Why You Should Bootstrap a Small Business (even w/ a 9-5)

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Estimated read time: 5 minutes 18 seconds

1. Why Companies Like Tesla Suck During a Recession

2. Why You Should Bootstrap a Small Business (even w/ a 9-5)

Good morning and happy Monday - let's get smarter

Why Companies Like Tesla Suck During a Recession

When there are poor economic times, a big investing fallacy is to move money into large caps. Names like Apple and Tesla

The thought is big tech companies are “safe”

Something similar happened in 1969 with a group of stocks called "The Nifty Fifty"

An except from legendary investor Howard Marks on the The Nifty Fifty and the pending doom that followed:

"The Nifty Fifty comprised the stocks of companies that were considered the best and fastest-growing – so good that nothing bad could ever happen to them. For these stocks, everyone was sure there was “no price too high.” But if you bought the Nifty Fifty when I started at the bank and held them until 1974, you were sitting on losses of more than 90% . . . from owning pieces of the best companies in America. Perceived quality, it turned out, wasn’t synonymous with safety or with successful investment."

The issue is that most equities/stocks perform poorly during slowing GDP growth/recessions and your capital allocation needs to be even more strict to specific sectors and factors

You don't want to be like this guy

Why? If a stock or your portfolio is down 70%, you need to return 233% just to get back to BREAKEVEN

If you have readily available 233% investment returns to recoup your 70% loss, there is a pretty good chance you are friends with this guy

Companies have specific "style factors" or attributes about them that impact how they perform during various macro environments

A style factor could be that it is: profitless, high debt, low debt, low beta, high beta -> these would style factors that are financial attributes about a company

Different attributes are more attractive and less attractive depending on where we are in the economic cycle

During economic acceleration when GDP is growing, being high beta like Tesla can be great, versus when GDP is slowing, it can be pure pain (explain why below)

High Beta (Tesla)

What is beta? Beta is a measure of stock’s volatility compared to the market

What is high beta? A beta of 1.0 means the stock is equally as volatile as the market, like the S&P 500. Tesla has a beta of 1.91

Why it underperforms

Increasing volatility means the standard deviation of outcomes is increasing

Standard deviation is a measure of the dispersion or spread of a set of data. If the standard deviation of outcomes is increasing, it means that the data points are becoming more spread out or diverse. This could indicate that there is a greater range of possible outcomes or that the data is becoming less predictable

For example, if a company's sales have a standard deviation of $50,000, this means that the actual sales figures are likely to be within $50,000 of the mean or average sales figure. If the standard deviation increases to $100,000, it means that the sales figures are becoming more diverse and may be farther away from the mean.

An increasing standard deviation can indicate greater uncertainty or risk. It's important for businesses and investors to consider the standard deviation of outcomes when making decisions, as it can help them understand the potential range of outcomes and the level of risk involved

More volatility = more bad things can happen = worse investment returns

Another style factor or attribute is high leverage

High leverage also typically = bad during a recession

High leverage

What is high leverage? Companies are capitalized be some combination of debt and investor equity. High leverage are companies with higher debt as a percentage of their capital

Example: Balance sheet has $200 of debt and $400 of equity. So their debt to equity ratio would be $200/$400 or 0.50.

What is considered high? High leverage is relative, meaning it it depends on other companies in your industry

Why is high leverage bad during a recession? 

1. Companies with high leverage have big debt payments and interest payments that can eat up a lot of their cash. If their revenue and sales are declining but their debt and interest payments are the same, instead of investing excess cash flow back into the business to: hire more employees, build a new product or facility, they have to use that cash to pay principal and interest payments on their debt

2. Risk of default: Debt holders get paid first and equity holders make whatever is left over in a business. If a company goes bankrupt, the debt holders would have claims on the business and the equity holders would likely get nothing. So, this means investing in or lending to the business is more risky. If it’s more risky, new lenders would require higher return in order to take on that risk. If I am a lender and I am worried about getting paid back, I might require 15% interest instead of 10%. This is even harder on the business but might be necessary

So while the common narrative pumped on CNBC might be to own large cap names because they are safe, you will understand that this is a broad and not mathematically or factually backed statement and that during a recession, certain style factors no matter how large the name will get you #pummeled

Be mindful of high beta (high volatility) and high leverage (high debt) names when ___ hits the fan

Why You Should Bootstrap a Small Business

Bootstrapping -> A founder funding a business on his/her own without any outside capital

One of the more common trends I saw across Twitter in 2022 and into 2023 is people with 9-5 jobs starting side projects

The reason?

Even a small project ($2-3k a month in revenue) service biz of software biz can be sold on a website like Microacquire or Flippa

If you are not familiar with Microacquire or Flippa (there are plenty of others), they are M&A marketplaces you can go to buy or sell your business

A typical M&A process if you're a seller can take months and months between finding a buyer, agreeing on a price, agreeing on a structure, etc

Also, lots of legal fees and broker fees can be incurred by both the buyer and seller

These sites make M&A for smaller projects and businesses fast and simple

Example

If you build a side business that gets 100 customers paying $10 a month you have a $1k a month business or $12k in revenue yearly

For simplicity, let's assume that you have minimal expenses so your profit is $10k a year

If you sell decide you don't want to run the business and want to sell it, you will either sell on a multiple of revenue or profit

Yearly revenue: $12k

Yearly profit: $10k

Average multiple let's say is 3-4x

The reason a business trades on a multiple is because the buyer is getting this business and these cash flows forever, so the multiple is intended to price in the value of the business over time

So that 100 customer business making $12k a year might sell for $36-$48k

Now think if you are able to get 1,000 customers or charge $100 a month?

You can sell the business for $480k, throw that money into real estate or another business and now have an asset that generates recurring passive cash flow

Let’s say that $480k generates 8% per year via real estate, stocks, bonds, a business, etc

Now you are generating an extra $38.4k a year passively

So think about if you can sell for $1m or $5m and generate $80k or $400k passively

More and more people are starting small side businesses that solve a problem they have or a problem they know well

Growing it to a certain point and selling it

These can be life-changing liquidity events that may take very minimal upfront cash

Benefits of bootstrapping versus taking outside capital?

The founder owns all the equity aka there is no dilution

If you raise capital from friends, family, or investors, you might give away 10-30% of the company

Now in order to get to that same passive cash flow number, you have to drastically increase the size of the sale

The other benefit is you can grow at your own pace

If a venture capital firm gets involved, their responsibility is to take investors money, grow it, and then return it to them as fast as possible

As a founder, this can mean they can can be very vocal about hiring, decision making, etc

An example is Bill Gurley, who is considered by many to be the Michael Jordan of venture capital was instrumental in pushing the Uber co-founder and former CEO Travis Kalanick out

Bill was an early investor in Uber and had a seat on Uber's board, and when certain scandals arose at Uber, Bill apparently started a board coup to push Travis out

Whether this was right or wrong is irrelevant to me, but it pushes home the point that when you have other people's money, you also have their opinions because they want their money to make money

If there's one thing I have learned in 28 years, it's no matter how rich someone is, they don't like to lose and they really don't like to lose money

The more equity of your company you can keep the less pressure, the less outside noise, and the bigger impact a sale will have on your life

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.