Book Excerpt from Rich Dad’s Advisors: OPM: How to Attract Other People’s Money for Your Investments–The Ultimate Leverageby Michael A. Lechter
Getting Out of the Rat Race and Navigating the CASHFLOW Quadrant Using OPM
How do you get out of the rat race? The Rich Dad answer is to put your money to work for you instead of you working for money. You do that by investing in or creating income-producing assets. When the monthly income from those assets—passive income—exceeds your monthly expenses, you’re financially free. You have made it out of the rat race.
Now, you have choices. You can continue to work at your job (or a different job) because you want to, not because you have to. Or if you choose, you can quit your job without changing your lifestyle.
Rich Dad talks about three basic types of assets: real estate, paper assets (e.g., stocks and bonds), and businesses. There is also a fourth type of asset: intellectual property, the intangible asset that results from creativity, innovation, know-how, good relationships, and reputation. Most of the time, intellectual property is part and parcel of a business and is considered part of the business asset. However, there are occasions when the intellectual property is itself an asset even without an associated business.
People go about building or acquiring assets in different ways—based, at least in part, on their past experiences and what they have been taught about money. Rich Dad’s CASHFLOW Quadrant describes four general categories of people with respect to the world of money: the E, employee; the S, self-employed or small business owner; the B, big business owner; and the I, investor.
- The E (employee) relies on earned income from his or her job, believing that he or she is most secure by letting his or her employer “take the risks.”
- The S (self-employed or small business owner) owns a business, but the business relies primarily on the time, efforts, and attention of that individual. There is typically no team of advisors and little, if any, leverage of the individual’s time and expertise.
- The B (big business) leverages (a) the owner’s expertise (and that of the business’s team of advisors), (b) other intellectual property, and (c) resources through systems and legal relationships. In this way, the big business, in effect, uses Other People’s Time and effort (OPT)—e.g., that of the business’s employees and/or strategic “co-venturers.”
- The I (investor) takes a more passive role and puts his or her money to work to generate more money (typically passive or portfolio income) and will often leverage his or her money (e.g., using “good debt”).
We use the term “co-venture” to cover not only actual business entities, such as partnerships, corporations, limited liability companies, limited partnerships, and the like, but also virtual business entities created through contractual relationships, such as licenses and profit-sharing arrangements, or through informal strategic business alliances. “Co-venturers” are the participants in the “co-venture.”
There is nothing intrinsically good or evil with any of the four categories. There are, at least from my perspective, certain advantages to the S category over the E, and the B and I categories over the E and S, but it really is a matter of choice.
Of course, many people fall within more than one category. For example, people invest income earned as employees in paper assets, such as the stock market, or rental properties all the time. Other people work as employees during the day and build a part-time, home-based, or Web-based business during off-hours. In any event, an individual can develop and accumulate his or her own wealth to use, to acquire, or to build income-producing assets.
It takes the average person time to accumulate wealth. People tend to view the resources that they have to invest as limited to what they have been able to save. However, you are not limited by your own resources. You can use Other People’s Money (OPM) and Other People’s Resources (OPR), which is actually a form of OPM. Instead of expending money to grow your business, you let someone else build it for you with his or her resources and/or money.
Generally, use of OPM and OPR is found on the right side of the CASHFLOW Quadrant. However, an individual can use OPM to navigate through the CASHFLOW Quadrant—to move from the E to the S, B, and/or I quadrant. Likewise, a business entity can use OPM and OPR to move from the S to the B and/or I quadrant, to grow, to take advantage of opportunities, and to become rich.
Expanding Beyond Your Own Resources: OPM and OPR
The basic concept of OPM is simple: You (as an individual or business entity) acquire or build income-producing assets—your business—by using money from sources other than your own.
Are you aware of people using OPM? Of course you are, although you may think of the use of OPM by another name.
Have you ever used OPM? You may not realize it, but the chances are good that you have.
Have you ever been in the position where you wanted to purchase a piece of rental property but could not just write a check for the purchase price? Did the fact that you couldn’t pay cash mean that the property was out of your reach? No. You would typically go to the bank and get a loan. Getting a loan in order to acquire a rental property is a classical use of OPM. The bank that loaned you the money is the source of OPM. (What if you couldn’t qualify for a loan? Throughout this book, we will discuss any number of other forms of OPM that you can use instead of getting a loan or in addition to getting a loan.)
The concept of using OPM applies to more than just real estate. Let’s say you have an idea and want to build a business around it but don’t have the money to go forward. Or you have a number of ideas and a number of opportunities, but you don’t have enough money for all of them. Does the fact that you don’t have the money mean that the business opportunity is out of your reach? Do you necessarily have to choose between opportunities? Not at all. OPM makes going forward possible. You use Other People’s Money or Other People’s Resources to build the business and pursue the opportunities. How do you do that? That’s what this book is all about.
Forms and Sources of OPM
OPM can take a number of different forms and come from many different types of sources. In general, OPM is either direct or indirect (i.e., OPR) and tends to be categorized in terms of the particular consideration (payback) that you have to give in return for the OPM. The basic categories of OPM are “debt,” “equity,” and what I refer to in general terms as “in-kind.”
