Creating and Using Synthetic Equity to Make Money

Several of you asked how it was possible for us to earn between $80,000 and $100,000 a year during college despite not having full-time jobs and being self-made.  The response was too long to put in the comments because it involved an explanation of something called synthetic equity; I’m publishing the follow-up response here, as its own essay.

I’ve told you my belief that the greatest way to achieve financial independence is to collect cash generating assets, while avoiding liabilities and risk.  If you go through life with that philosophy and you manage your affairs prudently, wealth flows into your checking account as you sleep, play video games, vacation with your family, read books, play golf, or whatever else it is you desire.  The more time you have to reinvest the fruits of your labor, and the higher the return you earn, the richer your family and fortune grow.

When you mention “acquiring cash generating assets”, the first thought most people have is using your own cash to purchase an investment outright.  You see a Holiday Inn Express, you pay $4 million for it and you earn $400k per year; that sort of thing.  If you can’t come up with $4 million, you may put a down payment of $1.2 million on the property and borrow the remaining $2.8 million, taking advantage of (and the risk that comes with) leverage.  Alternatively, you work at your day job and save your money to buy shares of stock, paid for with cash, and parked in in a brokerage account.

There is one way to own cash generating assets that people often forget: You create them.  We’ve talked about J.K. Rowling’s body of work – she wrote 4,175 pages spanning seven books that made her a billionaire.  Likewise, in the farm town where I spent much of my childhood, there was a doctor who invented a surgical procedure or product that provided a constant, substantial stream of royalties he used to build and maintain an enormous estate on the edge of town.  Every time “Bennie and the Jets” or “Tiny Dancer” is played on the radio, television, or in a movie, Elton John and Bernie Taupin collect a royalty.

We Used Synthetic Equity as Our Strategy of Choice for Building Wealth

Building on the concept of creating cash generators, Aaron and I decided to take advantage of something called synthetic equity.  We actively sought to create, control, and profit from as much synthetic equity as we could without risking our own money – only time, since we were young and had a lot of it then (we’re still young but our time is far more precious now compared to our college days).

Technically, synthetic equity is, “a derivative instrument with the essential risk/reward characteristics of a direct investment in a stock, a specific basket of stocks, or an appropriately weighted basket of stocks equivalent to a stock index.” For my own purposes early in my career, I expanded this definition and used it to great financial advantage.  That is, I consider synthetic equity to be a form of artificial ownership that entitles someone to receive a share of the cash generated by an asset, while requiring very little (if any) financial investment.

By using that definition, Aaron and I generated a lot of our early investment capital.  We then took our earnings from the synthetic equity we created and redeployed the cash into stocks, bonds, real estate, and our private businesses.  The best way to explain to you how I thought about synthetic equity is to provide a hypothetical scenario.

How We Would Create Synthetic Equity

Imagine that you own a widget factory.  You normally earn operating margins of 20% on your products.  You are old-school, have virtually no Internet presence or modern technology, and sell only to people who know you through word of mouth.

I approach you and say, “I think I can make you money.  I’ll develop an online commercial web site and ordering system that you can use to attract new customers.  Any customers that sign up through the site – since you wouldn’t get them anyway – will be required to order through it and pay up front instead of on terms, as your traditional old-line customers can.  I will own the site, the domain name, and all the code but I’ll effectively lease it to you in exchange for 5% of sales it generates in the the form of a commission.  That means we’ll have to call it a new company so we don’t use any of your trademarks – we can negotiate the name.”

Then, I’d continue: “It is a source of new, almost costless revenue to you that you won’t otherwise have.  I’m taking all of the risk so if it doesn’t work, you aren’t out a single penny.  If it does work, I get paid out of the cash generated from the new clients, which poses no hardship because they pay upfront instead of on 30 or 60 day terms like your existing customers.  We’ll set it up so the merchant bank automatically splits any incoming revenue so there is no dispute or disagreement as to the amount you owe me.”

