At the age of 50, the average American has a net worth of $132,384. At the age of 50, the average American engineer has a net worth of $973,028. Aside from the partial explanatory difference that can be attributed to engineer’s earnings a higher salary than the typical American, the large reason why engineers do so well is because they take life cycle costs into consideration before making every decision and are darn efficient when it comes to deploying capital.
I had an acquaintance of mine reach out to me for consulting advice on the two-store bakery and cafe chain that he founded and hoped to expand into a million-dollar business. I will share with you the process by which I helped him achieve his goal.
First, we had the clearly articulated goal–make a business worth $1 million. In recent years, round numbers have become unfashionable because of their arbitrariness. What’s so special about a million-dollar business compared to a $900,000 or $1.1 million business? Nothing. The point is to have goals, and if you can grow the business in a way that brings along psychological satisfaction, it would be counterproductive to dismiss a factor that facilitates inspiration and work ethic.
Second, we looked at the capitalization rate for the industry to see how much profit would be necessary to earning $1 million. For the typical bakery and cafe that is owner-operated, the average sale price is 2.5x annual profits. For a bakery and cafe that installs a management team and enjoys a largely passive ownership structure, the valuation range can be 7x earnings.
When goal-setting, it is always important to determine the specific inputs and outputs that will lead to the intended outcome. With the intended outcome a business that could be sold for $1 million at a capitalization rate of 7x earnings, we realized that we needed to establish annual cash flows of $142,857.
After his salary, the pre-existing cafe operations were earning about $45,000 each, or $90,000 total. This focused the scope of our projection: How could we add $52,857 in annual cash flows, which would require an additional $4,404.75 of monthly profit?
Putting the project into those concrete terms makes it much easier to facilitate and claw your way through action than just trying to amorphously pursue the end goal.
We considered playing around with various deals and special offer prices. Our estimates showed that this might only support a few hundred dollars in increased profits, with a small possibility of actually lowering profits so we discarded that idea.
We experimented with the idea of obtaining a liquor license at one of the cafe locations (because alcohol sales are the salvation for many retail food businesses) but held off because of its unrelatedness to the core business, the length of time and resources necessary to get it, plus the fact that a Mexican restaurant had recently tried and failed to obtain a liquor license.
Realizing the improbability of increasing foot traffic as well as the improbability of raising the amount of money profit generated from each customer that visits, we began to consider ways to reach a larger audience that would lead to dramatic movements in revenue generated.
After much thought, we decided to do a trial run of a catering service (sandwiches, sides, desserts, and beverages) for corporate events. By pulling up a google map of the twenty-five mile radius surrounding each of the cafes, we decided to send a letter to 330 nearby businesses of all sizes (where we believed there were at least 10 employees or more) to offer to cater their events.
In the first month of rolling out this service, the total net profits increased by $2,900, with several of the businesses settling up weekly or monthly catered food lunches. These types of bolt-on additions, while seemingly small, can often lead to substantial increases in the net worth of a business due to the capitalized nature of the profit stream. Not only does an additional $2,900 per month translate into an additional $34,800 in profits, but the capitalization multiplier of 7 adds $243,600 to the overall value of the business.
Simultaneously with the catering service, an online ordering app and super local delivery (5 mile radius) was added. To date, these efforts have added $1,750 to the overall profit pie, bringing in an additional $21,000. Applying the same multiplier, this adds an additional $147,000 to the business’ value.
A few tweaks and modest ambitions–catering, delivery, and online ordering—created $390,600 in capitalized value seemingly out of thin air just by looking at the business and asking, “What decisions can we make right now that will give us the greatest strides in moving towards our highest and best use?” Identifying the solutions and then developing them is how you increase the value of a pre-existing business, which can be quite significant once you factor in the effect of capitalized earnings.
By increasing the profit base to $145,800, a capitalization rate of 7 would create the value of the business to $1,020,600.
Capitalized earnings is the reason why small businesses make up such a disproportionately large percentage of America’s wealthy millionaire class. Is someone who opens two bakery chains that earns $147,000 necessarily doing more than someone who becomes an executive manager of sales and distribution at Panera and generates a similar annual income? No.
But in the latter context, the employee collects the income, and that is it. It is a one-time transaction that does not create any further wealth–whatever labor is given, is paid, and that is the end of the story. For the business owner, the “end of the story” part of the narrative is the sale of the business that results in those capitalization of the profit stream for the one-time payoff $1 million or whatever the profit multiplier may be.
For small business owners, those seemingly small bolt-on decisions executed throughout the life on the enterprise can come with a substantial payoff at the end. Earning $500 extra per month may not seem like a big deal, but if businesses in the industry are typically sold for 10x earnings, an extra $60,000 in sale value just got created.
When calculating value creation, whether it be the desire to build a million-dollar business or some other advancement, figure out the multiplier, figure out the annual profits necessary to reach the desired value when combined with the multiplier, and then determine the augmenting that can get you there. The most ordinary businesses in the world–hair salon chains, dry cleaners, the hole-in-the-wall restaurants with three locations, often support seven-figure valuations. That is why 1 out of 25 American households have reached millionaire status.