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Cash Flow for Baby Boomers

June 13, 2004

In an environment of low interest rates (low yields on cash savings), a Primary Bear Market, and higher than reported rate of price inflation, the single most important issue being faced by ageing Baby Boomers today is "cash flow". When you cut through all the waffle and static, this is "THE" issue.

Over the past few months I have written several theoretical and philosophical articles which may or may not have been of interest, but it is probably more important to recognize that many people out there may actually be in a state of anxiety about what to do about this issue - especially as they approach retirement, and are/may be running out of "yin" energy. (You haven't got the get up and go that you used you have)

It must be stressed that the following is only for those who are mentally active, and who have a disciplined approach to life - with an attention to detail as part of their personality profiles. If you are a "big picture" person, or a right brain dominated (artistic, creative) person this is not for you. You will also need to have a "you oriented" mentality - and recognize that when a business satisfies a genuine need, its owners will automatically benefit. "Me oriented" people will be unlikely to benefit from this approach.

Finally, before launching into further rationale and/or logic, I should like to stress that I have no hidden agenda here. Whatever you decide to do (if anything), you will be doing for your own risk and benefit. I can assume no responsibility for outcomes.

It struck me some years ago - when I was professionally involved in the field of Venture Capital Investment - that there was too much "investment" money looking for a home and an insufficient availability of quality deals to justify sensible investment. In the field of unlisted investment, one does not think in terms of Price/Earnings ratios, one thinks in terms of EBIT multiples, and the EBIT multiples (purchase prices) were starting to rise to unacceptably high levels.

What is EBIT? EBIT is short for "Earnings Before Interest and Tax" and is usually thought of in terms of "adjusted, maintainable Earnings" - ie Earnings before non recurring income or expenditure; and before Management BS. When you analyze a business' maintainable EBIT you come to the realization that every business has its own unique "personality profile" in that it tends to generate a Return on Shareholder Funds that oscillates around a constant mean over a protracted period.

Like a share whose price chart is plotted over time, you want to buy strategically relevant businesses that have earnings below their long term mean (moving average), and you want to sell businesses that are generating earnings substantially above their long term mean. The primary reason for this is usually related to capital expenditure and business infrastructure. It is possible to artificially inflate earnings by running the business lean, but what happens is that the infrastructure starts to fray at the edges - thereby increasing the need for capex. In turn, this subsequently drives EBIT down - and you don't want to buy businesses that have great track records but with EBITs that have nowhere to go but down. Of course, economic cycles also play a big part here.

The reason one thinks in terms of EBIT is that this eliminates aberrations that flow from capital structuring (Debt:Equity ratios). Some people even prefer to think of EBITDA - which eliminates all book entries related to depreciation and amortization, and strips the earnings capacity of business down to its bare essentials.

After I had been in the VC industry for several years I looked back and noticed that businesses which could (in the early 1980s) be bought for 5X EBIT were (in the early 1990s) being bought for 8-10X EBIT. That was the signal for me to get out of the industry, and to make way for other, less risk averse professionals to play their death or glory games.

What happened after I left the industry to become an adviser was that "EBIT multiples" were replaced by "Sales Multiples" because in the dot.com era businesses did not have any EBIT. Future EBIT:Sales ratios were "hypothesized" and sales multiples were then derived as a proxy for EBIT multiples.

Later, all logic flew out of the window when Professors of Finance started to "go off with the pixies" and develop complex market valuation models which factored in a premium for market dominance - and this premium (because emerging businesses at that time were largely based on the internet) was, in turn, linked to the concept of "market reach" that flowed from the number of hits that a web site could attract. The argument was that whatever the business might do (say Amazon.com) if it was the biggest, then an advertisement on that web site would have a chargeable value and the leading dot.com businesses could generate an additional, incremental income from advertising revenue.

As usual, when something seems too good to be true, it usually is, and two things were discovered:

  • Every business that spends money on advertising has a hard nosed approach to a concept called a "conversion factor". It's all very well diverting advertising money from one medium to another, but if sales don't rise as a consequence, what's the point? What if the additional "reach" does not give rise to additional conversions?
  • The internet is not profit friendly because it takes away the "relationship premium" that is built into your pricing structure (you no longer have a relationship with your customer) and it turns products/services into price sensitive commodities.

The net effect was the "magic profit pudding" that was the dot.com phenomenon collapsed like a badly baked soufflé and people lost money as both the Nasdaq and the Equity Markets as a whole topped out and entered Primary Bear phases.

