47 – How Small Business Owners Build Net Worth

Share:

Share on facebook
Share on twitter
Share on linkedin
Share on pinterest
Share on email

Episode Overview:

Ken tackles the challenge of running a small business while growing your personal net worth. Small businesses blur the lines of investment of time and money to yield results. It’s important to understand your market rate, the amount of “sweat equity” and the cash you’re willing to put in. Ken addresses some foundational considerations you need to be aware of. He then goes on to answer a listener’s questions that inspired this episode.

Transcriptions are auto-generated, please excuse grammar/spelling!

Happy day to you. This is Ken Kaufman, and I’m thrilled you’re here for Episode number 47, “How Do Small-Business Owners Build Net Worth?” This topic today was inspired by a listener who recently reached out and asked me a set of questions about how to go through this process of building net worth personally while being a small-business owner and while the small business is really consuming all of the available cash that perhaps is needed personally.

So, before I jump into the details of this listener’s question, I wanna lay out a few basic principles that especially apply to small-business owners. Now, here’s the biggest challenge for a small-business owner. The concept of putting time in and getting paid for that time versus putting money in and getting paid for the risk that I’m taking on that money, these tend to get merged and blended together very quickly in a small business. And it’s not a horrible thing, in fact, rightfully so this happens. If anybody out there’s ever started a business or if you’re in the process of it, you know that there’s so much that goes into making this happen, you just have to sacrifice everywhere to make it work. You’re gonna go without pay, you’re gonna put savings in. It’s all one big investment of capital and time, and emotionally they get blended together.

So, from my perspective, and this is me having been a small-business owner, having worked with and consulted many small-business owners, and just having been around the space for basically my whole career, there are some key principles that we need to lay out that will help small-business owners be the most effective at building net worth in spite of the way some of these things get convoluted and confused. And here’s how to drive that clarity that you need financially that will drive toward this net-worth growth.

So the first one is you’ve gotta determine what is the fair-market rate for the time that you’re committing to the business. So, for that job, for the responsibilities and for the functions that you’re taking on…and I realize it may be difficult to find exactly that role, but we need to get a feeling for, what could you go and earn if you were working for a different organization where you were just trading time for money? No equity involved, no upside, you were just giving them your time and they were paying you for that time. And you’ve gotta be honest about this. So that’s first.

Second is we need to determine what exactly is your investment into the business. And it’s a combination generally of two things. The first is, once you’ve decided what that wage is that you should rightfully earn for your time, how much less than that are you earning, especially in those early startup months and years? And understanding what is that difference between what you could earn with your time somewhere else versus what you are actually able to pay yourself in the business.

So, as you are able to successfully establish this, you look at the difference, and you understand that…there’s a term out there called “sweat equity,” and what you’re, in essence, doing is you are putting sweat equity into the business because you’re trading your time where you could’ve gotten paid for that time and were giving it a value and amount. So that’s the first part of looking at your investment.

The second part is now how much of your actual money are you having to invest and put into the business to buy inventory, to cover working capital, to buy all of your startup equipment or whatever’s needed to get yourself up and going?

So, now that we kind of understand what is your time worth and what is your investment into the business, this now takes us to the third and that is what is your expectation for what you should earn on this investment that you’ve made, both in your sweat equity as well as the actual capital that you put into the business until it gets to a place where it can be profitable. Unless you plan to be one of these unicorn businesses where you’re gonna grow to be a huge business…which most small businesses don’t, let’s be fair, let’s be real. Most of these small businesses that people start will be under a million dollars. Some will break the million-dollar mark, some will get over five million, not many. Maybe there will be a few that get over 10 million. But the percentages are pretty clear that most small businesses are gonna be under a million dollars a year.

And so, in terms of thinking, there’s gonna be this big exit where you’re gonna sell for this big multiple…most likely not the case for small-business owners. I’m just trying to be realistic here. But this has this impact on how we think about what is the return gonna be and how is that gonna impact our net worth.

