Making money out of other peoples’ money

I am interested in both business finance and personal finance.  Start with business finance.

Most successful entrepreneurs have at least a couple of things in common:

1.    They don’t get so attached to a business that they cannot bring themselves to sell it.  If a business is the owner’s passion that is good; they will put their heart and soul into making it work. They should, nevertheless, still be looking for the best time to sell it on, to realize the added value they have achieved in growing the profitability of the business.  That’s what an entrepreneur does

2.    At some point in their careers entrepreneurs make big use of other peoples’ money to make money for themselves – this is called leverage
Here’s how it works:
Suppose a company has profits of £1 million.  The owners are willing to sell it for ten times this or £10 million.  An entrepreneur buys the business using their own money of £1 million and borrowings of £9 million.  Suppose further that the business grows and within two years is running with profits of £2 million.  On the same valuation, the business is now worth £20 million which, if realised, would pay back the debt and leave the entrepreneur with £11 million as return on the original stake of only £1 million – a rich return.
But remember this is all about risk; it works in reverse as well.  If the business struggles and profits drop to £500,000, then the value of the business has gone down to £5 million and it still has debts of £9 million.  In that case the original buyer would have lost their entire £1 million capital and have to find some way of paying off the debt or getting the company to trade it’s way out of the problem.


Another implication of debt is paying interest.  At present, with bank base rate at 0.5%, there is only one way that it can move – upwards.  Take that into account when you are borrowing money to put into or buy businesses.  Make sure that your calculations cover for the fact that you may have to pay more for loans, particularly overdraft loans with variable rates.  Suppose you are offered a loan at 3% above base rate to fund a deal.  Just ask your self if the deal would still make sense if base rates went up to say 4% over the next couple of years, making your loan interest 7%.  Always look for the advantages of leverage but take the interest bill into account.

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Personal finance tip from Shaf – Buying your own house
Do the same rules of leverage cover a property you are buying using a mortgage?  Well yes they do; but remember that the main purpose of buying your own home is to have somewhere to live.  Right now, for example, banks are offering mortgages with the option of have the interest rate fixed for a period of time or taking their variable rate.  At the moment they are offering around 4.7% fixed for five years or their current variable rate of 4.24%.  This makes the variable rate a significant bit cheaper; but rates are going up.  Using the laws of leverage, the lowest risk option is to go for the fixed rate for five years option.  For most people this probably makes sense – don’t make a big leveraged play on your own house – it’s primarily a home not an investment.

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Finance leverage increases both the risks and the potential returns.