Mail Bag – How Does Someone Start Creating Passive Income?

Among the thousands of emails and messages I receive regularly, I came across one today that was sent to me on May 17th by Cale P. Here is the question that was posed:

I’m a pretty talented IT professional with great salary and a standard quality of living. I’ve known that I won’t be in IT for my whole career, at least I hoped. I have a natural ability to invent and I really would love to own private business(es) to see my decisions in a company flourish.

However, I’m unsure of how or when I will be able to reach my goal. I’m busy investing my savings to build my portfolio now. This includes dabbling in the stock market as of right now instead of full on investing. Mostly, I’ve just been saving bulk amounts of cash other than my investment in my home.

How should I, being someone who has a great deal of common sense but no college education in business, pursue owning a company? I could go into much more explanation like my career vs business but I would like to see if I can start the conversation before I write more.

The Rich Diversity of Cash-Generating Assets

It doesn’t necessarily require a formal education to become successful, but it does help.  Something north of 90% of self-made millionaires are college graduates, but that still means 1 out of every 10 have no college education.

That said, when we talk about “cash-generating assets” we aren’t just talking about businesses or stocks. The world is full of things that make your richer just by owning them because they throw off cash. The perfect cash-generating asset is one that produces a stream of money for you and your family to spend or reinvest and that increases its value every year to maintain pace with inflation. There are members of my own extended family that made money by owning car washes and storage units but no stocks. Still others invested everything in stocks and bonds. All ended up wealthy, but they chose different paths due to their own individual talents, experience, and risk tolerance.

There are countless asset types that can produce passive income. As you learned in the article on the Capitalist Class that I wrote for About.com, a division of The New York Times, to be a member of this economic rank requires at least $35,000 per month in passive income. It doesn’t matter if those earnings come from stocks, bonds, hotels, movie theaters, ice cream stands, song copyrights, book copyrights, patent licenses, sales commissions from a networking business model such as Avon or Mary Kay, or shares of a privately held family business.

In my own case, I start by asking one very, very important question …

What product or service can I give the world that will solve a need or want it has and for which it will be willing to pay me the most money for the least amount of work or investment on my part?

A Case of an IT Investment in My Own Life

In my own life, I have used information technology to create streams of income.  A few months ago, Kennon Green Enterprises, LLC approached a local manufacturing firm and struck a deal where we created the online ordering platform for their clients and, in exchange, we were paid 5% of sales.  Every day I wake up, we are collecting an on-going fee of 1 penny for every 20 pennies the company generates in sales.  That means for every $1,000,000 million in revenue they generate, we get $50,000 that has virtually no cost against it. Our total financial investment was less than $500 but we had the experience to put a system like that together.  The system wasn’t fully operational until a couple of weeks ago, but I expect we will report six-figures in taxable profit from this one operation in fiscal 2010.  It literally brings in money as we sleep.

This has been one of my favorite streams of earnings because it represents how using a specific knowledge base can result in a win-win for everyone involved.  It took us less than a month of work and yet we will now collect huge profits.  This is a “business” in a sense, but there are virtually no downsides.  We have very little money invested, only time and talent.

The idea came to me as I was drinking coffee and reading a magazine, while Aaron played The Legend of Zelda: Twilight Princess.  It didn’t require us to take out loans or risk our own capital.  That is what I mean when I say a “perfect” cash generator.  If the project failed, we weren’t out much, yet if it succeeded, it could have a big influence on our net worth due to the power of compounding.

Not Everyone Should Operate a Business

Furthermore, just because someone is good at creating wealth with one asset type does not automatically mean they will do well in another; e.g., someone who made hundreds of millions of dollars investing in technology patents because of an engineering background may be terrible when it comes to choosing individual stocks for his portfolio.  Doctors are notorious for making horrific investments because their skill set in medicine doesn’t translate in any way, shape, or form into finance.

Some People Just Cannot Run a Company Without Losing Money

Consider the case of Warren Buffett. Although he was the greatest investor of the 20th century, Buffett was horrible at running a business himself. According to some reports, not only did he lose substantial money investing in a service station in Nebraska during his twenties, but also later, when he tried to run the insurance companies during Berkshire Hathaway’s formative years, he lost the company hundreds of millions of dollars. Thus, there seems to be strong evidence that if Warren were put in charge of the day-to-day operations of one of his business, such as the Borsheim’s jewelry store, it wouldn’t be successful for long. Still, Buffett amassed billions of dollars because he realized that he isn’t good at running a company. His strength lies in identifying and valuing great businesses and motivating the people who do the day-to-day work. By focusing on this one area, where he excels, he has built a reputation and record that will be studied for centuries.

Likewise, if you fall into this same category, attempting to buy a company and run it yourself could cause you to lose everything you invested (and potentially more). In our grandparent’s generation, they called a person that could run a company a great “operator”. Indeed, in his memoir, Dave Thomas, the founder of Wendy’s who dropped out of high school and amassed a nine-figure fortune, lamented that many great business leaders are not, in fact, great operators, and that is what it takes to run a business such as a restaurant or a retailer.

