Is Company Profit Delivering a Risk Premium to You As Owner?

risk premium

Is 2021 the year you’re going to wear your investor hat rather than your owner hat? I hope it will be.  You deserve so much more for all the risk you’re taking.

Profit is the return on the investment risk the company owner(s) takes by being in business in the first place. Running a company is far riskier than investing the same capital in financial markets. Owners should get a higher return than they would in those markets. The risk premium is in addition to the compensation package the owner has.

Let’s say you had $500,000 in cash or cash equivalents. You are evaluating investment opportunities. One option is mutual funds. My research tells me that the average rate of return on mutual funds held for ten or more years is 12%. You could have a bit more or less, depending on the specific fund and the economic environment.

Mutual funds mitigate extreme ups and downs of the individual assets in the fund. The best run funds choose stable investments and are regularly monitored to ensure the funds stability. The 12% return represents the relatively low risk to investors.

Another option for your $500K is a high risk investment, from which you hope to gain an extremely high return in a short period of time. Make no mistake, there is no guaranteed way to double your money with any investment. There are examples of investments that doubled or more in a short period of time. For every one of these, there are hundreds that have failed, so the onus is on the buyer to beware.

It’s easy to be drawn to the high return, like doubling your money. But it is crucial to be clear that the potential high return is due to the high risk nature of the investment. The investor is more likely to lose it all.

One more option for your $500k is to start your own business. Let’s say you’re in professional or business services and you have a brilliant idea that will help a specific market improve their own performance. You decide to put your whole nest egg into the start-up.

What return can you expect?

Even the best ideas are highly risky because so many factors must fall into place to make the company successful.

  • Is there significant demand for your service/product?
  • What will it take to generate a stream of revenue?
  • How will your company grow to keep pace with demand?
  • What about overhead, employment costs, financial costs, and everything else?
  • How can your new idea penetrate the market?

It’s easy to quickly realize that investing your $500k in your company is a high risk endeavor, not the risk-mitigating one of a mutual fund. Since it’s high risk, you would expect a high rate of return.

My work is devoted to helping privately held professional and business services firms make a profit and then increase that profit year over year. Why? Because the owner(s) are entitled to a premium for the high risk they’ve taken by investing in the company rather than in a well-performing mutual fund. At the very least a company should generate a profit of 12% annually, to be equivalent to the return of a mutual fund. But to truly be compensated for the high risk, the profit should be closer to 20%, maybe more.

Is your company’s profit compensating you for the high investment risk?

You have lots of room for improvement if you:

  • Have let the day-to-day operations, decision-making and marketing distract you from an extreme focus on increasing profit.
  • Are thinking of profit as what’s left over after expenses are deducted from revenue.
  • Have let your accounting firm talk you into reducing taxes to the bone by removing cash from the company.
  • Have accepted the ‘conventional wisdom’ of your industry which tends to be conventional but not wise. If you do what everyone else does, you’ll get what everyone else gets.

That is not the mindset of a savvy investor. When you take off your owner hat and put on your investor hat, you begin to see profit very differently.

The time to start is now.

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