As one of the founders of Microsoft, Bill Gates was able to build his net worth from $0 to $100 million while he was in his 20s and 30s. That is part of his brilliance that is difficult to replicate. But since then, his net worth has grown from $100 million to $85 billion over the past three decades, almost exclusively through investment in the publicly traded stock market. I want to share with you four of the lessons I learned when studying how Bill Gates grew his fortune, with a particular emphasis on the structures and philosophies he followed later in life.
A. Bill Gates held on to the equity of his central cash-generating asset (Microsoft stock) throughout much of his life, only later exchanging it for other cash-generating assets in an effort to diversify.
When the frenzy of the Snapchat IPO caught everyone’s attention, I was struck by the cavalier willingness of Snapchat’s early founders to give up equity in exchange for picking up the cachet of well-known private equity funds and investment banks that were now becoming associated with them. It was the classic trade of ownership for social capital.
It shocks me that giving up equity often seems like a first stop for start-ups because it is treated as a badge of having made it. If a high-profile bank, fund, or firm owns 5% of you, your esteem increases. But good ideas are hard to come by, and if you own something that attracts the attention of sophisticated investors, you should be very reluctant to give up your ownership stake of something in high growth mode.
If I were hired as an attorney to advise and represent Silicon Valley start-ups, my process would be four-fold: (1) first, if the start-up needed capital, I would try to obtain financing via bonds and debt instruments at 6% or less. I’d much rather maintain ownership of the 15-20% growth and be obligated to pay off 6% rather than give up my claim on that 15-20% in the first instance; (2) if I didn’t like the debt financing, I would look to see whether the business could be tweaked to run at cost so that borrowing would be unnecessary. Depending on the obviousness of the changes, this could be possibly be step one; (3) if giving up equity were necessary, I would solicit dozens of bids to find out who was willing to pay the most for the lowest amount of ownership, and try to negotiate terms that would allow the start-up to repurchase the equity at a fixed future date at a predetermined price to limit the effects of issuing equity; (4) if all of those failed, I would seek to issue equity to those with expertise in the field that could provide defined operational assistance as part of their investment.
In the case of Bill Gates, he was able to sidestep this dilemma entirely by finding a way for Microsoft to run at a profit in the early years and stockpiling cash. The consequence is that he was extremely slow to hire—he often had to deny the encroachments of his peers to expand Microsoft’s hiring because he was convinced that Microsoft’s early profits weren’t yet strong enough to withstand a meaningful increase in payroll.
By having adequate cash reserves, and displaying an immunity to the social cachet of fancy investors, Bill Gates was able to maintain 49% of his equity in Microsoft. If he took on some more early investors, he would not be the Carnegie of our times. If he let his ownership stake in Microsoft dilute to 5% in the early days, his net worth would only be around $2 billion to $8 billion despite doing the exact same amount of work. It is not just the production that matters; but the production plus the structure of the ownership that matters. Never forget that.
Now, in recent years, there has been a tendency for readers of financial articles to only analyze matters literally and not learn from the broader principle at play. I guarantee you that there is someone reading this who is thinking “So what? Who cares? $8 billion is still an utterly insane amount of money, so all of this is inapplicable.”
Not true. You know who could use these Bill Gates “hold onto the equity for dear life” lessons the most of all? The contestants on Shark Tark. These are people who regularly come up with great ideas, convert them into a successful business model, and then can’t wait to give up a large chunk of their equity in exchange for a taste of ownership.
If you have a business generating $1,600,000 in revenue and $420,000 in profit, the difference between 40% equity and 80% equity is extreme. If you’re the operator, the same amount of work can either net you $168,000 or $336,000. That is an example of how ownership structure can affect your quality of life (this doesn’t mean you shouldn’t bring your business up for bid on Shark Tank. The touchstone of the analysis is this: Is the amount of growth gained through the assistance of a “Shark” compared to what you’d have otherwise greater than what you’d end up with by owning a larger slice of the ownership pie? If the answer is yes, then you should go on. But I don’t think many are answering that question soberly, or even posing it to themselves in the first instance.)
Bill Gates understood this. From its IPO in 1986 through 2003, Bill Gates hung onto his Microsoft stock for dear life and compounded at 38% annualized. Every $1,000 invested into the Microsoft IPO grew into $231,000 by 2003. It was all publicly traded and accessible to the public by that point. This is why I am sympathetic to the argument of investing 5-10% of your net worth into small-caps and fast-growing businesses. If a business is profitable, small, executing upon a scalable business model, has a five-year track record of over 15% growth, and a P/E ratio under 50, I understand why you would invest $2,500 to $5,000 in such a business. That is fertile ground displaying the characteristics of life-changing wealth.
