How To Build Wealth From Scratch

An acquaintance of mine serviced vending machines near campus as a part-time job in college. At some point, he purchased and acquired actual ownership of seven of the vending machines that he previously serviced. I admired his energetic and scrappy approach to getting his hands on a cash-generating asset.

Entering 2018, the average vending machine earned a monthly net profit of $111. With seven machines, the typical profit would be somewhere near $777 per month. If he is wise, he would have incorporated his ownership via a single member limited liability company, and then regularly extract the profits into some type of tax-protective vehicle so that the money could compound tax-free (and if he reached a point where he could stomach the up-front expense of a few thousand dollars in legal fees, he could actually use cash in a vehicle like a Roth IRA to purchase the vending machines themselves so that all of the profits from the vending machines would be forever tax protected and all the profits that flow from them could be used to purchase more conventional assets such as publicly traded stocks if he wished).

Under the latter scenario, the $777 per month cash engine, if regularly invested into a basket of stocks that yielded 10% over an investing lifetime, would grow into $4.9 million over a forty-year period. Assuming that he used a regular taxable account and earned 8.5% net returns, the end figure would be $3.1 million.

I mention this anecdote to highlight the point behind Warren Buffett’s oft-repeated phrase, “If you don’t find a way to make money while you sleep, you will work until the day that you die.” Anyone who builds wealth from scratch must find a way to translate their labor into a cash-generating asset. I’ll repeat it again, because it is the essence of everything that involves wealth-building: You must provide labor, save something as surplus, and take that surplus and then purchase or create a cash-generating asset with it.

Cash-generating assets can be found all around. They are found in the bond markets when you issue debt to a company or country. In periods like the 1970s and early 1980s, the rates grew high that bond investments gave better returns than many stocks! They are found in the securities markets, where you can purchase ownership shares in businesses where other people go to work to grow the business, and you can reap a portion of the increases in value and cash payouts to the shareholder base. You can find it in the real estate market, where you can receive monthly rents in exchange for relinquishing your occupancy rights. You can find it in the realm of intellectual property, where others pay for access to your ideas and specialized application of concepts. The gradual accumulation of cash-generating assets is how you build wealth.

The real secret sauce, if you desire to reap the benefits of building wealth from scratch before you turn 50, is to launch your own business. The “secret sauce” is capitalized earnings. When you make $1,000 working at a job, that’s it. There is no other financial numeration, absent a pension plan or some type of long-term benefit. But when a profit is generated through a business, you get to tap into capitalized earnings. Those 7 vending machines $9,324 can be sold at a capitalization rate of 5, meaning that if you decide to stop owning the vending machines and sell it, you will get a lump sum payout of $46,620. Business ownership comes with the lump sum possibility of a sale at the end of the journey; labor does not. If you seek to build wealth from scratch, you should ask yourself: How can I use the surplus from my labor to acquire particular assets that generate cash all by their own? Taking steps to answer that question is how you get rich.