The average yearly return potential for business is at least 30% over long periods of time.
Investing in business affords some of the best returns of any form of investment. You can leverage your money using a loan to purchase. You see returns from increasing cash flow over time and in turn increasing the company value over time.
I’ve written article measuring the return potential on other forms of investment:
- Return potential for bonds
- Return potential for real estate
- Return potential for mutual funds and index funds
- Return potential for precious metals
- Return potential for collectibles
Let’s see how business stacks up.
Starting A Business vs. Purchasing
There are two ways to invest in business. You can start your own business, or you can purchase an existing business.
You return potential for starting a business is nearly infinite. Take for example a website. You can start a website or blog for under $100, but it can turn into a business that makes $100,000 or more per year. A website like this can also be valued at over $300,000. And that can happen in a matter of a few years.
If you calculate the return on investment for a scenario like this you’re looking at returns of well over 100%.
This article, however, will be looking at the returns possible from purchasing a business. The returns from purchasing a successful business are much more repeatable and reliable.
Starting a business CAN make you crazy returns, but the odds of success are generally quite low.
Returns from purchasing businesses are easier to predict, though the potential returns are also much lower.
The Types Of Return For Business Purchase
Much like real estate, business ownership can create return on investment for you in many ways.
The cash flow of the business puts money in your pocket each and every month. That money can be reinvested and bring in even more returns.
If you can increase your cash flow over time, then the value of the company will increase as well.
Unless you bought the company outright, you will have debt payments. And while the debt payments negatively impact your company’s cash flow, a portion of your payment will go towards extra equity in your business, which is a type of return.
Also, businesses give owners plenty of tax advantages that investors in stocks and bonds don’t get.
So let’s break it all down.
Increase In Company Value (20% Return)
First of all we need to decide how to value a business, but valuing a business is not straightforward. Everyone has their own criteria and their own methodology, so instead of getting too complicated, we’re going to use my personal methodology for valuing business.
I base my valuation entirely on cash flow. I expect the money I put into the business to be back in my bank account in five years or less. I can multiply the company’s current yearly cash flow by 5 for a starting point.
Before we dive into some numbers, let’s create a hypothetical company to use as a baseline for our calculations.
Disclaimer: There are so many factors involved in valuing a company that it’s impossible to break it down to a simple calculation. Older companies are generally viewed as more valuable than younger companies. Brick and Mortar companies are generally more valuable than web based companies. Some companies have tangible assets and some don’t. This is merely an example. A thought experiment to attempt to calculate return potential on the purchase of a hypothetical business.
Our example company (Company Alpha)
In order to calculate a potential return for business, we’re going to use an example with easy numbers that is based in the real world.
Since I believe web businesses offer the highest return potential I’ll use a hypothetical website. We’ll call it Company Alpha.
Company Alpha has average expenses of $500 per month, and an average revenue of $10,500 per month. This means the cash flow is $10,000 per month.
So here are the number’s we’ll use:
- Monthly revenue of $10,500
- Monthly expenses of $500
- Monthly cash flow of $10,000
- Yearly pretax income of $120,000
- Company valued at $600,000 ($120,000 x 5)
Return potential on company value
The increase in company value is a fun one to calculate, because this is the one that includes the power of leverage.
Loan terms for business purchase vary widely. Your down payment can be as low as 10%, but it is more common to see down payments between 20-25%.
Let’s assume we are able to obtain a loan to purchase Company Alpha with a 25% down payment and 5% interest over 10 years.
We’re buying at the current value ($600,000) so our down payment will be $150,000.
So how much can we expect the Company Alpha’s value to grow over time? This is impossible to answer, so we’ll just make some more assumptions. I’m going to assume that the company growth just slightly outperforms the rate of inflation. Let’s assume the company value grows at an average rate of 5% per year.
Now we get to see the power of leverage in action. Our down payment was only 25% ($150,000), but the 5% growth of the company is applied to the full company value ($600,000).
The company value increases to $630,000 the year after we buy it. Our initial investment was $150,000, but our net work increases the full $30,000.
That’s a 20% return on investment! And that would be a 20% return on investment for as long as we own Company Alpha!
Cash Flow (14% Return)
In my opinion, cash flow ends up being the only business metric that matters in many ways. I value the company based on cash flow, the cash flow generally determines the health of a company, and the cash flow is what puts money in your pocket to support your life.
Perhaps some of these billion dollar companies like Uber (who loses billions of dollars every year) know how to become wealthy while losing money. I don’t.
