The Road To Financial Security Through Entrepreneurship

Steve Pomeranz: Just recently I interviewed my next guest.  He’s a private equity investor and entrepreneur.  His name is Douglas McCormick and it was about his new book Family Inc.: Using Business Principals to Maximize Your Family’s Wealth.  It was a very well organized book.  To take the view of a CFO and the role one would play in a company and in a way translate that to your family to help you organize your financial life.

In the book, he discussed the value of having your own business.  I’m going to quote from his book as well.  It says, “Today only 15% of the population earns more than $100,000, so probability suggests that the path to wealth is not through traditional employment alone.” Doug McCormick is with me on the phone, let’s talk to him about it.

Hey, Doug, welcome back to the show.

Douglas McCormick: Hey, thanks, glad to be here.

Steve Pomeranz: If W2 type employment isn’t the way to wealth because we’re just not making enough money, what are we really talking about in terms of being able …  Why does owning a business create so much wealth for people?

Douglas McCormick: I think the first thing is to realize what entrepreneurship is at its core.  The way I look at it, I mention it in the book, labor market’s very competitive.  You mention the stat that less than 15% of Americans make more than $100,000.  The median average income in America for a household is a little more than 50.  Obviously the labor market is very competitive.  If you look at the capital markets, for the most part, I advocate passive investing because it’s very difficult to beat the market.  Over a long period of time, if your portfolio generates more than 5% net real returns per year, that’s probably pretty good.  What we see in both of those, the two biggest assets a family has is labor and is capital, they’re very competitive markets.

Steve Pomeranz: It’s a very good point.  We understand the labor market and I like the way you’re putting it in a sense that if wages aren’t that high it’s because maybe it’s a supply and demand issue.  There’s other issues, too, but if it’s a very competitive market, it keeps wages down.  When you talk about capital markets, I don’t think a lot of people know what you’re referring to, but we’re talking about the standard world of publicly traded companies, the stocks and bonds, which can be accessed through mutual funds or through index funds and ETS and other kinds of products.  Doug’s belief is that there’s a commodity-like aspect to that, meaning that really the returns over a period of time, he thinks they’re going to be in the 5% range.  That’s an arguable point, everybody has their point of view, but I think the idea is that the returns aren’t going to be high enough, or you’re going to need a really really long time to create any decent wealth and a lot of savings.  So what’s the alternative?

Douglas McCormick: I think just to that point, if you look at your labor and your capital and you look at averages in returns and employment income, you’ve really got to save heavily to achieve financial independence.  Entrepreneurship is basically combining those two assets.  My experience has been, when you combine them, you shelter both of those assets from competition to a certain extent, so I think you can get essentially better returns on your labor and better returns on your capital.
I think there are really four fundamental reasons on why entrepreneurship generates significant wealth.  The first is I see entrepreneurs are able to work longer in life.  In a traditional employment relationship, you’re all in or you’re all out, but you don’t have the choice to be a part-time employee as you age, generally.  I see a lot of owners who scale back their involvement, stay involved in the very important issues that really drive the business, but build a team around them so that they can extend their career.  The second reason is, back to this point about a superior return on your investment, I believe that returns on capital in a private business can often exceed 50% per year.  Our tax code incentivizes entrepreneurship, so it’s more tax efficient.  And lastly, if you build a good business you can often sell it as opposed to retiring.

Really those four things, and we could talk about each one of them, but all contribute to a much better opportunity to create real wealth.

Steve Pomeranz: Those are excellent points.  You mentioned this idea that combining your labor and your capital into a business helps shelter you, I don’t know if you said from competition but that’s how I took it. Why is your labor combined with your own capital or some other money, why is that special?

Douglas McCormick: I think, first of all, when they’re sold individually, I think they do act in and work more like commodities.  The capital markets are very efficient and it’s very hard to shelter yourself from that perfect information, if you will.  The same thing in a labor market.  When you apply for a job, 10 other people apply, you’re all competing for that same exact opportunity.  But when you combine those in offering a product or service, there’s lots of ways you can differentiate what you’re offering in the market place relative to price.  I just think that gives a lot more degrees of freedom in how you position yourself in the market for your talents and your skills.

Steve Pomeranz: Are we talking about building a Facebook here or Google?  Those require enormous amounts of capital and so on.  What are we talking about?

