Should I Invest In A Small Business?
Becoming a millionaire really isn’t all that difficult. All you need is a nice steady income for a long period of time and a reasonably high savings rate (>50%) coupled with some decent investment returns. Easy peasy, right?
Not really! Especially if you depend upon an employer to provide that steady income. In this day and age, there’s no such thing as “lifetime employment”. Having a steady income can be quite the challenge. Even if you’re college educated your work experience could be a few years of employment followed by a 6 month unemployment period while you hunt for a job.
That’s life in today’s the modern workplace. Unless you’ve saved at a prodigious rate while working, those unemployment periods can definitely eat into hard-earned savings.
It was during one of these “unemployment periods” when I first encountered The Millionaire Next Door. (If you haven’t read the book already, I highly recommend it). The Millionaire Next Door is like a manual for becoming a millionaire in the United States.
Anyway, there was one section of the book struck me as terribly interesting — more than half of all millionaires are self employed or own a business. Reading this, it struck me that being in control of your income was the big secret — owners of small businesses certainly aren’t going to fire themselves. In bad economic times they’ll lay-off employees first.
At the time, I didn’t have the money to buy a business, but that idea of the “millionaire small-business owner” planted the seed that would eventually lead to me getting my MBA. My thinking (at the time) was that I would eventually start and run my own business.
Meanwhile, I saved and invested for the next 15 years and became a millionaire in my own right, without owning a business.
Buying Established Businesses
So a thought occurred to me recently, “Now that I’m already a millionaire maybe I should pursue owning a small business?” Afterall, I now have the capital to buy a established business with pre-built cashflow and a already existing customer base.
This takes a lot of the risk out of starting a new business. I could easily buy a restaurant, laundromat, hair salon, landscaping/gardening business, coffee shop, or any number of small local businesses. The cost to buy such established businesses is typically 4 to 5 times cash flow; meaning the investment returns can be fantastic when no cash needs to be reinvested.
That sounds great (who doesn’t like 20-25% returns?), but the reality is that for most businesses cash flow and net income are completely different things. All the physical stuff that makes your business “go” eventually wears out and needs replacing. This can consume a lot of capital.
For the sake of argument, let’s imagine I could conservatively realize a 10% cash return on my initial investment. If the business costs me $500,000 then I might be looking at a $50,000 annual return. The other 10% would need to be reinvested to maintain the business.
That’s still better than the average S&P 500 index fund is likely to return over the long-term, so on the surface the business numbers look really good!
Too bad there’s always a few hitches with such plans…
Problem 1: Time
OK, I admit it. I used to spend a lot of time looking a different businesses for sale. Many local businesses are listed online by business brokers and you can browse the listings easily. You can learn a lot just by reading those listings.
In the vast majority of cases, these businesses are being sold by the owner-operator who actively work at the business. Easily 60 hours a week.
That’s WAY too much time for me to invest in anything these days. I’ve got two kids I actually want to see before they leave for college. But that’s the life of many small business owners — they live and breath their business. Even if they hire employees, during their “off” hours the boss has to be willing to jump in at a moments notice if employees don’t show up for work, get sick, or whatever.
I’ve known a number of small business owners over the years, and they literally never go on vacation.
Yikes! Maybe I’m spoiled, but it’s nice to take a break once in awhile.
Problem 2: Money
Let’s say I decided to purchase a small business, how would I get paid from that investment? In most small businesses, the owner either pays themselves a salary, or pays themselves a “distribution” quarterly after taxes are paid. Or both. It can vary significantly, but most of the time the owner is primarily paid out of the “cash flow” number that’s posted along with the business description.
Which means when investing that hypothetical $500,000 small business, the most I’d probably be receiving is $50,000. For 60 hours of work a week (or more). Is this really worth it?
Basically it’s like buying myself a job. I already left my job and don’t really want another. Besides — Most corporate desk jobs pay around this much and I clearly wouldn’t need to invest $500,000.
Problem 3: Low Quality Businesses
Probably the biggest problem with most small businesses (at least the ones that I could purchase), is that they’re really terrible businesses.
Now I’m not saying that *all* small businesses are terrible of course, but many are. These businesses are marginal… often times they sell commodities or services which are indistinguishable from those sold by other small business down the road.
This means the business has little to no pricing power and no ‘moat’ to protect its profitability.
If I bought a landscaping business for example, I probably couldn’t charge twice what the other landscaping businesses in the area charge to mow lawns.
