Last week, after reading the newest book in the “Millionaire Next Door” series, I critiqued the critics. More specifically, I pointed out how the charge that Stanley’s work reflects survivorship bias doesn’t really hold up. Longitudinal surveys support Stanley’s conclusions.
Note: That earlier blog post appears here: Defending “Millionaire Next Door” Theory: What Stanley’s Critics Got Wrong.
That defense, though, seemed a little theoretical. It discussed some economists’ research papers. And it spotlighted some government statistics. Which is all fine and good. But the defense didn’t provide much of a road map for people who want to follow the “Millionaire Next Door” path.
Accordingly, in this blog post, as a “proof of concept” of Stanley’s and his co-authors’ work, I want to provide that road map and describe a rough business plan.
Identifying the Destination
Let’s start, though, by identifying the end point. What Stanley and his co-authors talked about were people with between $1,000,000 and $2,000,000 in net worth.
So based on IRS wealth statistics–Stanley thought those were the best wealth statistics available–this means on average the following:
|House in a middle class neighborhood:||$200,000|
|Cash (rainy-day and opportunity fund):||$150,000|
|Maximized IRA contributions over 35 years:||$600,000|
|Equity in a small business, direct real estate, etc:||$600,000|
Some important qualifications to make: First, obviously, people living in high cost of living areas pay more for housing.
Second, one would want to carry no personal debt other than a mortgage during your working years.
Note: Borrowing money to buy income producing assets like a business or rental real estate should be okay. Using a 5% loan, say, to invest in some venture that generates a 15% return makes you money–though at the cost of forcing you to bear more risk.
Third, equity in a small business might include an interest in a professional partnership (like a law or accounting or engineering firm), a farm, or stock in a closely-held corporation such as a founder might hold.
Anyway that’s the “destination” so to speak. And now let’s look at how someone applying “Millionaire Next Door” thinking moves from point “A” to point “B”.
First Stop: Prepare for and Pull Trigger on Self-employment
The first stop? Probably preparing for self-employment by accumulating the necessary capital and skills–and then making the leap.
Note: Slightly more a quarter of small business owners start their firms with no capital, but for firms that require owner investment, the average equity investment runs about $50,000.
Self-employment makes sense for a simple reason. Self-employed people on average earn a chunk more money. Maybe nearly 40% more according to the studies referenced in last week’s blog post. Further, the same studies say that self-employed people on average more steadily accumulate wealth.
As hinted at in earlier discussion, you can prepare yourself for self-employment in a variety of ways. Many professions offer people the chance to become partners: medical clinics, law firms, accounting firms, engineering firms, and so forth. Any of these options may work.
If you work in an environment or come from a family where you’re in contact with the self-employed or bumping into small business owners, that helps too. Keep in mind that every small business owner will at some point either want to sell the business to some new owner or transition the ownership and management to a family member. (You need to be really careful with buying an existing small business, though. See the post Buying a Small Business: Tips and Tactics for more details.)
Note: See also Five Questions Your Business Plan Must Answer for a format you can use to think concretely about a specific opportunity.
Second Stop: Run a Lean Household Budget Relative to Your Income
Stanley and his co-authors pointed out the critical importance of you and I running our lives and families in a manner allows us to save and invest lots.
This obviously means we need to not only earn a good income–self-employment on average helps with this as noted–but we need to save a big chunk of the extra income we earn.
Adjusting for inflation, for example, one of the longitudinal studies described last week suggested that in 2017 dollars, a typical “wage and salary” employee might earn about $53,000 on average while a typical “self-employed” person or entrepreneur might earn about $73,000.
To become the “Millionaire Next Door,” someone averaging $73,000 a year needs to save about $10,000 of their income. Or roughly 15%.
Saving $10,000 a year should grow to slightly more than $1,000,000 of wealth after 35 years if a person earns average rates of return. Note that I’m adjusting for inflation here. I mean $1,000,000 in current day dollars. Not “year 2050” or “year 2060” dollars.
Third Stop: Invest in and Grow Your Business
Your first investments should focus on getting your small business up and running and profitable.
For professionals joining established firms as partners and family members looking to “take over” the family farm or family firm, this investment may be mostly the blood, sweat and tears of building up the technical and industry skills and then the professional and business network that allow you to move from employee to co-owner.