The problem remained, however, that the Baby Boomers were ageing, and money kept flowing into Pension Funds. And so P/E multiples remained high (and this continuing wave of funds will force them to remain high for the foreseeable future), making the listed equity markets an unacceptably high risk proposition for the foreseeable future.

The Fed kept interest rates low to protect the markets from falling further and thereby "white anting" confidence levels in general and, ultimately, forcing a depression. This had a flow-on effect of screwing with investment yields, and it also caused a property boom which is an inflated balloon that no-one is focusing on with any "real" understanding. Conventional wisdom is that property is in finite supply and will therefore "always" grow in value relative to a growing population. What few people are focusing on is that population growth rates in the West are peaking and may even turn negative in some countries. Speculative development has given rise to a glut of some types of property, and this glut may or may not be addressable by population growth - in a reasonable time frame.

All of the above, in turn, presents a massive dilemma for Professional Investors because they have now run out of options to place "large" amounts of savings flowing from a large number of small (pension) savings flows.

  • Capital value of Treasury Bonds will get slaughtered if yields start to rise
  • Property Premiums are priced in for population growth rates that will not materialize, and so rental growth can "only" manifest as a result of Fed induced inflation. If the Fed is unable to generate inflation, property prices will implode like the Nasdaq soufflé because tenants will not be able to afford rental escalations that have been built in to lease agreements.
  • Venture Capital is now a dirty word flowing from the incredibly stupid/irresponsible behaviour of the VC "hustlers" of the 1990s
  • Infrastructure investment is now going "retail" because the Funds Managers can charge the public higher fees, but when you focus on where this infrastructure investment is needed it is typically needed in areas that can't afford to pay for it (which is why the Funds Managers perceive a gap in the market). To exit such investments will require cash flow from the investment at the time of exit as the retail funds are rolled over into wholesale hands or are listed. It follows that to invest in retail funds of this nature is a long term proposition that typically does not suit Baby Boomer requirements.
  • The Stock Markets have P/E ratios that just don't make sense. It matters not that prices may or may not be rising. Where there is no value, stock market "investment" is not just a high risk proposition. It is a gamble with the odds stacked against you.
  • Asian production capacity is now bursting at the seams, relatively small amounts of capital are required there except, perhaps, for infrastructure investment.
  • Derivatives. Derivatives represent the ultimate gambler's gamble because "investing" therein involves betting on what the bettors will be doing - as opposed to betting on the horses themselves. Derivatives also seek to create investment opportunities out of thin air. It follows that you will be punting on how other punters will place their own bets on imaginary (non existent) horses!! How dumb is that for an "average" investor who was trained to sell widgets for a living!?
  • Finally, at the opposite end of the spectrum, Precious Metals. Come on guys? Precious Metals represent an insurance policy against a financial catastrophe. They are not an "investment" opportunity. One does not "invest" in cash. One uses cash to invest in other activities/ventures. Precious Metals are all about personal WEALTH PROTECTION as opposed to WEALTH CREATION. And you have to have excessive wealth in the first place before you need to start worrying about how to protect it.

The above scenario was the subject of my increasing focus some years ago, and I started to wonder about the future viability of the economy as a result. On one level, the question arose as to whether the economy would ever get through this maze and, if so, how? On another level, I started to ask the question regarding how - precisely - could Baby Boomers live to a ripe old age without suffering a miserable implosion in their standards of living?

This led me to a single point of philosophical focus:

When one contemplates the tapestry of history, one concludes that it is not "governments" that dig us out of our economic/financial problems, it is "individuals". Governments - which are populated by egotistical, self-serving politicians who are typically lacking in character (humility and integrity) - get us into trouble. On an individual level, we have to get ourselves out of trouble.

It became obvious to me that the lessons of history would begin to manifest - yet again - as people who found themselves facing tough times moved to self generate their required incomes, as opposed to continue relying on salary incomes. In any event, middle aged retrenchees or retirees would probably be unemployable and would be forced to either become consultants or go into business for their own account. Thus:

When the going gets tough, the tough get going

All of which naturally caused me to focus on the "small end of town" - those businesses that could be run by individuals - and what I discovered there came as a pleasant surprise to me. Even as P/E multiples of large listed companies were averaging 25X P/E ratios and more, small businesses were changing hands for EBIT multiples of around 1-4X. That's right. One to four times EBIT

Bingo!?? Well, maybe.