Douglas McCormick: I think there’s generally misperception around what entrepreneurship is in America.  I think, for most of us, the opportunity is much smaller.  Having said that, the risk is much lower and the needed capital to make these businesses work or get started is also much lower.  When I think about entrepreneurship, I, first of all, think that in many cases this is a game of incrementalism for people.  For example, you didn’t just wake up one day and decided you wanted to be in the financial advisory business and own your own business.  You leveraged 20 years of experience which allowed you to make a very informed decision about what you were going to go do.  I think your business is a great example of the kind of businesses that I see Americans pursue opportunities like that that I think are very compelling on a risk and on a wealth creation opportunity basis.

Steve Pomeranz: I have a personal story that works within this as well.  I was a W2 employee and then for whatever happenstance or reasons I decided to go out on my own and become a fee-only investment advisor, in 1996 way back when few people were doing that.  For me, it was a way of differentiating, of separating myself from the competition, and also doing the right thing.  You build up, you now have control of your own destiny, which is very important, and then over time the income that you generate or the revenues that you generate have value to others.  That can be sold.  I want to talk about that for a moment because that, to me, is one of the major differences between working for somebody else and working for yourself is if you can do it right, this ability to have something for sale and get a bulk of capital in your pocket maybe at retirement or at sometime near retirement.

Douglas McCormick: Totally agree.  I think essentially the name of the game, in that regard, is you take in your skill sets as a financial advisor, you’ve created and surrounded yourself with a team such that you’re really not …  When it comes time to retire the business doesn’t go away, there is a going concern there.  I think the best managers create organizations that can perform well in their absence.  Essentially over time, good entrepreneurs find a way to replace themselves in the organization and that allows them to sell a going concern.  To your point, the economics of owning a business and selling as a going concern versus being an employee are dramatically different because essentially a buyer is assuming that that business will continue to perform at perpetuity and so they’re often willing to pay multiples of earnings representative of that future earning stream.

Steve Pomeranz: That’s a beautiful thing.  That’s a wealth creator in a nutshell right there.

Douglas McCormick: Steve, just to highlight the significant point there, not only is it a significant wealth creator, but our tax system encourages this kind of behavior.  Your income year in and year out is ordinary income, taxed at a higher rate, when you sell a business like that that is treated like capital gains and lots of tax incentives to make that work as well.

Steve Pomeranz: As with everything, there’s pros and cons, there’s negatives to this.  A lot of people may get the idea, this sounds very interesting, I do want to start a business, but it takes a certain set of skills and a certain amount of capital. So what are some of the negatives to starting your own business because we know, or at least we read, that most businesses fail.

Douglas McCormick: Couple things there, I think the negatives I would highlight there are illiquidity, meaning hard to get your money out of your business in any point in time.  Over the long run, entrepreneurship can create a lot of wealth, but it’s not as if you can just one day show up to work and decide you want to cash in that wealth.  The second thing is it does violate a lot of the ways we think about diversification.  This is, by definition, putting a lot of eggs in one basket ,so I think you have to acknowledge that concentration.  I don’t think this is a negative, but I think it’s important to highlight that before you become an entrepreneur you have to have a financial profile that can accommodate a little more risk or at least a little more volatility in your monthly earnings, and I think the key element of that financial profile is a reasonably healthy balance sheet.  I think in many cases people end up trapped in an employee relationship because they’re always trying to make this month’s obligations to get paid for.  To be an entrepreneur and be successful, I think you’ve got to have a little bit of a war chest where you can afford to go without a paycheck for a period of time.

Steve Pomeranz: That’s exactly right.  I know when I first started out, even just paying social security for me and my employees, that was kind of a deal breaker and I had to find a legal way to get around paying social security just for a small period of time.  There is a way to do that, you can’t do that forever, but new businesses can do that and that saved the day.  It really was a question of having enough capital to survive, especially when you’re starting up.

Also, I would want to say one more thing in that in takes a lot of skill, of course, you need to be an expert at what you’re doing, but also there’s a lot of dedication to owning your own business, wouldn’t you agree?

Douglas McCormick: Oh yeah.  There’s an old saying that says, “Ever since I started my business I sleep like a baby” and the follow on is “I wake up every hour crying.”  I think it is not for the faint of heart but it’s for …  As anxiety ridden as the experience can be, I also think it’s tremendously gratifying for most people that do it, and it’s a great sense of accomplishment, and I think you get a chance to feel like you’re building something in certain ways that you don’t get that fulfillment in a traditional employment relationship.

Steve Pomeranz: I agree.  My guest, Douglas McCormick.  The book is Family Inc: Using Business Principles to Maximize Your Family’s Wealth.  Thank you so much for joining me.

Douglas McCormick: Hey, thanks so much.  Enjoy.