Interested in franchising? This investment and growth process may be accumulating the capital to start a business (through whatever means necessary including side hustles and second jobs) and then later diverting profits to pay down loans from sellers and lenders including Small Business Administration loans.
People who bootstrap and start an entirely new, “from-scratch” business may make their investment through a grind of “Thomas Edison” like discipline. He or she may need to try one product or service after another until something gets traction.
Two things, I think, to remember in all this. First, millions of other small business owners have found something that works. You can too.
Second, as noted earlier, you will probably need to invest money into whatever you do to start. Then as the business grows, you’ll need to invest additional sums. (The Kauffman Firm Survey, a longitudinal survey of roughly 5,000 businesses started in 2004 highlights this reality.)
In a self-employed person’s first years , therefore, their savings go into their business. If the average self-employed person earns roughly an extra $20,000 a year, for example, maybe he or she needs to reinvest most of that money back into the business.
Side Trip: Build an Opportunity Fund?
And let me mention one other thing too. The IRS wealth statistics shared earlier suggest that the millionaires carry large cash balances.
Maybe these people see that money partly as a rainy-day fund. But if someone works in their own business, cash sometimes allows the entrepreneur to make investments that produce astronomically high returns: 20%, 40%, 60% or higher. (See this blog post’s discussion: Small Business Investment Returns Astronomical.)
These opportunities take a variety of forms: A slick tax planning maneuver you can use to save tons in taxes but which requires extra cash. A bargain basement price on some key resource–available only because you can pay in cash. The chance to buy a competitor’s business at a great price because you don’t need to first arrange for a bank loan.
In addition to the money expressly invested in a small business, therefore, you may want to accumulate additional cash balances to exploit these sorts of opportunities once you are established.
Fourth Stop: An Affordable Home
Home ownership seems to produce pretty good returns. (See our blog post Lessons from the Rate of Return on Everything, which summarizes research the Federal Reserve supported concerning the returns to home ownership.)
You and I need to be really careful here. Too much house relative to our family’s income will put pressure on the business’s and the family’s finances.
We don’t for example want to live in a neighborhood of big spenders who push us to consume more.
Rather, we want to live in a neighborhood where the financial ambiance of the community lets us exercise relative frugality, save and invest.
But once your business gets established, home ownership probably helps you build wealth.
Fifth Stop: Maximize Your IRA Account
A fifth stop? As soon as you can, and ideally when you still have 20 or 25 years of of work left, maximize your IRA account. So this means you contribute $5,000 or $6,000 a year if you’re single. Double that annual amount if you’re married.
You don’t want to bank entirely on your small business. Yes, it should produce returns well in excess of what the traditional investments available in a tax-deferred retirement account produce. But these higher returns come with way higher risks.
Furthermore, on its own a small business probably won’t produce the wealth necessary to become the “millionaire next door.”
Someone with a mature successful small business might own a firm generating $100,000 a year in profits. That firm will probably be worth between $200,000 and $500,000 in a sale to some new owner. Which is great!
But obviously the small business owner needs additional wealth, over and above the equity in a small business, to achieve “millionaire next door” status.
Tip: Some small business owners can operate as an S corporation and use the S corporation’s tax savings to fund much or all of their pension plan. This blog post explains in more detail how: The Million Dollar S Corporation Mistake.
Four Final Comments about Millionaire Next Door Business Plan
First, this plan doesn’t work for everybody. You and your family need to be okay with the plan. And with its risk. Note that like everything else in life, you get no guarantees here. But as noted earlier, lots of people have taken this path.
Note: This blog post compares small business ownership to a couple of other popular wealth building strategies: Small Business Entrepreneurship Better than Bogleheads or Mr. Money Mustache?
Second, this really important point that connects back to Stanley’s research and writing: Becoming a millionaire requires more than just a good income. Someone needs to show financial discipline and common sense.
A third comment: Keep in mind the average numbers may not make sense for your situation and the community where you live and operate a business. The averages may be way too high or way too low.
Fourth, a final comment for parents and grandparents. For a few generations now, many of us have thought about saving substantial sums for a child’s or grandchild’s potential college expenses. Which makes sense. But maybe we also ought to consider saving for a child’s or grandchild’s potential startup capital. Just a thought.
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