As you progress through life you’re going to value cash flow as you can’t really spend the money that is locked up in Angel Investments and other high risk ventures (such as private equity deals). This is probably one of the biggest mistakes we made, locking up too much money for longer periods of time and being forced to wait years (yes plural) to eventually exit the positions and turn them into cash generating machines. Since we’ve had some downtime we looked through about 10-years of income and made a few interesting observations that should be valuable to people who are still working up the ladder.
Cash Generating Net Worth: This is one we’ll start with. You can only reach “financial independence” if you are generating enough cash flow to cover your cost of living + some emergency spend as well (cost of home, food, utilities, healthcare and a bit of money for emergencies). If your money is currently in higher risk assets such as FANG, angel investments or private deals with no cash flow… You’re not really set yet. You have to liquidate those positions over time and eventually buy a cash flowing asset such as: 1) rental properties, 2) internet income producing websites, 3) stocks with dividends, 4) bonds and 5) high yield savings.
While obvious when written out like that, it’s actually quite easy to count too many eggs before they hatch. If you think it’s not a big deal and you can “eventually get out of the position”, just ask the employees at WeWork. Overnight, many employees went from “home shopping’ to searching for an entirely new career. The major issue with appreciating assets with no cash flow is that you’d be forced to sell when you need cash on hand. So even if you believe the stock market will go up 7% or so per year (as it has done historically over long periods), it does not mean you’d be selling at the tops. It is quite easy for you to own Amazon stock, the company misses earnings (-10% on the day) and you’re forced to sell to realize some cash. Take this seriously when building out your portfolio once you’re over $1M or so in net worth.
Mathematical Example on Other Income: A good rule of thumb we noticed when we looked at failed projects versus successful ones… The failed projects all saw income growth that was lower than your typical high quality career. In a good career, you can get double digit improvements on your total compensation fairly easily if you’re an above average employee. So if your “side-hustle” is only growing at around 10%, you are probably better off selling it.
A great example is a re-selling business of sneakers. While this is a good market right now due to the popularity of certain shoes, it eventually hits a limit where the growth stalls out. Making more than $100K is pretty difficult unless you’ve found something special that helps you. We’re not sure what that differentiating item is since most of the value is based on creating bots, email addresses and shipping to tax advantaged locations for re-sale. All that aside, we’ll continue with this business model as a good example.
Once you’ve reached a point where you’re making around $60,000 a year, you should consider selling it. Why? You want to make sure you’re showing large amounts of “growth potential” despite knowing that it will fizzle out after improving a bit. By the time you actually sell it, you’ll probably be making around $80,000 a year since the sales process takes time. After this you should sleep easy at night knowing you maxed out the income. And. If you’re really nosey, you can track the business a couple of years down the line to see if you were correct and if the person was able to somehow ramp up the business.
To summarize the above, if you’re seeing growth in the low double digit range (10-15%) and you’re aware of potential scale limits… You want to sell about 2 years before that limit is reached. We are sure there are exceptions but don’t spend time “brainstorming” when it has become clear that the limit has been met. The only reason you shouldn’t sell is if you’re willing to run the business at 0% revenue growth since it isn’t time consuming. Unfortunately (or fortunately) we have one of those on our hands right now.
Taking on More Risk: Another fun way to see if you should take on a new venture is to calculate your total net worth change in a year. If your net worth is say $1 million and you’re ending this year with $1.1M… Your net worth change was 10%. If this is you, it’s time to start taking on more risk/task or projects since you’re going to slowly downward spiral into nilhism thinking. You’ll look at the year-end balance and say… What’s the point of working since I didn’t really move the needle.
A good metric to stand by is around 20% increases in net worth. If you’re putting your best foot forward, it should be possible to move your net worth by around 20% per year. If you’re in the $100M+ net worth camp, this is a completely different ball game. We’re simply referring to people who are worth $0 to $5 million or so. While moving your net worth by $1M is not easy (when you’re worth $5M), you’re probably extremely talented otherwise you wouldn’t have made it there so quickly.
We’re getting a lot more private messages from people who have reached this hurdle and our answer is quite simple. You must start a new project or purchase a new fixable project to have something new to do. If you’re really working long hours, say 60-80 hours a week and can only move your net worth by 5-10%… You have to hit the sell button on one of your time consuming income streams. If you don’t have anything to sell, it means you have to work *less* at the position you’re in since you’ve very clearly reached a wage/income ceiling for one reason or another. Don’t sit on your hands as you’ll become bored/disgruntled and lazy leading to the standard downward spiral.
How the Cash Flow Should Look: Generally speaking, if you followed our plan in Efficiency, it should look something like this: 1) first cash flow item is around $100,000 a year with your career, 2) after 5-years or so your idea should be working and generating around $150,000 per year, 3) after 10 years, you should either be out of your career or you should have career income equal to your side income at around $200,000, 4) after a couple of years like this you should have a third cash flow – real estate for example – generating about $30-50K per year. That’s the extremely simplified snapshot and if you see your business income surpass your career income, you’re free to quit at that point.
The key item to be aware of is that you always have to discount at least one of your cash flow items to zero. That is $0.00. Why? You could lose it all. While we gave a WeWork example for the perils associated with “paper wealth” any high income earning position can be replaced. The more money you make the more likely the firm is searching for ways to replace you. If you’re making $150,000 per year in a high cost city, you’re not on the radar. Start making $400,000-500,000 and you’re 100% on the radar.
For what it is worth, from a psychological perspective, the two largest jumps are when you get your second and then third income stream up and running. As another rule of thumb it is only an “income stream” if it would cover your cost of living. Once you get a fourth stream, the novelty factor wears off as it’s unlikely that you lose three different income streams at once, the fourth one was just icing on the cake. As a note, we don’t use dollar amounts here as we have no idea where you live, an income stream of $2,000 a month in Thailand is a ton of money, in New York or Los Angeles it’s not great (remember we’re comparing this to the cost of living in the country/city).
Cash Flow for Expenses: As always, the worst way to try and get rich is by being “frugal”. You can only cut your costs so far (can’t cut food, water, housing and taxes… it Just isn’t possible). That said, a good mathematical formula is to never spend more than 10-15% of your pre-tax income on rent/housing. This was probably the smartest cost decision that was made over the past decade. If you make a lot of money due to a lucky break or due to a successful career, there is no reason to ramp up the housing expense if you’re in your 20s. Most guys in their 20s are forced to live with roommates so having a decent one bedroom or studio apartment is fine until you reach your 30s and can upgrade to a higher quality one bedroom. This is also one of the reasons why it’s so important to start making money early. The earlier you do, the more you can take advantage of social expectations that work in your favor.
Q&A as usual we’ll start next month with a Q&A, we’ll open it up on Thursday the 5th.