I expect my businesses to have positive cash flow. I expect them to bring in more money than they spend over time. If they don’t, then how will they make me wealthier? It may be possible, but it’s certainly not easy to see how.
Return on cash flow
When we buy Company Alpha it has a yearly cash flow of $120,000. This is going to change a bit when we buy the company, because we took out a loan in order to buy.
This adds an expense to the company’s balance sheet. The debt payment. Based on the terms we referenced earlier, we have a $450,000 loan at 5% for 10 years. That’s a $4,800 monthly payment.
This increases our monthly expenses to $5,300, which in turn decreases our monthly cash flow to $5,200 per month. That makes the new yearly income $62,400.
So the first year of operation gives us a 42% return on our investment ($62,400 / $150,000) from cash flow. But we can’t expect that 42% return to continue every year.
How much will our revenue increase each year? I’m going to reuse my 5% assumption from before.
Cash flow return over a long time is difficult to calculate. We’ll have our debt payments drop out after 10 years and our cash flow will increase over time. The total cash made over let’s say 30 years can be estimated like this.
($120,000 x 1.05^30) x 0.5 x 30 = $7.8 million (estimated total revenue )
($5300 x 120) + ($500 x 240) = $756,000 (estimated total expenses)
If we subtract the total revenue from the total expenses we say that we’re expecting to make about $7 million in cash over 30 years.
This comes out to about a 14% return on investment over 30 years.
($7,000,000 / $150,000) ^ (1 / 30) = 1.136 (About a 14% return over 30 years)
Equity on Debt Payments (4% Return)
There is a portion of your debt payments that go directly to additional ownership of Company Alpha. These returns are smaller, but not negligible.
For our purchase of Company Alpha, after you finish the terms of the loan, you’ve gained $450,000 of equity in the company.
Over 30 years this would be a 3.7% return.
($450,000 / $150,000) ^ (1 / 30) = 1.037 (about a 4% return on investment)
It’s always important to consider taxes when looking at the potential return for investments.
When it comes to businesses, different types of returns are taxed in different ways. And again taxes can be different depending on ownership structure and other things. So we’ll just be looking at one possible taxation scenario.
Company value tax
The return you get from the value of the company increasing would only be taxed if/when you decide to sell the company.
And when that happens you would be taxed on the increase in value of the company. So if you bought Company Alpha for $600,000 and then eventually sold it for $2.6 million, you would only be taxed for the $2 million increase in value.
And that amount would be taxed under long term capital gains rules (assuming you’ve owned the company for more than one year). These rules can be drastically different depending on what country you are being taxed in.
In the U.S. this tax rate maxes out at 20%.
Cash flow tax
This is another category where taxation can be very dependent on the setup and behavior of the company.
We would of course want to avoid double taxation to maximize our return potential. To keep our example simple, we’ll assume Company Alpha is held by a single owner LLC.
This would make the take rate on our cash flow the same as regular income. And regular income tax maxes out at 37%. Based on our expected cash flow of $62,400 for the first year, our tax rate would be more like 22%.
We’ll base our tax rate here on the 2020 U.S. personal income tax.
This puts our expected tax rate at 22%.
Tax on debt
Our debt payments would actually give us a tax credit for all interest paid. To keep this example as simple as possible we’ll just say the tax rate for our return on debt payments is 0%.
Our Returns Visualized
Let’s put it all together and get a very rough, but also very possible picture of our potential 30 year returns on the purchase of Company Alpha.
|Category||Pretax Return||Estimated Tax Rate||Return After Tax|
When it’s all said and done we have at least a 30% return on our investment after 30 years.
These numbers are purely hypothetical and do not represent an expected return for the purchase of a business. They are also oversimplified in many of these examples. These numbers are meant to be a rough yet reasonable estimate of the returns that are possible with the purchase of a business.
The numbers in this article should be used to educate rather than make decisions.
There’s no doubt that business investment offers the opportunity to make exceptional returns on your investment, but doing so requires expertise and great decision making.
While the example in this article is very simplified, I think I’ve been able to show that the potential return on the purchase of a business is up there with real estate as the best of the best.
In fact I believe that the 31% number that we arrived at is quite conservative. I believe significantly better returns are possible with debt allowing a lower down payment, better growth on the company’s income over the years, and reinvestment of the money made through cash flow.
Regardless, I’ve shown that businesses have the potential to be a very lucrative investment.