Well, I could try but I probably wouldn’t have too many customers. Instead, I’d have about 100 single-star reviews on Yelp, complaining about how much I charge to mow lawns.
Having no moat is a huge problem. If you can’t raise prices without losing customers, how are you going to keep up with inflation? This fact is one of the main reasons why I keep my net worth primarily invested in stocks — Many of the large publicly traded companies in the US have some form of moat.
On top of that, most small businesses have pretty poor growth prospects compared to Fortune 500 businesses. There’s only so many landscaping businesses, hair salons, and gas stations a city can support. (It completely dependent upon the state of local economy of course.)
Some small businesses are able to open multiple locations however — I have a friend that used to own a small chain of coffee shops in the Seattle area. She started out with a single location near the university district that was reasonably successful. Successfull enough that she decided to open a second location downtown.
That second location proved to be much more difficult to run and maintain profitability. So much so, that she eventually sold the business. Now, (years later) the coffee chain is completely out of business. The new owner failed to run it successfully.
Growing and managing more than one location can be a tricky business.
Not My Ball Of Wax
If it isn’t already clear, I’m not convinced that buying a small business is for me. Stock investing is just a better way to go when you have a family and limited time. It takes much less time than investing in a small business would require.
Right now, my net worth is primarily invested in good quality stocks, and this investment is mostly passive. Meaning, I don’t need to lift a finger to own great businesses that provide reasonably good returns.
In contrast, owning a small business is the exact opposite of passive. I would need to invest not only my money, but prodigious amounts of time. Time that’s pretty precious to me.
Was The Millionaire Next Door Wrong?
So what about the Millionaire Next Door? What am I missing that made those business owners successful millionaires?
Frankly, I think it could simply be survivorship bias. The Millionaire Next Door was looking at only the business owners that were extremely successful, not those that failed. In particular, I believe the more successful cases could actually be due to successful entrepreneurship, not the purchasing of a small business.
This belief is based upon the network of successful small business owners that I personally know — Nearly all were entrepreneurs, putting in money, time, and prodigious amounts of “sweat equity” to build that successful business. None of them purchased the business.
If I look at the purchase of a small business from an investment perspective, it does not seem like a good use of my money. Why would I want to sell my stock in a good business, just to buy a worse business that takes up a ton of my time? All for a few extra percentage points of return and A TON more risk?
It seems like a really bad idea.
What do you think? Is buying a small business a good idea? Or, is entrepreneurship the way to go?
100% agree with this analysis. It is exactly the same problem I’ve encountered. I originally had a business that I started, sold off and moved into the investment space. I’ve never found another business I’d want to buy with the amount of capital I have available and so never do. My largest fear is that I’d be swapping hours as an employee earning $100k+ into a small business where I work as much or harder and earn <$50k a year because it wasn't really any good.
Once I stop working, I don't want another 8-5+ business/job. I want to remain with my passive dividends etc. The only angles I've found to where this might be more feasible for me in terms of a business are either 1- buying a website through a site like empireflippers where you only pay a 3x PE, and like this blog, could make money whilst you sleep, or 2- real estate portfolio which is a combo of business and passive and where things can be outsourced. Or 3- building up enough capital to acquire unlisted investments with existing management teams where it's the same as buying listed shares, but in the unlisted space, the only thing is the size of business that I'd be comfortable holding in the unlisted space will unlikely ever be the size of capital I have, hence the existence of private-equity funds.
Websites are quite a bit of work too! I speak with some experience here! 😉
Your survivorship bias observation is very astute.
My business banker once told me ~50% of businesses fail in their first 12 months of operation. Apparently that increases to a failure rate in the mid 80% by the end of year 3. Hardly any make make it to the end of year 5.
A big challenge for folks who have been laid off or recently “retired” from one career, and are now considering “buying” a job is their previous career seldom taught the skills required to successfully run a business. Book keeping, logistics, supply chain, recruitment, customer service, etc.
There is a huge difference between working in a business and working on a business where you are now the person taking the risks and making the big decisions.
One thing I will say in favour of working for yourself is you get to keep the benefits of your efforts. When the business is successful that can be huge. Potentially earning the owner a place in the next edition of the Millionaire Next Door.
Yep, when the business has that “special sauce” it does indeed pay-off as TMND shows us.
I think it’s more complex, but small business owners are a huge backbone of America. While maybe investing is the better option (especially considering how well the market is doing), there’s also a freedom and pride that comes along with being a small business owner.
