One of the luckiest things I’ve ever done was not sell any major assets during the downturn between 2009 – 2012. It’s understandable to panic sell when things are crashing and burning. It’s also easy to sell in a down market when you have a major life event e.g. losing your job, having a baby, etc. But fortunately, many of my investments were either illiquid (real estate) or were locked up with long vesting periods (private funds). Even if I wanted to sell, I couldn’t!

For example, in 2012 I put my home on the market for 28 days to see if I could get any motivated buyers after Facebook went public. I just left my day job and was thinking it might be a good idea to get more liquid in case my early retirement plan didn’t pan out. Fortunately, no buyers were to be found as IPO money takes a year to work its way into the economy. Now the home has appreciated 60% since 2012 based on a written offer I received recently on a relatively large figure.

But seeing a 60% rise in an already expensive home was not my biggest lucky break. Hanging onto my business was. Every year since 2011 someone has inquired about buying FinancialSamurai.com. There was a period of time during the bear market when several personal finance sites sold for between $1 – $4 million. Although $1 – $4 million is a lot of money in absolute terms, based on the cash flow, the acquisition prices were all absolute STEALS.

For example, one guy with an operating profit of about $700,000 a year sold his site for only $2,500,000. You’re not even a real millionaire at $2,500,000 thanks to inflation. If you have a partner, then you’re definitely not a millionaire because you’ve got to divide the after-tax proceeds by two.

To generate $700,000 a year at a 8% rate of return requires $8,750,000 in capital. At a more conservative 4% rate of return, you’d need a whopping $17,500,000 in capital to generate $700,000 a year!

It’s hard to say someone making $2,500,000 got robbed, but robbed he was because if he had held on for just 3.6 more years, not only would he have made a total of $2,500,000 in operating profits, but he would still own a site making $700,000 a year or more for the foreseeable future.

Think About Your PayBack Period

The payback period is the length of time required to recover the cost of an investment. In the site sale example above, if the buyer can maintain the traffic and revenue figures, he’d recover his full $2,500,000 investment in just 3.6 years. All money earned after the payback period is 28% a year gravy.

But let’s say the buyer has some hustle and expertise, he could conceivably grow operating profits from $700,000 in year one to $850,000 in year two and $1,000,000 in year three. In this scenario, the buyer lowers his payback period to 2.9 years AND could sell the site for $3,600,000 (44% more) based on the same pitifully low multiple of 3.6X operating profits ($1,000,000 operating profits X 3.6 multiple).

But since 2008 – 2010, something magical happened. Valuations for media companies as well as valuations for the entire S&P 500 have expanded. See the chart below.

When the site owner sold his site in 2010, the S&P 500 was trading at 15X Cyclically Adjusted Price to Earnings (CAPE). Valuations have since moved up from 15X to 29.56X, a 97% increase. Let’s say the valuation increase in online media companies rose in lock step with the overall market’s valuation increase.

A 97% increase in a 3.6 multiple equals 7X (3.6 X 1.97). Let’s do some math and find out how much the person who spent $2,500,000 on a site back in 2010 has made so far!

Investment Scenario

2010 Investment: $2,500,000

Business Operating Profit: $700,000

Estimated Payback Period: 3.6 years

Forecast Operating Profits

Year 1 Operating Profit: $700,000

Year 2 Operating Profit: $850,000

Year 3 Operating Profit: $1,000,000 – Everything paid back in 3 years

Year 4 Operating Profit: $1,000,000

Year 5 Operating Profit: $1,000,000

Year 6 Operating Profit: $1,000,000

Year 7 Operating Profit: $1,000,000 – Keeping operating profit flat for four years to stay conservative despite massive leverage in online businesses

Total Operating Profit Over 7 Years: $6,550,000

Percentage Return If Not Sold: 262% ($6,550,000 / $2,500,000 investment). Not bad! The owner will continue to make $1,000,000+ a year in cash flow.