I Would Effectively Own 25% of the Company in the Form of Synthetic Equity

In a scenario like this, the worst we would be out is a few hundred dollars in domain registrations, graphics licenses, etc., plus any time we had invested.  Yet, in effect, a new firm had been created in which I owned 25%, or 1/4th, of all of the stock because I was entitled to 25 cents out of every $1.00 profit the company generated.  (I was sure to list my cut as a percentage of sales, not profit, because the latter can be manipulated too easily.)

That is, if the company sold $100 worth of widgets, they would ordinarily make $20.  Instead, they are going to make $15 and I am going to make $5 but without my platform, they wouldn’t make anything so we both win.  They have invested all of the capital and I invested my skill sets and ideas.

Practically speaking, I’ve put up no cash and now own 25% of the new business.  If I can sell $1,000,000 worth of widgets, I’m going to get a check for $50,000 and the company is going to earn the other $150,000 in operating profit.  They have the machines, they have the payroll, they have the factory.  I just have a computer connection and a cup of coffee.

Synthetic equity can be an enormous source of opportunity.  A business owner who might never part with a single share of stock in his company might be willing to create some sort of special project or joint partnership.  The fact that he still technically owns 100% of the company doesn’t matter as long as you are earning the right to a substantial portion of the profit.  Overnight, you could be earning revenue from a company that took decades to build.

Trying to Value Synthetic Equity Can Be Tricky

In a situation like that, I’d be collecting $50,000 a year and have almost no expense so 80% to 90% of it would be profit.  My balance sheet would show almost no assets.  Yet, to earn that amount of dividend income, I would have to own nearly 23,150 shares of Johnson & Johnson!  The company’s stock price is around $60.74 today, so you’d be talking about a $1,406,131 investment to bring in the same household income.

Alternatively, you could just capitalize it at 10% and say the $50,000 earnings stream is worth $500,000 before any taxes that would be owed if it were sold.  However, I ascribed $0 to all of it.  No capitalized value.  Nothing.  I assumed that the contracts could disappear tomorrow, the relationship terminated, and the money cease.  The only thing I ever allowed myself to count was cash in the bank, stocks and bonds at the broker, real estate, etc.  Part of this is my belief, which we have discussed, that people are better off thinking about wealth in terms of private income – that is, the total cash that flows into your bank account each year.  It is a much more important metric than someone trying to estimate your net worth because net worth can be manipulated or subject to judgment (just look at the people who are 40% underwater on their mortgage in California).

I Had to Use Synthetic Equity Because I Wasn’t Born Into Money

In my case, and Aaron’s case, we took the synthetic equity approach because we weren’t born into money.  If we had each had a trust fund with $5 million in it, I would have immediately taken over a small business or hotel or something and used it as a funding vehicle to start my empire.  But that was a luxury neither of us had.

That means we needed to figure out a way to generate returns as if we were holding enormous asset bases without actually owning those assets.  The single best way I could do that was synthetic equity.  We effectively became significant owners in other people’s businesses with them putting up all of the money and us taking a cut.  But they benefited in very real ways.  One of the very first people with whom we had an arrangement like this has generated millions of dollars in sales that otherwise would not have existed.  He’s thrilled with it.  We are thrilled with the deposits that flowed into our coffers.

(Note: This approach had a lot of appeal to Aaron and me because we don’t like people having demands on our time.  By focusing on technology, we could automate almost everything so our total responsibilities were limited to a few hours a week.  That allowed us to think, study, and become more knowledgable about finance, accounting, business operations, etc.  This is what I mean when I say one of the best things I ever learned during childhood was Buffett’s concept of “arranging” your life.  It is genius.)

Synthetic Equity Is All Around You – Identify and Focus On It

Some of the best business models in the world are based on (my expanded definition of) synthetic equity.  This explains their enormous return on equity – they get part of the profit without major equity investment requirements!