The reason most small business sell for low multiples is that they have high associated risks of failure; and these high risks require a combination of hands-on management and entrepreneurial skill to address. In turn, this implies that one cannot sensibly aspire to "invest" in small businesses, if one aspires to be a passive investor.

So it was at that point that I began to apply my mind to addressing the issue of investment risk minimization in small business.

Bottom Line

After some years of investigation, assessment and hands-on involvement, the conclusion I have arrived at is that one solution will lie in a combination of the following:

  1. Franchising - where the strategic risk of small business is minimized because the business model has been perfected (It is important to avoid Franchise businesses which are in the early stages of their life cycles because their business model will not have been perfected. It is also important to avoid Franchises offering "frivolous" products/services - like "party products" - because these will not survive tough economic times)
  2. Sharing - where the investor does not seek to own the business outright, but partners with a younger, high energy Operator who will need you for your ability to provide capital and a wiser head
  3. High energy input by the Operator to physically "deliver on the promise" of the Franchise by honestly providing the best possible quality product/service, on time and to specification, with a smile and a gracious, friendly attitude. (So that your customers will be happy to buy again and again)
  4. Hands-on administration by the Investor (you). Small businesses do not require much administration, but Operators - who are focused on "physically" running the business - typically neglect the Admin function. A semi retired person can keep a finger on the pulse of the business via the low demand admin function and, at the same time, provide valuable input and guidance.
  5. Hands-on direct local marketing by the Investor. Again, this function is typically neglected, and a semi retired person can add significant value with the objective of customer demand creation.

In summary, try to find yourself an ambitious, high energy, youngster of about 25-30 years of age who will operate the Franchise for a salary, and who will be attracted by the opportunity to purchase 50% of the equity of the business on "soft" terms. In turn, this purchase can be paid for with a combination of some (relatively small) up-front capital (there must always be some "hurt" money on the table) and profit share - which will be funded by his/her 50% of the profits after salary.

You should not seek commercial advice from an attorney. Attorneys know about the law. They typically do not understand the nuances of business. For example, an Attorney will invariably advise you to aspire to own 51% of the voting equity of the business - so that you can remain in control. This advice is pure garbage in a small business. The fact is that Management "controls" the business, and if you are going to leave the business (unsupervised) in the hands of a third party, 51% ownership is not going to help you. Asking for 51% immediately puts the Operator on guard, and this starts the relationship off on the wrong foot. In the end, the terms of the Shareholder Agreement will protect you, but you should not even think in terms of leaving the business totally under the unaccountable Management control of a third party.

When structuring your deal with your future business partner, seek advice from an Accountant - who will assist you in generating a "Memorandum of Understanding" or a "Term Sheet" or an "Agreement to Agree". These are three descriptions of the same thing - a 3-4 page document which documents the commercial intention of the parties.

At that point you can go to an Attorney to draft a Shareholders Agreement.

You will then be set to seek out a suitable business Franchise with your aspirant business partner, and it may be of some comfort that Franchising is the fastest growing industry in the world today. The statistics are absolutely staggering, and they offer genuine hope both on an economic level and on an individual level.

The following is a rough example of the kind of income you might expect from a business that will cost you around $250,000. (The example is conceptual and should not be taken as representational. But it will serve to illustrate the principles. My preliminary investigations show that similar Earnings multiples prevail in more than one country)

If the Operator earns a salary of (say) $30,000 p.a. you will have $77,000 left over to split between you. (The Operator's share can be diverted to you until such time as his/her shares have been paid for) If you want to be generous and pay him/her $45,000 p.a. by way of salary, there will still be sufficient to represent more than 20% p.a. pre tax return on investment.

Each Franchise will have its own Financial Model, but most Franchises will be seeking to yield an EBITDA (before the Operator's salary) of around 40% of the initial purchase price.

Caveat

Of course, the word "seeking" needs to be emphasized here. There are no guarantees. Whether or not the objectives are realized will be a function of the strategic relevance of the Franchise itself, and of the quality of "input" of the Operator of the business, and of your own Admin and Marketing input, and your guidance (common sense).

You might even make use of the services of a Head Hunter or Recruitment Agency to find the Operator in the first place. Once you have found such an Operator, the guiding light should be to find a Franchise that satisfies a genuine need (for example "healthy" fast food, or a "signage" company that offers quick turnaround time, or an instant print business) and then move to deliver that satisfaction - in the best way possible.

Ultimately, the reason we will survive beyond October 2011 is that we are all genetically programmed for survival. To murder a metaphor: "Hope springs eternal in the human tit"


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