The heart of a good operator is someone who realizes that sales minus costs equal profit. They know how to find the right blend of revenue and profit margin to result in the highest possible return on equity. Sam Walton, for example, focused on making only a few pennies for every dollar in sales. His model was based upon huge volume that got the return on shareholders’ money as high as 60% during the expansion years of the 1960’s and 1970’s. Tiffany & Company, on the other hand, focuses on high profit margins and a more exclusive sales clientele. A good operator would be successful whether he or she was running either business.

If you don’t have that talent – the ability to count pennies and drive new business through the door – then owning something like a franchise might be a disaster for you because your success will come down to how effectively you can watch the bottom line, hire quality employees, and satisfy customer needs. You may be a brilliant accountant or investor but if you lack those specific skills, you are going to get your ass handed to you, for lack of a better phrase.

Others Make It Work for Them

In my hometown back in the Midwest, there is a lawyer that has a practice in criminal law.  He also used his earnings to buy control of a chain of ice cream businesses throughout the city.  Every day, as he is in the courthouse arguing cases, he and his family are bringing in sales from ice cream cones, banana splits, shakes, malts, and more.  My guess is the business is successful because he was able to use his job to get the company off the ground and he doesn’t need to “live out” of the earnings.  Any time you can hold something for investment and aren’t forced to use the money it generates to pay bills, your net worth is likely to expand faster.

Clearly, this lawyer knows how to manage sales and costs.  If he didn’t the chain of ice cream businesses would be bleeding money and he would have to cover the expense from his legal income.  For him, given his interests and talents, owning these frozen treat stands is a perfect business strategy that will help him grow wealthier.  For someone else, it would be an unmitigated disaster that could eat up all of their savings and force them into bankruptcy.  That is one of the reasons I cannot say, “Go buy a business!”  Some people have the skills, while others don’t.  History has shown that a well-run company, however, is a “gift that keeps on giving” in Buffett’s words. That is why I enjoy talking about them.

The Challenge Is Greatest at $5 Million and Below

To make matters worse, the challenge is more difficult at $5 million or below, which is where virtually all self-made millionaires begin!  In other words, if you have $5 million in net worth, you could invest your assets into a mid-tier hotel franchise such as a Hampton Inn, then pay one of the handful of high-profile hotel management firms to manage your property in exchange for 5% of the revenue.  You are never going to have to step foot in your real estate and yet, provided you have a good location and management company, each year a stream of profits is going to be deposited into your bank account.

Options like that, which are so readily available for those with the money to hire quality people, aren’t available in the early days.  After all, it requires a special type of genius to be able to buy a hotel and grow it into a fortune.  A complete idiot, however, could inherit a property of hotel investments and live off the dividends they threw off annually.  Some commentators have theorized that money creates its own gravitational pull, just like a planet.  The more you have, and the larger your fortune, the more money gets attracted to it because you are presented with bigger and more lucrative opportunities.

(It is possible to do this on a smaller scale because you can hire single family or apartment building management companies.  There are some of these firms in small towns that will take care of choosing new tenants, signing leases, and much more for a pre-arranged fee and revenue sharing schedule.  That way, you just choose the individual investments but they take care of running them.  Sure, you are giving up more money, but if you aren’t an operator, that may be worth it.)

Know Thyself

With all of that said, if I were a regular employee trying to figure out where to begin creating passive income, I would ask myself several questions:

• Do I have the skills or desire to become an operator?  Do I want to deal with choosing signage for a chain of ice cream stands or watching payroll costs for employees?  If not, owning and operating a business is out of the question.  If I am a good operator, the options become endless because I can do almost anything from investing in a new commercial office building to buying a set of waffle houses.
• Can I create assets that will generate cash?  I, for example, have tens of thousands of finance articles that generate thousands of dollars each month in royalties, as well as a book, etc.  These were created “out of thin air” in that they didn’t require any money to start generating cash, just my ideas and some time.  Barry Manilow is worth hundreds of millions of dollars now, but he started by writing famous jingles for television products.  His earnings from these projects are what made him rich long before he was a hit songwriter.  He created something out of thin air and turned it into cash, which is really useful when you are starting without a lot of money.
• Do I want to have to learn detailed accounting rules, how to value individual stocks, etc.?  If not, a better idea may be to create as much passive income as possible and on the equity portion of your portfolio, dollar cost average into low-cost index funds.  Over decades, you, effectively, could ignore the volatility and compound your money at somewhere between 7% and 11% if history is any guide.  Thus, it would serve as an augment to your cash generators; a way to inventory profits, as it were.

Of course, I have a lot to say about stocks and bonds, but until the question of “are you an operator” is answered, it is pointless to discuss.  So, I put that out there: Are you an operator?

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