And so, when you think about after 5 years, or 10 years, or 20 years, or 50 years of being in this business, and whatever you’ve invested in terms of sweat equity or your compensation that you’re not being paid for based on what you could earn in the market, as well as money that you’ve put in, the only thing you can do is look around and say, “Well, if I were to put this investment into something else that would, say, be about the same type of risk, or maybe even less risk, what return could I earn?” And I’ll jump back to that here in a little bit.

And then, the fourth component that you have to think about if you’re a small-business owner trying to figure out how to build net worth is, how are you going to diversify? The biggest challenge that small-business owners have is that they have all their eggs in this one basket, their small business. And you’ll find out from this listener, the listener works in the small business and her husband runs the small business, and so it’s literally the source where they’re putting all their time and it’s where they’re putting all their money, and they are completely undiversified. Now, if the business does phenomenally well, that’s great, they’ll do great and not have any other distractions. But if the business doesn’t do well or if it fails, well, again, all your eggs being in one basket has a very dramatic impact, either very much for the good or very much for the bad.

So, let’s go ahead and jump into an example. And I wanna just take these points, get them a little bit more concrete in your mind, and then I’m gonna go to the listener’s question and I think we’ll be able to do a great job with this listener, helping them understand how to move forward.

So, let’s just imagine that you’re a residential home-framing contractor. You’ve been working for another contractor for a while and you’ve decided you wanna head out on your own, do your own thing, build your own business. Awesome. So, you pull all the money out of your savings, you buy equipment, you buy the truck you need to get started, you get yourself properly licensed. And boom, you’re open up for business. Well, what would be the equivalent wage for that role? I don’t know, different markets are gonna be different and who knows what the exact circumstances are here, but just for the sake of doing easy math, let’s say that this equivalent role would earn $100,000 a year, this person would be able to earn $100,000 a year doing these same functions for another business. So that is the base. You now know, “Okay, year one, no way I’m gonna pay myself that 100,000, I can’t make that much money.” You’ve got way too much cash tied up and the labor that you’ve gotta hire, the materials you’ve gotta purchase for each job, your overhead costs, and so much more. So again, year one, no salary. Let’s say, year two you take 50,000 of the 100,000 of salary. And then, miraculously in year three, you can get yourself that full $100,000 salary each year. So, that’s year three and beyond.

So, you have invested the equivalent of $150,000 of your time and skill, or your sweat equity, into the business. Does that make sense? Good, because this needs to count and you need to keep track of this and you need to understand this. And all of this will come around full circle shortly. Now, you also have $100,000 in savings that you used to start the business. You invest that hard cash and that brings your total investment from your 150,000 of sweat equity to a 100,000 of cash to $250,000. Now how in the world are you gonna make that back? And not just get that money back but what return does your capital deserve to get?

Now I’m gonna go down a little bit of a rabbit hole here. This is a point of, I don’t know, a place I care a lot and I’m passionate about a great deal when it comes to thinking about how you invest in your small business. So, bear with me here for just a minute and then we’ll get ourselves back on track. But here’s the basic premise, if you have a well-diversified portfolio of stocks in large U.S. companies, those types of portfolios, especially if their index just following, say, an S&P 500 or something similar, those portfolios are averaging like 10% a year on a compounded basis. Now, I’m not making any investment-return guarantees, all I’m doing here is trying to illustrate a point. If U.S. large companies, a portfolio that’s diversified, say, across 3,500 different of those companies, or 500 of them if it’s the S&P 500, if that earns a 10% return each year, then my logic is that your business should be doing better than that because your business is more risky. You say, “Well, what do you mean?” Well, small businesses are always more risky than large businesses, large U.S. companies, that means they’re greater than $10 billion in market capitalization and they’re well-known brands, it’s less likely that one of those companies goes out of business versus a small business. Other reasons why a large company would be perceived as this safer bet is small companies a lot of times have a higher failure rate than large companies. I alluded to that already in one way. You also, in a small business, probably have customer and geographic-concentration risks that big U.S. companies don’t have either. You’re more risky all the way around, and in the world of finance the more risky you are, the more potential return you should be able to yield to your investors. And so, if a diversified portfolio of U.S. company stocks is earning a 10% return annually, most likely you should expect to earn a better than a 10% return.

