In today’s email:

• The allure of passive income through small business ownership

• Got questions? Q&A is on the way

👇🏻Watch: I interviewed Caleb Basile from QoE Prep to discuss the dangers of skipping a quality of earnings review during due diligence. Check it out here ⤵️

The Allure of Passive Income…

Every influencer alive talks about the importance of building passive income. But what is it really?

My definition of passive income is a payment or benefit I receive from owning something that require little-to-no direct engagement on my part. Set it and forget it.

Here are some things I would consider “passive”:

• dividends from stocks or bonds

• royalties from intellectual property licensing

• annuities from the sale of long-held assets or funds

• interest received from loans provided

These I WOULD NOT consider passive:

• Small business ownership, even when 100% absentee

• Real estate, unless exclusively as a limited partner in a capital fund

• Rental properties

Obviously, the list for each of these categories could be much longer, but I hope you get the picture.

So, let’s focus on small business ownership. Here are the primary reasons why it’s not passive.

1. When you acquire a business, you own the debt

2. Even with management in place, your involvement is still required

You bought the business- now you own the debt!

Regardless of whether you secured 100% seller financing or built a traditional transaction using SBA 7a debt, you own the debt.

Therefore, you are required to repay that debt regardless of the financial performance of the business. This creates a compelling incentive for you to ensure that the business does not fail => especially if you signed a personal guarantee!

Some first-time buyers think that they can simply “hire a manager” to run the day-to-day operations of the business. Maybe you can. Maybe you can’t. That depends entirely on the cash flow of the business which is now seriously impaired by the acquisition debt you placed on it when you bought it.

Consider this simple illustration:

Let’s assume you bought a business earning $5M in revenue with 20% EBITA ($1M/year). You acquire the business using 80% SBA 7a debt, 15% seller’s note in line with the SBA debt, and 5% equity (down payment).

If everything else stays the same (which of course it won’t), your cash flow of $1M/year is reduced to $227,000/yr because of the $773,000 of annual debt service you placed on the business. That’s a debt service coverage ratio (DSCR) of 1.29 which is common in SBA funded deals.

That’s insane!!

Do you see how cash flow is severely restricted even when buying the largest business that the SBA will lend against?

And now you’re going to add additional overhead by hiring a manager?

It’s fine, I’ll hire a manager…

Now, some first-time buyers think “well, I can offer the manager equity to better align incentives”.

Sorry, wrong again (but I do have a consolation prize for you in the back)!

Here’s why- equity is the opportunity to participate in the potential upside of the business. But it has nothing to do with the downside.

Meaning, while you have $4,750,000 of personally guaranteed debt hanging around your neck if the business fails, your manager has a slight potential for upside if the business succeeds. Those are not aligned incentives.

Debt ⍯ Equity

When things get tough, the prospect of future earnings fades fast, and the value of equity is heavily discounted. Your manager will be concerned with maintaining their salary and providing for their family- not sacrificing everything they have for the good of the business life you will.

Then, on a practical note, what happens when your manager:

• takes a vacation?

• gets sick?

• finds a better job?

• sees that you’re an absentee owner and demands higher compensation?

• gets hit by a bus? ☠️

Morbid I know, but who’s running the business? The answer is you, friend!

Now, take everything we’ve discussed up until this point and slash the cash flow by 50%, 75%, 90%. The vast majority of small business deals are not $5M with 20% EBITA margins.

As the numbers drop, EVERYTHING GETS AMPLIFIED!

If I sound passionate about this, it’s because I am. I’ve lived it. I’ve seen several buyers make this mistake and I don’t want you to be one of them.

If you go this route, you are buying a job. And that’s ok! You’re buying a job that you control and can build into something bigger. Something you own. Something that’s yours.

But what if I still want passive exposure to the upside of small business ownership without the “ownership” part?

This is where investing comes in. You can:

1. Invest directly with business buyers by providing equity capital

2. Invest in a fund where you get a piece of the operator’s returns.

If the idea of investing in small businesses without direct ownership or operational responsibility is appealing to you, I encourage you to look into this.

At Sunset Coast Capital, I operate an independent sponsor firm that invests directly into lower middle market acquisitions and, in two weeks, I’m launching our newest 506c fund for accredited investors. If you’re interested, you can apply here. If admitted you’ll have access to our entire deal flow and the option to invest (or not invest) on a deal-by-deal basis. Now that’s passive.

🙋🏻‍♂️ Got Questions?

Lately I’ve been getting a lot more questions through emails and LinkedIn than I can handle. So, for at least the next 30 days, I’m going to do 30 minutes of Q&A on YouTube. If you have a question you would like answered, leave a comment on the latest YouTube video and I’ll answer it the following day.

Yes, this is a YouTube engagement hack. And yes, hopefully it will help me become more consistent on YouTube while providing more value to everyone here.

Here’s the link to my channel: Jed’s YouTube

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-Jed