Aren’t small business owners the true entrepreneurs? Many of them risk a lot.
Don’t get me wrong, I’m not against small businesses. Not at all. But as an investment, most would pale in comparison to what I would buy in the stock market.
It’s not for me. The time factor is huge. My parent had a small Thai restaurant and they rarely went on vacation. They spent 60+ hours per week working and the kids worked there too. It was “successful” enough to send 3 kids to college without student loans. It paid the bills. Owning a small business like that is much better than working a minimum wage job.
However, if you’re already well-off, you probably don’t want to put in that kind of sweat equity. My parent sold the business and the next owner couldn’t make it work. It really depends on where you are in life.
You have the experience of having actually lived the small business life Joe. I value your perspective!
Indeed, it’s certainly a better life than minimum wage, but passive investments seem like a better fit for me right now.
Maybe someday I’ll investigate forming a partnership with a young person that has the time and energy to do well.
I built and own several businesses. Buying and running those would be possible for an outsider. What you need is a business that is automated already or that you can automate quickly. For this to work you need a product-based business that does not require in-person contact with customers to succeed. Everything else can be done with just a few employees or even without any employees at all if you use external providers.
Thanks for your thoughts El. What kind of businesses do you own?
A public facing business that is easy to understand is https://aerobis.com. aerobis builds high-quality mobile fitness equipment under own brands. Equipment is sold worldwide to clubs, trainers as well as retail to consumers. A lot of it’s operations is automated.
I think the only reason to buy a business is if you can add value to it and sell it later on (ie. build equity). Just buying a business for the cash flow is nice if you can get an experienced operator, but at that point you can probably do something else that’s less risky, potentially more diversified, and get the same returns after whatever the tax rate.
As for the building equity route, sometimes this means finding a bad business, turning it around, and then selling. The problem with a lot of businesses is that after a certain point, you can’t easily add that much value, especially if you didn’t start the business and learn all the ins and outs. There’s a lot of education there and it’s easier to learn when mistakes don’t necessarily have such huge stakes.
I’m with you, I don’t think I’d buy a business.
I once had a experience business mentor tell me there’s only three real reasons to buy a business:
1. Valuation. It’s absurdly cheap.
2. IP. Intellectual property, trademarks, brand names, proprietary systems, industrial secrets, etc. These will provide value far into the future.
3. Talent. Along with the business come the managers and talented people that make it an outstanding biz.
In my case, if I was to buy a small biz, I’d most likely be bringing the talent to add value and fix up the bad business… and I’m not sure that’s something I’d succeed at.
A couple of things, The Millionaire Next Door is pretty dated, I think there are a lot more 9 to 5 corporate millionaires now than when they gathered their data. Also running a small business is possible for anyone who can fog a mirror, that’s too much competition for good odds of success. Better, if you have the talent, to find an area that needs talent badly due to barriers of entry, like medicine or engineering. I think the new millionaires next door are doc’s and engineers who can control their spending. Plus lawyers, investment bankers and accountants. Certainly they represent a lot of the bloggers.
Interesting thoughts Steveark! There’s plenty of competition in the blog space right now. I’m not sure all the new docs and engineers are really adding a lot of value.
I started and run a small language school with my wife. We built it from scratch and bootstrapped (never borrowed a penny). After fifteen years it is finally profitable. Put me in the ‘build a business’ camp rather than the buy one camp 🙂
Fifteen years! Wow, that’s some dedication, and no borrowing either! Is this a business you could sell one day, with an office and employees? Or, is it more of a sole proprietorship?
Thanks RetireJapan!
It’s a sole proprietorship at the moment but with ten employees and 350 students. We’ll probably incorporate at some point.
Whether we can sell it is the rub, isn’t it? Unfortunately language schools in Japan only go for 2-5 times net I am told, which isn’t much of a payday. It’s boosting our investment accounts at the moment though, which is the main thing 🙂
In buying high quality companies that regularly and consistently raise dividends over long periods of time, you are screening out the very strongest business models and companies. If a small company were able to pull this off you would be becoming very rich over a couple of decades. Those percentage very low indeed so more likely is you spend all your free time working at your ‘business’ to draw a modest salary. There may be a lift when you go to sell it if you can improve the financials in a few years.
I agree with your analysis and am glad I went for the more stable and successful companies versus buying a business.
-Mike
The world is a sea of companies, and the very best companies are often public! 🙂
That said, Buffett bought See’s Candies for something like $24million back in the day. It was a “smallish” business. Since that purchase, See’s has generated something like $1billion in profits. Incredible! That’s impressive, but I consider See’s a very special case…
It certainly can happen though.
