When we sell or exchange our time or ideas we are involved in enterprise. Everybody quickly understands that their time and ideas are worth something (tell a ten-year old to mow the lawn for you or shovel snow), but very few people actually understand how the value of time and ideas relates to enterprise.
For example, there is a big difference between earning money in a business and building wealth with a business. The difference, which is much larger than most people realize, has to do with something I call the magic of the number 7, or the power of the earnings multiple.
Start by asking yourself what an enterprise is worth if you want to buy or sell it. It turns out that most people haven’t thought very deeply about the value of enterprise, or why and how enterprise is important and what makes it valuable.
Think about this. The annual sales for one business might be $100,000 and the owner earns $50,000, but the business is worth nothing. The annual sales of another business is $50,000 and the owner doesn’t earn any wages, but the business is worth $24,500. Figure out how this works and you know the secret of building wealth with a business.
If you really want to understand how enterprise creates wealth, start by studying the example below.
Most people simply think in terms of making money to survive; making money to be financially independent; making money to prove that they are great; or, whatever. Not that many people think of an enterprise or business as an independent entity/organism that is built or created to generate wealth.
In an introductory talk that I give to people who are looking to go into business for themselves I tell them about the secret, powerful, magic number 7 as the key to wealth building in business. This number is a multiple of earnings that on average can be used to calculate the value of a good business.
Then I make the point that when you own a business and you take $1 out of the business and stick it in your personal account you get a $1 value. However, when you keep that $1 in the business (as long as you pay yourself a justifiable management salary), that $1 magically is worth $7.
There are very few ways on earth that you can turn $1 into $7. That is why most wealth is created by entrepreneurs and by investors who back those entrepreneurs.
In my introductory talk I use a hot dog stand or food cart as an example. Let’s say you buy a little stand and start working it eight hours per day, six days per week, 313 days per year, by yourself.
Assume that the business yields $50,000 in sales per year. Let’s say that after all costs, including taxes, but not including wages, what is left is $20,000.
You decide to pay yourself a total salary of $20,000. That means that the business has no net earnings or profits! Although you are making money to survive, the business is not making a profit. A BUSINESS THAT HAS NO PROFIT HAS NO VALUE FROM AN INVESTMENT POINT OF VIEW!!
If you want to understand how wealth is built in a business you need to really know what is going on in this example. Let’s work it a little more.
Instead of paying yourself $20,000, you get total wages of $16,500, leaving $3,500. You multiply that by 7 and you have a business with a value of $24,500. Add that to the $16,500 and you build a TOTAL value of $41,000 for yourself!
The problem is that your time may be worth more than $16,500, in which case you may have artificially inflated the value of the business. That won’t work. A savvy business buyer will quickly tell you that something is wrong. If your time is worth more than $20,000 you are actually subsidizing your business with your own sweat equity. A lot of small business owners actually do this.
If it takes more than $20,000 in wages to run a business and the business can never generate that amount it will never be worth anything! But suppose that it takes less, but you don’t work the business yourself!
Let’s go further. Suppose you live in a town with very reliable teenagers who can participate in a work-release program from their high school and will work at a total wage cost of $6 per hour. You hire two and they are so trustworthy you can turn all responsibility for running the food stand over to them.
Now the wages in the business are a total of 313 x 8 x 6 = $15,024 dollars per year. The business is making a profit of $4,976 per year. Let’s say after taxes the profit is $3,500.
See what’s happening? Let’s go back to that magic number 7. When we multiply $3,500 x 7 we get $24,500 as the value of the business.
This is pretty amazing and is absolutely correct. In one case you work hard, pay yourself and have a business worth “nothing.” In the other case you don’t work at all (but you don’t put any money in your pockets either, unless you have another job), and end up with a business worth more than what you would have paid yourself.
The lesson here is NOT just that you should hire other people and pay them less. The lesson is that if you work the food stand yourself, you should value your labor at the going rate. If you pay yourself more than the going rate the business profits will not demonstrate its real value. If you pay yourself more, the business won’t survive.
Suppose you keep the food stand open an extra two hours per day by hiring a third part-time teenager and you get some extra sales so the business has total annual revenues of $70,000. Non-wage costs now are $42,000, leaving $28,000. Total wages are $18,780 leaving $9,220.
Let’s say earnings after taxes are now $6,500. Guess what? Apply the 7x earnings multiple and you get a business valuation of $45,500, an increase of $21,000 by adding 2 hours of work per day!!
Of course, there is a lot more to business valuation, but this example demonstrates what is at the core of creating business wealth.
If you or someone else has a business opportunity that can generate a profit (EARNINGS), other than just making money for you, then you are truly involved in wealth building. That is why profitable business opportunities attract investors, can cost a lot of money and make a lot of money.
The main and final point of the examples and the calculations is this: In business there are many legitimate things that can be done to grow earnings. When earnings are increased the effects are multiplied, more than in any other human activity. That is the secret of wealth building in business.
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