By 2003 or so, Bill Gates started to diversify by exchanging his Microsoft stock for meaningful interests in other publicly traded stocks. Bill Gates got his net worth from $0 to $100 million at an early age by being a successful operator of a brilliant idea, but his fortune has grown from $100 to $85 billion (despite giving almost $30 billion away in the meantime) exclusively through the publicly traded markets in the past three decades. Depending on how you count, that’s an 850 to 1150 fold increase in wealth through businesses available in the American stock market.
B. Bill Gates has gradually transferred his net worth from Microsoft stock to his holding company Cascade Investments LLC.
The popular image of Bill Gates as this guy with his net worth wrapped up in Microsoft stock that he gradually sells so that he can cure things like malaria is not a proper summary of how he structures his financial life.
Shortly after Microsoft went public in 1986, Gates merged his holding company Dominion Income Management into Cascade Investment LLC and hired low-profile investor Michael Larson to manage his wildly expansive investment portfolio. For almost twenty-five years, Gates has instructed Larson to sell $100-$200 million worth of the stock each month, pay the taxes on it, and then put about half of it into his investment portfolio at Cascade while the other half or so goes toward the Bill and Melinda Gates charitable foundation.
The assets that Bill Gates has acquired are incredibly lucrative. Through Cascade Investment LLC, Gates owns 6.65% of Arcos Dorados, which is the largest Latin American franchisee of McDonald’s. He bought 18.24% of AutoNation, the largest automobile retailer in the United States. He bought 5% of Berkshire Hathaway, making him the second largest shareholder next to Warren Buffett himself (that’s right, he owns more than Vice Chairman Charlie Munger now). He owns 12% of Canadian National Railway, building up his position when railroads were discarded during the 2004-2005 period and reaping nearly 20% annual returns since then.
He owns 20% of Coca-Cola FEMSA, the Mexican bottler of Coca-Cola products. That’s right. If you want a Mexican Coke, you’re putting money into the pockets of Bill Gates. Ever stayed at a Four Seasons hotel? Gates owns 47.5% of that as well. Driven a John Deere tractor? Gates owns 8.3% of the agriculture giant. Technically, via Liberty Media spinoffs, he has a 4.1% stake in the Atlanta Braves baseball franchise. Ever had your trash taken out by Republic services? Waste Management? Bill Gates is collecting a fee from you there, too, with his 30.99% ownership position. There are also obscure investments in businesses like Minnesota’s utility-cum-conglomerate Otter Tail Corporation.
C. Bill Gates, and nearly every other individual that builds a fortune of permanent value, invests in a repetitive business.
You can thank lawyers for the reason that Bill Gates’ friend Warren Buffett isn’t as candid as he used to be. Back in 1977, Buffett said that he wanted to be the owner of a newspaper in a town with no other major competitors because it would mean that he could more or less set his own advertising rates—every month, the local grocery stores and consumer product vendors would have to pay the newspaper shareholders money if they wanted to get the word out. Even people who wanted to sell cars or notify the public of their family member’s deaths would have to go through the local paper. He analogized it to owning a toll booth where people had to pay you over and over again for the same thing. When Buffett launched a Sunday competitor with the Buffalo Courier-Express for anti-competitive practices, the lawyers for the Courier-Express used this quote against Buffett in their allegations of monopolistic behavior, and then, he has been far more reserved about the business characteristics that get his juices flowing.
In my own research, I noticed that the richest individuals in South American and old European nations tended to be the owners of the largest breweries. Why? Because at a minimum, the typical individual purchases alcohol at least four times per year for major holiday. About 15% of any given population consumes at least twelve beers per week or more. And an estimated 3% of people consume alcohol daily (though they’re included in the previous group). If you can make $2.50 on every $10 someone spends on your product, and people buy your product regularly, you are going to self-propel your way towards a fortune so long as you can maintain the brand through product quality controls and intelligent advertising initiatives.