The more conventional approaches to using OPM to start up or build a business involve raising money and are sometimes referred to as “capital formation” or “raising capital.” They typically involve taking some form of loan (debt) or selling an ownership interest (equity) in your business.
Certain sources of OPM tend to come immediately to mind: high-net-worth individual investors (e.g., “Angels”), financial institutions and funds (e.g., investment banks, commercial banks, savings and loan associations, insurance companies, pension funds, credit unions, venture capital firms), and equity offerings (e.g., ownership interest offered for sale to investors), such as private placements and public offerings. However, there are other sources of OPM that may not be so apparent. These include credit card companies (your personal account or that of your business entity), your friends and family, co-venturers (e.g., vendors that provide favorable credit/ payment terms), customers (through advance payments), and government lending programs or grants.
Other People’s Money, however, can also be provided indirectly—called “in-kind.” Instead of providing money directly, other people provide specific services or resources that you would otherwise have to pay for. In other words, you are using Other People’s Resources—OPR. Strategic use of OPR can often be the easiest way to get started and the fastest route for a business to get to the “big time.”
Other People’s Money (OPM) and Other People’s Resources (OPR) are flip sides of the same coin. With OPM, you build your business by using money from other people. With OPR, you build your business by using resources paid for by other people—indirectly using the OPM that went to develop or acquire the resource.
You can think of the relationship between OPM and OPR like this (let’s ignore the issue of “payback” for now): If someone provides you the money so that you can buy a ticket to the movies, that is use of OPM. If that someone actually pays for your ticket or buys the ticket and then provides it to you so that you can go to the movies, that is use of OPR (the ticket is the resource). Using either OPM or OPR gets you into the movie. And, in either case, you get the use of the other person’s money to do so.
Use of OPR typically involves some form of co-venture—for example, a contractual relationship, formation of a joint venture, or a strategic alliance. By “co-venturing,” you can acquire virtual resources, virtual employees, virtual manufacturing capacity, virtual distribution channels, and so on. You get the benefit of the virtual resources without having to spend the time, effort, and money to develop them yourself.
We will discuss how you can build a business with OPR later.
The Benefits of Using OPM
OPM lets you do things you would otherwise not be able to do
Using OPM opens the door to opportunities for you. It permits you to participate in “deals” that would otherwise be beyond your resources. It allows you to start up the business of your dreams even though you do not have the means. It permits you to make choices that you otherwise could not make. It permits you to be able to afford opportunities instead of saying “I can’t afford it.” In other words, it lets you play in the game.
OPM buys you time — it lets you do things before you would otherwise be able to do them
Have you ever heard the term “window of opportunity”? There are many times when you take advantage of an opportunity only if you can move quickly enough. Using OPM can sometimes let you move quickly enough to take advantage of opportunities that you would otherwise miss. For example, let’s say that you find a potential rental property that is worth $2 million, but the seller is asking only $1 million for it. You know that the “window of opportunity” is short—as soon as the word gets out, someone else will gobble up the property.
Let’s assume that you don’t have $1 million in your checking account. Realistically, what are your options? Think about it. How long would it take you to save $1 million? Even if you had a million dollars in certain fixed assets, how long would it take you to sell those assets to get the money? If you are like most people, it will take you a while—and probably longer than it would take for someone else to come along and purchase the property. Now ask yourself these questions: How long would it take you to borrow $1 million? How long would it take you to find someone to go in with you on the property (a co-venturer)? Using OPM gives you a realistic shot at being able to purchase the property before the window of opportunity shuts.
The same type of situation occurs all the time in other types of businesses. Perhaps you have an opportunity for a huge contract to supply goods to a third party. The problem is that you cannot afford to manufacture the goods because you have virtually nothing in the way of liquid assets. Your business may miss that window of opportunity if you have to rely on your own resources alone.
OPM lets you leverage your resources — and do more with what you have
When you acquire or build an asset using certain forms of OPM, you can get the full benefit of the appreciation in value of the asset, even though it was acquired or built using OPM. In fact, OPM and OPR can accelerate the appreciation in the asset. Again, a classic example of this is when you take a loan to purchase a rental property. Let’s say that you put up 25 percent of the purchase price and borrow the rest from the bank. If the value of that rental property appreciates, you get 100 percent of the appreciation, even though your actual cash outlay was only 25 percent of the purchase price.
The same is true when you take a loan to build a business. If the value of the business increases, even though it was built with OPM, you get the full benefit of the appreciation.
Another example is when you use OPR to build a business. If the value of the business (e.g., the goodwill associated with the business and its trademarks) increases, even though the increased value was entirely due to the use of OPR, you can get the full benefit of the appreciation. We will discuss how this is done in Chapter 3.
OPM can let you spread the risk and obligations
Some opportunities may present a bigger bite than you want to chew. Some opportunities present huge potential returns but also present real risks of failure. Not every venture is successful. There may be a vacancy problem with rental properties. Your new product might not sell as well as, or as quickly as, you anticipate. Maybe the size of the rental payments on the office space that the business will have to lease scares you. Even though you may be able to self-fund the venture, you may not want to risk the entire amount. You can often spread that risk by bringing in co-venturers.
