The single best and most common way for a person to compound an investment at a rate of 18% or higher for 10 or more years.
Is to buy a business. It's also the most common way (after starting a business) for people to hit $10mm+ net worths.

I'm going to weave in commentary that is relevant to stocks in some of these posts. The first thing I want to mention related to buying a business is that in my personal experience business owners are less flustered than other people by the gyrations of the stock market. This is not universally the case, but it is certainly the case with a solid majority of folks I've observed (also FWIW this is NOT true for people in the real estate business).

I think a lot of this comes from knowing/feeling intuitively how ridiculously insane it is to think that the value of a business - especially one as large as Google - fluctuates by 20% in any given year (40% in the past 12 months) and can drawdown by far more. Business owners have all had bad years where their profits took a dump - literally all of them. I don't think I've ever met a single business owner who didn't have horror stories. None of them were thinking at the time: "Gee, now that my profits have dropped by half I sure as hell better sell my business before it goes to zero". They instinctively know that you don't sell when times are tough in a way that is super difficult to internalize for people who haven't owned a business.

There are also huge tax benefits to being a business owner that are relevant to investing in stocks as well. For example, as a business owner there is tons of flexibility in when you realize accounting profits - and in many cases you can engineer accounting losses outright. This would enable you to do things - for example - like rollover a traditional 401k to a roth and offset or remove outright the tax bill for the conversion.

Below I will run through what is not only plausible, but what I'd call a reasonable base-case outcome of purchasing a small business using seller financing and an SBA guaranteed loan. The net result is a high teens CAGR over 10 years - something only a handful of professional asset managers will achieve over the same period (out of literally thousands). Now on to the post.

Buying a small business.

The SBA has a program that guarantees a certain percentage of qualified loans banks make to small businesses. For loans above $150,000 they’ll guarantee up to 75%, and if my memory serves this is available for loans up to $5m. The bank and SBA like to see 20% buyer equity in the deal and do permit seller financing so long as the seller’s debt is subordinated. Seller financing is incredibly common, and my recommendation to anyone wanting to buy a business (with some exceptions) is to use it even if you don’t need it - it’s a good thing for the seller to keep skin in the game while you are learning/taking over the business (I’ll discuss this in further detail below).

Here’s the numbers we’re going to work with:

Purchase price: $5,000,000

Down payment: $1,000,000

Seller financing: $1,000,000

SBA Guaranteed loan: $3,000,000

Closing costs: ~2% of purchase price or $100,000

Diligence costs: at least $25,000 (you can do diligence on your own but I think it’s worth paying for)

Interest rate: ~9% today but I’m going to use 7% because that’s probably where they’ll be in the not distant future

Loan terms are usually 10 years, and I’m going to assume seller financing is the same rate as the bank financing (common). This gives us a monthly debt payment of $46,443.39 or $557,321 per year. I just googled it and saw that most lenders require business profits to be at least 20% higher than debt service - though in my personal experience most acquisitions have the debt covered by 30% or more unless they’re a stable real-estate related deal.

Businesses in the $5m valuation range usually sell for around 5-7X EBITDA (though there can be material adjustments depending on assets). You’ll see higher valuations if the business is growing/stable (margins, sales, etc), doesn’t have insane levels of customer concentration, and if it has management in place that could theoretically run the business without the owner (businesses that can operate without the owner can be owned passively, which dramatically increases the amount of demand). You’ll see lower valuations if the inverse is true or if you’re talking about less stable businesses like restaurants.

I’m going to use 6X because I want to keep the example simple and so will assume this is a company that can be owned passively.

6X EBITDA means $833,333 of EBITDA for a $5,000,000 purchase price. EBITDA is a good proxy for pre-debt/tax cash flow when it comes to small businesses - so in our example above we’d have the following:

EBITDA: $833,333

Debt service: $557,321

After-debt pre-tax cash flow: $276,012

After-debt post-tax cash flow year 1: $263,531 (I’ll explain how I got this below)

Now I’m going to run through the ten year return using two different scenarios. However, rather than using EBITDA I’m just going to use cash flow because it’s a more useful way to think about things when capex/investments/new hires are being made (very common after an acquisition).

In the first scenario I’m going to assume no change to cash flow over the entire ten year period and no change to valuation at the end.

Then I’m going to run through a more likely scenario where cash flow takes a dump in the year after acquisition as investments are made (I’ll explain below), but then starts climbing and hits a new high by year 5.

Scenario 1:

Cash out: $1,000,000 for the down payment + $100,000 of closing costs + $25,000 of diligence = $1,125,000. In practice we should probably add another $50,000 because the acquirer will likely have to quit their job in advance of taking over the business and there is an opportunity cost to the time spent before the acquisition closes, but I’ll just stick to the $1.125m figure.

Cash-in = after tax cash flow + exit value (assuming a sale at the end of year 10). In order to calculate cash flow we have to calculate taxes.

A simplified formula for calculating taxes is the following:

[EBITDA - Asset Write Offs - Interest] X 20%

When you buy a business through an asset acquisition you get to write off the entire purchase price against your operating income - usually this is amortized over 10 years - so you effectively get to reduce your operating income for tax purposes by 10% of the purchase price every single year. You heard that right - it’s insane and I’ll go into more detail below, but here’s the calculation:

EBITDA ($833,333) - Asset Write Offs ($500,000) - Interest ($270,928) = $62,405 - this is the figure you pay taxes on.