How is Bill Gates’ Microsoft stock fortune a testament to this insight? Because the business model behind Microsoft Word (and its related applications, such as Excel and Powerpoint) is that the computer programs effectively function as a perpetual royalty on corporate America, business-y individuals, and students. Gonna buy a laptop and write a school paper or prepare a presentation? You’re gonna need Microsoft products. Gonna compile data logs? You’re gonna need Microsoft Excel. Have a group presentation of some sort? Bring on Powerpoint. The result is that a very large chunk of the population pays Microsoft $25-$100 per year, depending on what programs they need and the deal they are able to get (notice that you don’t actually purchase Microsoft Word itself, but rather, a license to use Microsoft Word which has to be renewed at a cost upon expiration.)
Bill Gates doesn’t usually talk about this aspect of how he was able to get rich so quickly and sustainably. Some of it is probably a result of trying to maintain his good-guy image—the world may glamorize the results of wealth, but the details of the process and why your business is good frequently invite condemnation. Secondly, there are pragmatic reasons for why Bill Gates does not discuss his execution of the “toll booth” business model—he personally went through anti-trust lawsuits in Microsoft’s early days and is all too familiar with Buffett’s story at the Buffalo Evening News. “Bragging” about Microsoft’s override on corporate America would be an invitation for public scrutiny that could lead to the imposition of new regulations.
But I do think Bill Gates is more than aware it. Just look at those post-Microsoft investments in his name. Coca-Cola bottling? Same repetitive purchase concept as the breweries. Republic Services and Waste Management? You are collecting a percentage of the monthly trash bill from customers. Even the seemingly esoteric investment like Otter Tail principally relies upon the collection of monthly electric bills from Americans up north. As he has diversified away from Microsoft specifically, Bill Gates has made investments across industries that share the same “repetitive purchase” characteristic that made Microsoft such a burgeoning success in the first instance.
D. If he so desired, Bill Gates could have had a trillion-dollar net worth by 2022.
Every now and then, an article will pop up speculating as to when and whom (Zuckerberg? Musk? The Google founders? A Saudi Arabian oil prince?) will be the world’s first trillionaire. The consensus view seems to be that it will happen sometime in the 2040s. An aside: The word is so foreign my spell check regards it as a typo. Ha!
What most people don’t realize is that, if he made it his primary goal, Bill Gates could have been a trillionaire by 2022 or so if he remained fixated on improving his net worth. At the time Microsoft went public, Bill Gates owned 49% of it. Based on the current market cap of $502 billion, Bill Gates would have $245 billion worth of stock if he didn’t sell any Microsoft.
But wait, there’s more! Microsoft paid out $10.53 in dividends over this time frame. What if that money had been used to repurchase stock at the average price of $27 that the stock traded at between 2003 and 2017? If Microsoft had allocated an additional $94 billion to share repurchases at the average trading price of $27 (which is dramatically lower than the current price of $65), then it would have retired an additional 3.48 billion shares.
Instead of 7.8 billion shares outstanding right now, Microsoft would have 4.320 billion shares outstanding. It earns $23 billion per year in net profits. Instead of earnings per share at $2.75, earnings per share would be at $5.32 right now. At the current P/E ratio of 23, the stock would be at $122 per share. That would increase the net worth by a factor of 1.87, so the $245 billion would be a net worth of $458 billion. Basically, Bill Gates would only need the stock to double once more and then he’d be a trillionaire.
Obviously, this inquiry is an academic in nature because a massive flooding of Microsoft stock purchases on the market (remember, repurchases actually require finding someone out there to buy the stock from so the corporation can destroy the equity) would have brought the price of the stock well above $27 to accommodate the demand. But still, the raw material for extreme wealth that exceeds even our current understanding of Bill Gates’ extreme wealth was there.
What I like about the fact that Bill Gates is not currently a billionaire is that he recognized when to live in the present rather than perpetually worship at the altar of opportunity cost.
On one hand, you have the supermajority of the population that is not overly dedicated to the concept of gratification and fails to internalize that each share you own in a business like Microsoft will entitle you to all the dividends and capitalization of future cash flows from now until the day the business is insolvent. If you don’t relinquish it, you have a claim on the rewards for life.
On the other hand, people who do delay gratification and build substantial wealth run into the Ebenezer Scrooge problem of mindlessly amassing wealth for its own sake without any real purpose in mind. Bill Gates avoided the trap of thinking there is a prize for being the richest corpse in the graveyard—he understood that there is a point at which the wealth should be converted into goods and services, and the foundation that he runs with his wife Melinda is a testament to successfully calibrating knowledge of opportunity cost with the recognition that we can only perform good works in the present.
Originally posted 2017-03-25 13:11:00.