The Cost of OPM
OPM is an immensely powerful tool for building your business. Great benefits can be achieved. But just like any other tool, there is typically a price for using it. The specific benefits and costs differ depending upon the particular type and source of OPM that you use. For example, you might have to pay interest or give up either a partial ownership interest in your business or some of the profits that you would otherwise make. If you use your own funds, you would not have that cost (but you would not get the benefits of using Other People’s Money).
There are a number of aspects to the price you pay for using OPM. There are both short-term costs and long-term costs. The price can be monetary or nonmonetary—such as additional obligations and responsibilities or giving up a modicum of independence or control of the business. Generally, the more risk perceived by the investor, the greater the percentage of the rewards and more say-so in the control of the business the investor will expect. The trick is to choose the right form(s) of OPM for your particular circumstances and make sure that the costs are acceptable.
You also need to plan ahead and recognize that early fund-raising activities can affect your ability to raise additional funds when you need them to grow your business in the future. Strategizing when to use OPM is as important as considerations of the benefits and costs of using OPM. If you don’t plan correctly, you can end up giving away the store.
The benefits from using OPM are very often well worth paying the price. In some cases, you can think of the cost as an entry fee to let you play the game. Even though you might have to give up a portion of your business or profits, even a small percentage of a large number can be much greater than 100 percent of a small number. Because of leveraging, this is particularly true if the only reason you were able to take advantage of an opportunity was by using OPM. Remember, 100 percent of a venture that doesn’t go forward is zero.
Alternative Approaches to Dealing with Capital Needs
What are your options when you discover that the costs of an opportunity are beyond your resources?
- One option is to simply forgo (at least temporarily) the opportunity.
- Another option is to try to accumulate the necessary resources yourself (e.g., sell or rent assets and save the money) and hope that the opportunity will still be there if and when you finally accumulate the funds.
- The third option—and the subject of this book—is to use Other People’s Money and Other People’s Resources.
With this third option, you seek an “infusion of resources” from an outside source. That infusion can be in a number of different forms. It can be a direct contribution of money or an indirect contribution of money (OPR). The OPM can be in the form of credit or a loan (debt) or in payment for an ownership interest (equity) in the business. Or, when you use OPR, you obtain access to the specific resources that you need to go forward (through a strategic co-venture) in return for some other consideration, such as a share of profits or bartered services.
As noted above, each form of OPM has its distinct advantages and disadvantages. Basically, the issues relate to (a) availability, the criteria that you must meet in order to attract the OPM, and (b) the cost of the OPM. The different forms of OPM and OPR are not mutually exclusive. You can choose different combinations (at the same time or sequentially) of forms of OPM depending upon the circumstances.
There is a strategy for determining whether to use your own money or OPM, and for determining how much and the most appropriate form or combination of forms of OPM to seek (debt, sale of equity, and/or co-venture). The pros and cons of the different forms of OPM, and strategies for choosing among them, will be discussed in detail in later sections of this book.
Pitfalls to Be Avoided
There are also potential hazards for the unwary (or cheap or lazy) in the process of raising capital. Most significant, people often get into trouble by failing to properly document transactions and/or by inadvertently violating the federal and/or state laws governing securities.
It is always important to have clear written agreements to prevent misunderstandings in the future. This is particularly true when dealing with family and friends. If an investment is not properly documented—if there is no comprehensive written agreement—it is very easy for legitimate misunderstandings to occur. Over and above that, it is an unfortunate fact of life that memories tend to be selective—some people remember what they want to remember.
Folks who don’t bother with written agreements tend to get to know litigation attorneys very well, and, as a result, the savings from being cheap are lost.
The Securities Laws can bite you
A vast array of both federal and state statutes and regulations deal with the sale of securities. These laws are far from intuitive. It is all too easy to unknowingly violate those laws, particularly when you are dealing with friends and family. What is a security? As often as not, people don’t even realize that they are dealing with a “security.” Few people realize it, but most passive investments in businesses (as opposed to those that involve active roles in business management) are considered securities. For example, it would not occur to most people that when they send an e-mail asking their cousin George for money to help fund their business, they are probably asking him to invest in a security.
The consequences of failing to comply with the securities laws can be severe—and then some. Penalties can include payment of substantial fines. The “then some” may even include prison sentences. At a minimum, you would be vulnerable to the potentially significant claims of “aggrieved” investors. You may well be required to pay equity investors back their investment as well as other losses that they may have incurred. And more than that, if there is a securities law violation, having a limited liability business entity may not shield your personal assets, and liabilities for securities law violations are not dischargeable in bankruptcy.
When do you need to worry about the securities laws? What types of transactions fall under the securities laws? And if your transaction is under those laws, what is required of you? We will discuss these issues in more detail later in this book, and we will try to put the use of OPM and OPR in perspective by looking at a few alternative scenarios in the next few chapters.
Copyright © 2005 by Michael A. Lechter, Esq. Reprinted with permission from the publisher
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Category: Finance a Business