So hopefully, again…I could keep talking on that subject for a while, but let’s just go ahead and leave that one there, your return needs to be something fair and reasonable. So, if we were to expect this, you know, 10% return on all this $250,000 that you’ve invested, in 10 years, that means your total return expectation would be $650,000. So you’d be more than doubling your money. And if you were to double it, say, to, you know, $500,000, the rule of 72, divided by the 10 and 10%, that’s 7.2 years to get to $500,000. So, let’s say we settled at that, the rule of 72. And you’re gonna be at 10% and you’re gonna be 7.2 years in order to get that return that you feel good about and you’re comfortable with. And that’s gonna get you to 500,000, so you put 250 in and within 10 years you get 500 back.

Let’s see how this looks. So, at year three, you’re barely able to cover your full salary. And years 4 and 5, let’s just go ahead and assume those are gonna be lean too, so no profit taking from the business. But then, years 6 through 10, let’s say those last 5 years of this 10-year window, so year 6 through 10, you’re starting to really get momentum and you’re able to generate an extra $100,000 of cash profit that you can pull from the business as a distribution, or a dividend, or however your entity and tax situation is structured, there’s some different terms, sometimes guaranteed payments. However that structure is. But you get to bring home an extra $100,000 those last 5 years. Well, there’s your $500,000 return.

But hopefully, it doesn’t end there. Hopefully, this business keeps going and continues to generate income beyond just what your time is worth into perpetuity, all the way down the road. Now, I realize this is a simplified example, I didn’t do all the time value of money calculations perfectly. And I actually purposefully avoided that, I’m trying to talk very simple math, math that just makes simple sense. If your business cannot generate the income you deserve for your time and a return on your investment that’s reasonable, then you need to think long and hard about what you’re doing. Long and hard about what you’re doing.

Now, with all those principles cleared, let’s go to the listener’s question, the one that I mentioned at the beginning of the podcast and that launched me off into this whole rant. This is what she said, “As a small-business owner, I am constantly concerned about how to manage our personal…” I’m sorry, “how to manage our money personally when we still have enough operating cash for payroll and such. For instance, a lot of times, during the slow season, I’ll run payroll, pay my husband, and then transfer the money back to the business to pay our guys or payroll taxes, etc.” So they’re trying to pay her husband a fair wage, but then having to pull the money back because they’ve got other cash flow shortages in the business. “So, I’m always scared to make any big moves like investing while we’re trying to grow the business. So I would love some insight on how other small-business owners budget and plan for both their small business and their personal lives.”

So, this perspective and concern is shared by so many small-business owners. I’ve seen many instances when the business is bleeding the family budget dry and vice versa. Where the family budget bleeds the business dry. And it’s really important to have the right healthy mix and healthy balance between the two. And I recommend that these kind of four steps that we look at and we have to think about that I mentioned earlier, which is going along the lines of determining the market rate for wage, and then determining what the overall investment is to the business, understanding what our expectation is on that return, and then fourth, finding the opportunities to diversify away from the business when it makes sense to do so.

And so, to go ahead and layer this in, my overarching theme to all of this here is make the business work for you. Personally. The business exists to benefit you and your husband. My advice, number one, would be, let’s figure out how to make the business succeed for what you’re trying to accomplish, yes, with the business, but also it’s gotta make sense in the personal life. Now, the first thing is you gotta determine your husband’s time and what that’s worth and set that up as a first objective to get him paid.

Now, also you didn’t directly say that you work in the business but it sounds like you do, you’re at least in running payroll, handling cash flow, and helping with some administrative items of running the business. You should also be paid for your time as well. And if you’re not, that should be looked at and considered as ongoing sweat equity that, at some point, we’ve gotta figure out how to get paid back at a fair return.