Some people really enjoy the time and effort required to do things like this though and there’s nothing wrong with that. When you get to the point of becoming financially independent, it’s up to each person to find the direction that’s going to make them the happiest.
I’m with you, though – I’d rather stick with the passivity of the stock market than put in the time with a small business. Running my blog, writing a few books, and maybe some other small projects should be enough to fill my days without interfering with the additional time I plan to spend with my daughter and wife.
— Jim
Yep, I’m with you Jim! Between the blog and the family, I just don’t have the time!
Our only income for the last 33 years is from our small service business. People tell my husband how lucky he is to be working for himself and doing what he loves. What they don’t see is the endless hours, customer and vendor headaches, payroll even if we don’t get paid, and screw-ups by others that we have to eat the cost. We are just now recovering from the 2008 meltdown that flattened non-essential businesses. He is satisfied that he has added to the workforce and the knowledge of his craft but I has been a hard road.
Fortunately we are thrifty people and prefer the freedom of self-employment and have been able to weather the many storms. But I always say the self-employment is exciting—-I’m excited when I get to eat this week.
As a former business owner, I guess it would really depend. As you have already noticed, most publically listed “opportunities” aren’t that great. But, it is actually possible to find healthy and worthwhile businesses to purchase if you look hard enough… kind of like real estate!
The key is to find something with enough free cash flow to fund current operations with minimal effort from you, or if you do spend time, to create a healthy incentive for you to do so. As Jim mentioned above, adding additional value can increase the resale value at a later date, so you could reap significant rewards on the backend if done right.
Now with all that said, I haven’t come across any businesses worth purchasing in quite a while… not that I’m looking… FIRE is too much fun! 😉
I’ve become much to lazy to start a business. I won’t even invest in real estate because it is too damn much work!
I also play with the idea of buying a business in the future and I have checked some businesses for sale. But as of now it looks too complicated and time consuming.
Also, with small businesses like this there is a risk of depending too much on the owner. As you mention, there is no moat and usually very low switching cost. So there is a chance that the relationship of the owner with clients is the only thing that keeps them coming back. Once the owner is gone the clients may have no problem switching to a competitor.
Another thing that scares me is valuation. Let´s just say these businesses are far from audited by a Big 4. Profit margins and other financial ratios might not mean anything here as the records could be inaccurate in the first place.
Having my own business some day is certainly a dream of mine. Being able to hire my kids I feel would be really rewarding. A couple good friends of mine are next in line to own their family businesses. There’s one thing in common between these two businesses though. They are both big enough businesses where the owner can be absent for weeks at a time, and the business is still humming along and profitable. I think a business where the owners necessity to be there in order to turn a profit would be a nightmare. You’d truly be buying a job, and a crappy job at that. One with no vacation benefits, likely no retirement benefits and very likely no health benefits. So any business that I would be interested in buying would have to have some scale built into the model, and established systems in place so that the transfer of ownership could be relatively smooth. At my engineering job I work with some small suppliers at times where the company owner is frequently the one that answers the phone, and the one that makes all the decisions. Some of these guys sound tired and burnt on the phone. I don’t blame them. They’ve worked their heart out for 30-40 years and are still involved in the daily operations of their business. In a case like this, I would much rather be an employee than a business owner. Just spewing my thoughts. Great article with many great points about why owning or buying a small business may not be the best idea.
I just ‘sold’ a business I started 7 years ago by creating an ESOP. In the first 4 years I worked non stop. The experience warped me for better and worse. I will reiterate one comment from millionaire next door which is that most people have no business owning a business.
My issue is all about timing. I have been looking at a small business near my eventual retirement home. It is mostly passive, probably less than 20 hrs/week, perfectly for putzing around after I FIRE, but I am still 5 years away from that and concerned that pulling the trigger now is a no-go because I currently live 3 hours away from that business and have ZERO desire to run up there every time they might need me. I wish this opportunity would wait, but it likely won’t.
“The Millionaire Next Door was looking at only the business owners that were extremely successful, not those that failed.”
So true. This is true for book publishing stats as well. The stats say the average salary of a novelist is $5000/year, but in reality it’s even lower than that because it’s not counting the writers who never got published. So yeah. As much fun as the idea of buying or starting a business is, it’s hard work and low probability of success. I’m too lazy and an early retiree to put in that much work. You have to love it 😛