• A hotel franchiser such as Choice Hotels International.  The company earns a royalty from nearly every penny a franchisee earns, yet it is the franchisee that puts up nearly all the money and borrows from the bank.  The same can be said of McDonald’s.
• A hedge fund manager that takes a 20% or 30% cut of profits effectively owns 20% to 30% of the business in the form of synthetic equity beacause he is entitled to that proportionate interest even if he had $0 invested in the fund.  Think about Warren Buffett’s seven original investment partnerships.  If he was entitled to 25% of profits and the partnership had $100 million in other people’s money, he was essentially holding $25 million in synthetic equity.  To keep it simple and ignore hurdle rates, if the partnership earned 10%, or $10 million, Buffett would receive $2.5 million, or 1/4th of the company’s profit.
• A marketing company that works in partnership with wholesalers and manufacturers to “rep” lines with major retailers in exchange for a commission effectively holds synthetic equity in the companies they represent.
• A real estate property management company that is paid 5% to 10% of rents in exchange for managing a property has none of their own money invested yet effectively owns 5% to 10% synthetic equity in the apartments, houses, hotels, office buildings, and industrial real estate under their care.
• Apple is now taking a 30% cut of all intellectual property distributed through their sites and online stores – music, movies, books, video games, and software applications.  In effect, Apple has become a major synthetic equity holder in the companies that create content, generating billions in profit.

The Key to a Good Synthetic Equity Structure Is That Everyone Must Win

I believe that a synthetic equity ownership deal must be structured so that everyone wins and walks away richer and happier.  It is not a zero-sum game.

Take the video game company that developed “Angry Birds”, the #1 selling game for a long time on the iTunes store.  Sure, they did the work and Apple gets 30% of the revenue from the game sold through the Apple platforms for iPhone, iPad, and Mac.  But had Apple not developed that distribution channel, Angry Birds would have sold a tiny fraction of the copies.

To paraphrase Buffett, it is somewhat akin for the owners of Angry Birds having 70% equity in a diamond instead of 100% equity in a rhinestone.  They are much better off for all of Apple’s work.  Apple gets to profit from their content.  Consumers get access to that content.  Everybody wins, makes money and is happy.

There Are Drawbacks to Synthetic Equity

There are some very major drawbacks to synthetic equity, which can be overcome if you structure your contracts correctly with good attorneys.  First, you can almost never capitalize your earnings like you could with pure equity.

That is, if you own a factory earning $1 million per year, you could probably sell it for $10 million.  If you own a synthetic equity right that earns $1 million per year, there may be nothing from stopping a competitor coming along and taking away the business by offering more lucrative terms to your client so your cash stream evaporates.  As a result, you could almost never sell your synthetic equity earnings at a capitalized rate.  The $10 million just wouldn’t exist for you (some software service companies get around this through the use of multi-year management contracts, which are then valued in mergers and acquisitions at lower rates of 3x earnings).

Second, all synthetic equity investments tend to expose you to the risk of being in business with someone else.  If they don’t have integrity, forget about it.  They will try to reneg, steal from you, and make your life miserable.  To overcome this, you must put in structural, contractual safeguards.  Fast food franchises, for example, have required cash registers that monitor and report all transactions to provide an audit trail when determining the total royalty owed to the franchiser.

I Believe the Best Way to Use Synthetic Equity Is as a Cash Stream to Fund Pure Equity

What does a hedge fund manager do with the profit he earns from managing the fund?  He almost always reinvests it alongside his partners.  He took the earnings from his synthetic equity and used them to buy pure equity investments.  In a similar sense, McDonald’s can use the franchise royalties it earns to own and operate company restuarants.

Aaron and I used our synthetic equity earnings to fund our investments.  Much of this went to expanding our holdings of publicly traded stocks, others went to help us live comfortably during the time we started our first privately owned operating business, still others went into tangible assets.

This approach should make it clear that if you are talking about creating cash generators, the old rules of asset base don’t apply.  To earn $500,000 you may need a $5,000,000 hotel or office building, sure.  But you may also need a 5% service contract to manage a $10,000,000 real estate portfolio with none of your own money invested.  In that case, your balance sheet would show $0 in starting assets and $500,000 in revenue.

That is one of the reasons I am convinced that I could get my household income back into the six-figures within a few years if I woke up and had lost everything.  Without having the advantage of capital, I’d pull the synthetic equity concept back out of my intellectual toolbox and put it to work.

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