Second, you wanna calculate and understand what the overall investment is into the business, and that includes the unpaid wages, which would be the sweat equity, and then any investments that you’re making out of your personal savings or other personal assets that you have.

Now, third, you set this expectation for the return that you expect, and then manage the business to generate that return. Now, this is what I mean by taking control of the business and getting the business to a place where you can succeed personally. This is a big step and for a lot of initial business owners, they think, “No, I just gotta keep plowing my money back in business, this is gonna work, this is gonna work, this is gonna work.” Well, blind faith can be good but sometimes it can also be completely blind. And we have to step back and we have to take a look and realize where do we need to actually change what we’re doing, where do we need to find more efficiencies, how do we make our business profitable so that we can also sustain the personal life that we need to, whatever your goals are for your family and whatever you wanna accomplish.

And I’m not saying to this listener who asked the question, I’m obviously making some assumptions here, just for the sake of…you know, just information, a little bit of entertainment to keep us all engaged in the thoughts and the concept. But it’s really important that the business is organized in this way and the goals need to be set in the business to be able to help you achieve personally what you wanna achieve, not just what the business might need to achieve or might want to achieve.

And then, all of this sets you up for number four. And number four is this concept of not having all your net worth tied up in your business. Again, it’s the source of all your income, it’s the source of all of your future potential net worth. All your eggs are completely in this basket. And it’s not the worst thing, this has paid off for a lot of people who’ve done it this way. It’s also destroyed a lot of people who have done it this way. My advice or, you know, my recommendation for you to be thinking about and to be considering very seriously is, as you can get the business work and start to pay the wage, and then start to pay back some of what your investment’s been over time, and then you’re ongoing profitable and you can be, you know, continuing to have more income come in, as that happens and as you’re able to cover your personal expenses, you get into that habit of, “I’m paying myself before anybody else gets paid.” And this is on a personal level, meaning you’re setting money aside for savings, and for retirement, and for other things that you care about, and whatever your other priorities are, going through the whole waterfall that I’ve talked about in multiple episodes in the past.

And as you do this, at some point, the income at home is gonna become more than your expenses at home, and then off you go to diversification. And you can start putting money aside in other things and letting those assets grow. And that is the whole successful model of building net worth. It’s training ourselves to live on less than what we make and taking those assets that remain and invest in them so that they can start working for us and they can start growing. Just like that small business is growing and it’s gonna be a good investment if you, you know, take it down the right path and you’re working on it and building it and growing it. But these other assets that can just passively be working for you with no effort and no time, very important way to start diversifying yourself.

Now, all that being said, running a small business is hard, especially the financial ups and downs. I’ve been there on many occasions, the best thing you can do to get this business creating all this value for you personally, and then grow that value or net worth is to focus on getting that business to that place where it cannot just cover your wages but it can start to have enough profit leftover in cash each month or each year that you can take it out and start to show yourself that you’re generating a good return on your investment. And you’re taking that return and you’re gonna go invest it in other assets and let those start growing while you continue to grow your small business.

So, listener, thank you again for bringing this scenario up. I hope this has been a helpful discussion and conversation around some perspectives, some mentalities, and some key principles to apply in how to organize the way you think about your business finances, how to think about and organize your personal finances, and all of that being in the direction of helping you build the net worth that you need over time.

So there it is, how small-business owners over time build net worth. If any of you have any more questions on this topic, please feel free to send them in to me, it’s ken@networthhacks.com. Love to hear from you and love to respond to any of your questions or if you wanna challenge any of the perspectives and things that I’ve shared today. Many, many thanks to you for joining today. This is a wrap for Episode 47. Happy day.

Leave a Reply:

About the Podcast

Join Chief Financial Officer Ken Kaufman as he helps you track and hack your net worth. For those seeking financial independence, your net worth is one of the most significant measurements of success. Using his two decades of financial experience, Ken Kaufman helps you overcome your financial obstacles and look onward towards a better, brighter financial future.

Listen

Join Our Group

Like & Follow

Recent Episodes

Sign up for our Newsletter

Get news, updates, and exclusive tips on reaching financial success.