Build Wealth by Creating Leverage
If you want to build wealth, focus on creating leverage.
Leverage can have negative connotations. A power dynamic that gives you an ‘upper hand’ in negotiations. Or, from a financial lens, loading up your balance sheet with debt.
This isn’t the type of leverage I’m talking about.
To me, leverage is creating assets and maximising their utility.
In other words, getting everything you can out of all you’ve got.
Leverage grows with accountability and risk
We all have one input to creating leverage. That is time.
How we choose to invest that time correlates to the potential leverage we can create.
We can spend it:
- developing relationships (partnership leverage)
- honing your craft (specific knowledge leverage)
- hiring employees for your business (labour leverage).
- raising capital (capital leverage)
- reading and consuming educational content (knowledge leverage)
- messing around on social media (social leverage)
- watching Netflix (no leverage…)
Over time, this combination of leverage builds you as an asset.
In other words, you invest this time developing yourself.
When you start a business, you’re creating a replica of yourself.
You create a separate vehicle that you control and own. Your goal as a founder is to help this vehicle create its own leverage — by leveraging Labour (hiring employees) and Capital (funding).
The outcome is an asset that can create unlimited leverage. You own a piece of this asset that grows and creates leverage without your input.
So why doesn’t everyone start a business?
It’s because one's ability to create leverage comes with accountability and risk.
Leverage vehicles and risk
Employees have limited leverage. Despite how hard or how many hours an employee works, their income is always capped. This is because there is little to no risk involved. The monthly paycheck is certain. They are guaranteed paid leave and public holidays.
Freelancers accept more risk than employees. The accountability is high as there is no-one else to blame. Work is not guaranteed. Leverage is also limited due to hours in the day. Factoring this risk, a freelancer’s income is often lower than the salary they could be paid as an employee. But, this extra risk they are taking is offset by time leverage — freedom. Freedom to work their own hours. Freedom to make their own decisions.
Business owners design vehicles to create leverage. They build machines which create financial and time leverage for the founder. The business leverages other assets in the form of labour, capital and products. The leverage potential is unlimited.
Investors leverage capital. Think real-estate and equity investors. Capital is a powerful form of leverage. It scales really well, but it’s hard to obtain.
What assets are you leveraging?
Entrepreneurs design machines to leverage 3 assets — Labour, Capital and Product.
Labour leverage
Labour based leverage is people and is the oldest form of leverage. The ancient Egyptians leveraging slaves to build pyramids. The law firm leveraging associates to deliver legal services. The startup leveraging developers to build product. These are examples of labour leverage.
Labour based leverage is messy because humans are irrational. Everyone has their own worldview, values and incentives which don’t always align with the goals of the Principal and organisation. Firms spend enormous resources on aligning the incentives of all its constituents to fulfil the mission of the company. Culture and leadership programs, learning and development, Christmas parties and financial incentive programs. Humans don’t act like robots — we all need a purpose to inspire us.
It’s far easier to work with people that have the same values as us. This is why the best companies are ruthless when it comes to hiring. “People like us do things like this”. If we work with people we like, we can achieve more together, faster.
It’s important to consider that a labour based business model is one of the worst forms of leverage. It’s better to have fewer people in your organisation with a high amount of output. You can build a small but high-value output firm by leveraging other forms of assets— Capital and Product.
A heuristic to understand an organisation’s leverage is the metric revenue per employee. This is calculated as the firm’s annual Revenue / Headcount.
The majority of small businesses have relatively low revenue per employee as they are service-based business — which by definition is leveraging labour.
Contrast this to some of the world’s most valuable companies like Berkshire Hathaway and Google that have high revenues per employee ($1m+).
These are examples of firms that leverage capital and product, in addition to labour.
Capital leverage
Capital leverage is a more complex form of leverage compared to labour leverage. Capital leverage is anything to do with money — share-trading, lending, banking, investing and funds management. If you look at the roles of CEOs of large companies, you will realise that their job is an asset manager. Her role is to allocate capital to grow the value of the company.
It’s important to note that capital is a powerful form of leverage. You can convert it to labour and product leverage. Equally, capital leverage scales well. One small team of technical fund managers can manage $Billions of capital. The challenge is that capital is hard to obtain. Obtaining capital relies on specific knowledge, track record and good judgement. In other words, you need to understand how it works and how to best invest it.
Product leverage
Product leverage is the newest form of leverage. A product is anything of value that isn’t labour or capital. It’s the toilet paper you buy. The software you use to run your business. It’s the videos you watch on Youtube.
There are 2 forms of product — Physical and Digital product.
The difference between the two products is the marginal cost of replication.
Marginal Cost is the extra amount of costs it takes to make one more of something. If the cost to produce a widget is $3, I need to incur an additional $3 for every widget I produce. These costs are variable in nature. The more I sell, the more costs I incur.
Digital products are superior forms of product because the marginal cost of replication is zero. The cost to replicate a PDF file, to share a podcast or to replicate software is essentially nothing. As the cost of producing the unit is fixed (the code-base and hosting), digital product businesses utilise scale economies. Gross profit margins grow with more users. This is why the world’s most valuable companies are Media and technology businesses (Facebook, Apple, Amazon, Netflix, Google). All of these organisations sell zero marginal cost products.
Firms that build digital products leverage labour and capital to build code based leverage. The code and IP is the asset which is being created and leveraged by users.
There are significant upfront costs to build digital product businesses. Teams of developers and product designers invest hours to create and build the product upfront. The returns are generated as these digital assets are leveraged over their lifetime. As long as the product is being consumed by users, there are limited diminishing returns. It’s a permanent asset in the ecosystem which can infinitely be leveraged by the market. Contrast this to a physical product which has a shelf life. Or leveraging labour in a service business which is limited by hours in the day and mental bandwidth.
Code-based businesses leverage an army of robots that don’t eat, sleep, shit or complain. These workers work whilst you sleep. They’re the perfect worker — which is why you should leverage them. For these reasons, digital product business models are attractive to venture capitalists and investors. They print money.
What we can learn from this
So should we all quit our jobs and start building digital products? Sure, if you want. Start a Youtube channel, a podcast, an app.
Whatever you do, focus on creating leverage. Build assets.
Key Takeaways
- We all have one input to creating leverage. That is time. How we choose to invest that time correlates to the potential leverage we can create. Leverage = value. Value = wealth. Wealth = freedom.
- Building financial wealth is contingent on one accepting accountability and risk. If you want to get rich, you need to act like an entrepreneur and investor.
- A business is a vehicle to replicate yourself. A business is a vehicle that can create leverage that is not bound by you or your hours in the day.
- There are 3 forms of leverage — Labour, Capital and Product
- Building a financially successful business is mostly about what business model you choose to operate.
- Code and media product business models are leveraged by the newly rich. Software and media are powered by robots that work for you while you sleep.
- If you want to build wealth, focus on creating leverage.
This is a riff on Naval Ravikant’s tweet-storm ‘how to get rich”
