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?