But because valuations for online media properties have increased by 97% since 2010, the buyer can now turn around and sell his $1,000,000 a year operating profit business for $7,000,000 based on a 7X multiple instead of a 3.6 multiple.

Total Return After Sale: $13,550,000, or 542% ($6,550,000 operating profits + $7,000,000 sale price = $13,550,000 / $2,500,000). Now imagine if the business grew operating profits to $2,000,000 before selling. We’re talking over a $20,000,000+ return from a nice little lifestyle business. Compared to the measly $2,500,000, we now have some REAL F YOU money.

A 125% return in the S&P 500 since January 1, 2010 is nice. But a 262% – 542% return based on creating something from nothing is so much better. Who’s to say the entrepreneur wasn’t also diversified in stocks, real estate, bonds, and private investments as well. Further, the 262% -542% return is on a much larger nut.

Don’t Be Tempted By Short Term Gains

Now obviously an investor might be stupid enough to drive a newly acquired business into the ground. But most people who spend $2,500,000 have enough smarts to make sure they hold operating profits at least flat to reach their base case payback period.

Large absolute dollar amounts are enticing. But they are dangled in front of you because you have something even more enticing for the buyer! Never forget the rationalness of finance. In our permanently low interest rate environment, please do not sell your cash cows.

If you can buy a cash generating business with a payback period of less than five years, you should get excited. Your investment essentially becomes risk free after five years, and will then make a 20% return into perpetuity. A 20% return is a home run compared to a historical average 8% – 9% S&P 500 return.

If you believe you can increase operating profits after acquisition, then you should get really excited. Finally, if you believe there will be valuation expansion on top of business growth, you should go ALL-IN.

Below is a chart showing how much capital you need to have to generate $55,000 and $20,000 with various interest / return rates. For reference, the 10-year bond yield is currently around 2.25%.

Profits + Equity = Net Level Rich

There’s a reason why so many of today’s wealthiest people are entrepreneurs. Not only do they create businesses that generate revenue, they also own equity that can be sold for multiples of annual revenue or earnings. Most day jobbers are not building equity. When it’s time to go, they are left with nothing because they are no longer contributing their time. There is no leverage in being a laborer.

Some of you have asked why I’m so conservative with my public equity investments. Others have asked why I’m considering selling a rental property to simplify life. The #1 reason besides reaching my FIRE number is because my business has returns that blow every single asset class I own out of the water. Once you’re a business owner, you realize that a 10% annual hurdle rate is like stepping over an ant hill.

I encourage everybody to build a business that also grows a strong brand. Making money from your day job is fine, but you’re slaving away making someone else who owns all the equity rich. Even if you are at a startup with equity, just know that for every $1 you make, you’re literally making someone else more senior 20 – 10,000X richer. Instead, get in the mindset of making yourself rich by growing your own equity.

If you own a business, please be patient and do away with short term thinking. People mocked the founders of Snapchat for rejecting a $3 billion offer from Facebook in 2013. But unlike the peanut gallery, the founders knew that if they just sat in their seats and continued to execute, their business would be worth much more over time. Today, no matter how ridiculous the value proposition, Snapchat is worth $25 billion.

Yes, growing a business is not easy. But at least starting one today is. Most people never try, which is why most people will never come close to creating next level wealth. There are endless examples of people who’ve created something from nothing who’ve sold for mega millions in a relatively short amount of time. Maybe you’re next? Oh wait, it’s the weekend. Time to go play before work begins again!

Related:

Ranking The Best Passive Income Investments

The First Million Might Be The Easiest

Financial Samurai Entrepreneurship Category

Readers, with all the great wealth being built off internet, why don’t more people give entrepreneurship a shot when the hurdle is so low? Why do you think so many business owners sell their cash cows for such low multiples in a low interest rate environment? Do you know any business owners who sold, then try to recreate their old business with no luck? If anybody has a business with a three year payback period or shorter and wants to sell, I’m interested!

from Financial Samurai


via Finance Xpress