this reason, Harley usually advises buyers to carefully consider the risks of buying a business where 25% or more of revenue comes from a single customer.
Customer concentration is something our analysts also look out for in public companies, too. A highly concentrated customer base can often lead our analysts to attach a higher Uncertainty rating to their valuation.
4. Changing things too quickly
Quite often, a buyer will think they can do things differently and better than the old operators. And in many cases, Harley says, they will be correct.
They might introduce more efficient processes, tweak the company’s product offering or make more use of technology. All of these things could have a positive impact on the company’s profits and ultimately lead to attractive returns from a sensible purchase price.
Problems can arise, though, when a new owner comes in and tries to implement these changes too quickly. Why? Because it can irritate important stakeholders like team members and clients at a time when you should still be building trust.
As a result, Harley recommends that new owners keep things as they are for at least the first couple of months to assess which changes to implement and how best to go about it. You see examples of poorly executed transformation at public companies quite regularly. A recent one is the case of Intel, where a new CEO came in with a grand vision that ultimately tanked the share price.
Waiting for the fat pitch
Buying a small business is not a small decision. Unless you are tucking the business into an existing empire, the investment you make will likely be a highly concentrated bet on yourself. Bigger than any holding in your stock portfolio and bigger than any other component of your net worth.
Yes, the potential upside from buying right and running the business well can be attractive. But you really can’t afford to lose. In order to make sure the odds are as much in your favour as possible, you should only swing when the setup looks favourable based on your criteria and the numbers you have crunched.
My colleague James Gruber spent four years looking at motels in various locations before pulling the trigger on the asset he wrote about here. Harley also took two years to find a suitable deal in the gym franchise business he sold before becoming a business broker.
In this regard, you could say that deciding to buy a small business is a lot like deciding to invest in individual shares in the stock market. You need to wait for the fat pitch.
Thank you to Harley Stibbard of Vision Business Brokers and Advisors for his help in compiling this article.