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Business ownership is the fastest way to significant net worth and financial independence (FI). It is possible to grow your net worth $2 or more for every dollar you increase your revenue. This is before investment gains! By understanding the accounting behind business valuation, anyone can accumulate a seven figure net worth in as few as five years which can be turned liquid and invested in income producing assets allowing for early retirement.
Building a massive net worth is more difficult, if not impossible, with earned income only. Mega-wealthy people like Warren Buffett and Bill Gates know wealth is created from multiplier effects. Buffett grew Berkshire Hathaway by investing in other successful companies and insurance. Bill Gates grew Microsoft into a world leading software company. In each case the majority of the wealth created, around twenty times the profit level, came from multipliers. Only about 5% of their wealth came from actual profits!
Average people can use the same methods as the uber-wealthy to supercharge their net worth. Business owners have the advantage. Wage earners have no multipliers to help them accelerate their net worth growth, whereas a business owner can increase her net worth by $2 or more for every dollar of increased revenue the business has even if she saves and invests none of the profits.
Accounting practices sell for 1 to 1.5 times revenue. There are a few that sell outside this range, but most fall within the range. Most industries are similar. If you review the financials of public companies you will find many trade around 2 times revenue.
This creates an interesting situation for the business owner. Let’s say your favorite accountant wants to increase his net worth really fast. The easiest and fastest way to do so would be to increase the size of the business. An additional $100,000 of revenue should yield an additional $50,000 of profit (accounting practice margins are 30% – 50%) in a well managed firm, which I have. Since I have no need to spend more, I can invest the entire $50,000 profit, assuming no taxes.
At first glance you would say my net worth has increased $50,000. And you would be wrong. The company is now larger and more profitable. A buyer of the firm is willing to pay for that stream of growing profits. Since we know accounting practices sell for 1 to 1.5 times revenue, the value of the practice has increased $150,000. (I run an efficient firm so my practice is valued at the high end of the range. In reality I might get a bit more, depending on the current market and the buyer.)
Think of this for a minute. An increase in revenue is worth more than the revenue! A $100,000 revenue increase raises the value of the firm $150,000, plus there is that $50,000 of profit to add the net worth column. That brings us to a $200,000 increase in net worth on only $100,000 in additional revenue ($50,000 in additional profits) for the business owner.
Who would pay so much for a company? Anyone with good math skills. Paying $150,000 for $50,000 of profit is like buying a stock with a 3 price/earnings (P/E) ratio! The difference between a public company and a small business is that when a sale takes place it is usually the entire company being sold when a small business transfers ownership. There is customer retention risk to the buyer. Sellers can counteract this risk (and get a higher selling price) by taking a small position at the buying firm to help clients adjust to the new corporate environment.
The buying firm that retains all the clients of the acquired firm will reap a 33% return on their investments. They paid $150,000 for a $50,000 stream of profits. There will be willing buyers. A small business owner wants to increase her revenue quickly to supercharge her net worth. Working 10 -15 years to reach retirement can be a real drag. A business owner can get there in five.
Imagine you start your own accounting practice and use some of the advice on this blog to grow revenues to $500,000 per year by year five. This is a reasonable goal for a small tax/accounting office. Your profits the last year should be $200,000 or more. I assume you saved half your income each year as recommended on this blog. In year five you can sell for $750,000. You should also have another $250,000 or more of your earned income saved and invested. There you have it. A $1 million net worth in five years and you only built a very small accounting practice.
It works the same way in other industries, too. A small business with a steady to growing stream of profits is very valuable. A lot of smart money is hungry for such investments. A million dollar net worth should throw off $40,000 or more per year (the 4% rule). Since you were living on $50,000 or less when you ran your company, selling is a step up because you have enough money for all your needs without working.
Retirement is a short five years away when you engage the accountant in you.
What about Non-Business Owners
The same multiplier effects exist in public companies too. The P/E ratio is a common barometer used by investors to gauge value. Because reported earnings are easy to manipulate there are better measures of wealth creation within a company. As the economy grows, so do profits.
The value of your index funds do not increase the same amount as earnings are increasing; your index fund grows about 20 times faster! If the stock market has a 20 P/E ratio it means stock prices are 20 times earnings. If earnings increase $1, the price of the stocks in the index will increase $20 or the P/E ratio falls.
The P/E ratio moves around a lot over time. At the end of the day stocks will reflect the earnings growth of the underlying companies. Dividends and stock buy-backs are funded by earnings. Borrowed money can sustain dividends and buy-backs only temporarily. In the end it is about earnings, or more accurately, free cash flow.
The reason an investment in a broad index fund is so powerful is because of the multiplier effect of increasing earnings. A small business owner only realizes the actual profits of the company. Only if the business is sold in whole or in part can she diversify her net worth. A broad basket of stocks can throw off a steady and increasing income stream and is already diversified.
Another way to look at this is by reversing the P/E ratio to get the earnings yield. A 20 P/E ratio is a 5% earnings yield (E/P). The higher the P/E ratio the lower the earnings yield. It becomes clear quickly why interest rates have such a powerful effect on business valuations.
Working hard and saving half your income is a sure way to reach retirement in 15 years or less. Starting and running a business is a real pain in the ass at times. Building a million dollar accounting practice is work. Even a practice half that size is work. The great news is it doesn’t have to be an all-or-none proposition.
While you are in the wealth building phase a micro business with $100,000 in revenue still supercharges your net worth. Selling a micro business can put you over the top years sooner. There is nothing preventing you from starting several micro businesses either. Keeping a business small has its advantages.
Take The Wealthy Accountant blog as an example. Blogs have virtually no overhead or expenses unless the sucker gets huge, requiring employees and office space, a rare occurrence. A small blog with a steady $50,000 of revenue can be sold for several times revenue. If you sold for only 1.5 times earnings, the annual rate of return on the investment would approach 70%! It would be silly to sell at such a low price. Even a sale of such a blog at 5 times revenue ($250,000) would generate nearly a 20% rate of return on the investment. Remember, almost all revenue on a blog flows to the bottom line. In accountant speak, the margins are extremely high.
For the record, I have no plans on selling The Wealthy Accountant.
It Always Comes Back to Taxes
As if the wealth creation of business ownership wasn’t enough to encourage you, now the government wants to chip in. If your small business adds $100,000 to revenues and $50,000 to profits, the government will tax the $50,000 of profits only. The $150,000 increased value of the company is not taxed.
You are only taxed on the increased value of the company when you sell. (I am only talking income taxes here. Property and similar taxes are disregarded for this discussion.) The $50,000 profit is taxed as ordinary income where rates top out at 39.6%. (I also disregard the additional taxes assessed high earners due to the Affordable Care Act.) But when you sell the business the gain is taxed as a long-term capital gain where the top tax rate is 20%.
If you have a really smart accountant you probably organized your business as Section 1202 Qualified Small Business Stock where the gain on the sale could be completely tax-free in certain circumstances! (Before you call me asking for one of these awesome deals, I remind you they only apply in a narrow set of circumstances. Most business owners are better off with a different structure.)
The End is Near
The hardest part of FI is the waiting. People saving half or more of their income get excited when they see their account balance grow, but along the way feel the drudgery of a long slog. Sure, non-savers spend a lifetime working to have nothing at the end. But fifteen years for a dedicated person responsible with their money is still a long time if you want out of the rat race now.
A sideline gig can supercharge your net worth so you reach FI sooner, in as little as five years. The light at the end of the tunnel has just gotten brighter. If you are standing on railroad tracks looking into that tunnel, might I suggest standing to the side. You don’t want to get run over the moment you finally make it.