$62,405 X 20% = $12,481.

What we now have for after tax cash flow is: $276,012 - $12,481 = $263,531.

Pause a moment to observe how beautiful this is. You invest $1,125,000 and put $263,531 into your pocket in year 1. However, it gets FAR better than that. You also paid back principle of $286,393 using profits from the business. So - you really pulled in: $263,531 + $286,393 = $549,924.

Crazy right? Like hard to fathom crazy…Our tax code is designed to reward business owners and risk takers - thank Uncle Sam.

The after tax cash flow actually drops every year assuming no change to EBITDA due to an increasing amount of principle being paid (and hence less interest to write off), but the effect isn’t huge. Over ten years (I did the calculation) you would end up taking out: $2,408,100.

Then, at the end - assuming the business is worth exactly what you paid for it, you also have $5,000,000 less the broker’s commission (some people try to sell themselves but I recommend against this, in practice you probably aren’t selling for exactly what you got it for, and good brokers will be able to more than make up for their fee by getting you a higher price). Still, let’s assume the sales commission was 7% - you end up with: $5,000,000 X .93 = $4,650,000

Now, remember that you amortized your cost basis, so this is going to mostly be profit taxed at a long term capital gains rate of 20% (you will have some basis from new capital investment, but I’m keeping this simple and conservative). $4,650,000 X .8 = $3,720,000.

So, total cash out over the period is: $3,720,000 + $2,408,100 = $6,128,100.

We can now calculate our compounded growth rate over the period:

[$6,128,100 / $1,125,000] ^ (1/10) - 1 = 18.47%

Remember - that is your AFTER TAX return. There are literally a handful of professional money managers that perform that well over 10 years - out of tens of thousands - and unless you’re ultra wealthy you have no chance getting into them anyway.

Scenario 2

I’m not going to run through the second scenario in the same amount of detail, but in practice there are probably going to be two big differences between what I outlined above and what happens in practice.

#1, It’s pretty common for businesses at these valuations to be under capitalized and/or have an owner/operator who still makes it rain. Hence, it’s also common to need to upgrade equipment/machinery and/or hire a new employee (or even two). It’s also pretty common for new owners to want to make sure they keep the employees there - especially during the first year of transition - losing a key employee can be a nightmare, especially if they’re involved in sales and have the potential to bring business with them if they leave. Hence, employees often get a nice pay bump after a new owner takes over.

#2, the business will probably grow.

The result of #1 is that the business will likely take a big hit to cash flow in year 1 and then gradually work its way back to where it was by say year 4-5 (being conservative), and then start growing afterwards.

You’d be amazed how many businesses of this size operate with little or no marketing/sales and have websites that don’t drive any business.

I assumed a $100k hit to cash flow in year 1, then assumed it got back to it’s starting point by year 5, and then grew at 5% per year thereafter.

Using these assumptions EBITDA grows to $1,063,568 by year 10 from $833,333. It’s entirely possible that this business would command a higher multiple of say, 6.5 (up from 6).

This gives us the following:

Cash out during 10 year period: $2,718,708

Cash out from sale: 6.5 X $1,063,568 = $6,913,192 X .93 (broker fee) = $6,429,268.56

Using conservative assumptions about cost basis again (leaving it at zero) - we have $6,429,268.56 X .8 = $5,143,414.85

Total cash out: $5,143,414.85 + $2,718,708 = $7,862,122.85

Our compounded growth rate is hence:

[$7,862,122.85/$1,125,000]^(1/10)-1 = 21.46%

Final hypothetical for this section

There are obviously many cases in which a new owner comes in and increases profit right from the beginning. This is particularly true when the business is being operated with a godawful web presence, has no marketing budget, and no sales force (again, a very common scenario because in most cases the owner is who drives business at companies with these valuations). If we assumed 10% EBITDA growth in year 1 and 2 as the sales engine comes online and then 5% thereafter once the easy pickings are gone, we end up with a business doing $1,418,826 in EBITDA by the end of year 10. Since I’m working on an optimistic case here, let’s also assume this business is running beautifully with a completely passive owner, and has some asset or IP that makes it attractive to a strategic buyer who wasn’t previously interested either because they didn’t know about the company (because of no web presence, hard to find, etc) or because it was too small. So, let’s say it now commands a 7X multiple.

We would then have the following:

Cash out during 10 year period: $4,844,380

Cash out from sale (not showing work): $7,389,244

Total cash out: $12,233,623.95

Total CAGR over the period: 28.46%

Two facts to close on.

Most millionaires in the US are tradespeople who own their own business. Painters, roofers, plumbers, etc.

The vast majority of people that achieve a $10m+ net worth (which usually excludes higher earners that work for a salary, e.g. lawyers) - did it by starting or buying a business. Starting a business is far harder than buying one...

My next post will also be on the same topic, but will instead use anecdotes of real businesses to explain possible return outcomes, downsides, considerations when choosing a business, what to look out for when doing diligence, and anything else I can think of that is interesting and related. I’ll also use that post/anecdotes to talk about the differences between buying a business for $1,000,000 vs. $5,000,000 vs. $10,000,000 (they are huge).

As a teaser, one of the anecdotes I'll explore is buying an asset management business - specifically a registered investment advisor (very very interesting w the highest returns and also highest risk - but definitely ways to mitigate the risk which I'll discuss).
Nathan Helton's avatar
Can't wait to read the next post, keep up the prolific writing!



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