Personal Proximity to Profits (or "Personal Value Capture")
I’ve been playing with this idea of “personal proximity to profits.” I’m trying to understand the different types of relationships we can each, individually, have with a business or cash flow.
It’s similar to the idea of “Value Creation vs. Value Capture” but at an individual level rather than a company level. Where Value Capture in a business is (roughly) Consumer-Surplus-compared-to-Gross-Margin, this concept is more like Gross-Margin-compared-to-profit-personally-accrued.
For example, owning 100% of a small business is a much higher Profit Proximity than owning shares of a public company.
Here is roughly how I plot out different types of business relationships, and the axis that determines the relationships.
Personal Proximity to Profits Chart
I’ll explore the Proximity to Profit of a few examples (starred). I don’t have the expertise to expand upon all of these with confidence, but this has been an interesting mental model for me to compare opportunities.
Proximity to Profits when Owning 100% of a small business
Sky King and I talked about owning a personal business in our conversation on my podcast. He said “You’re not even in the game until you have a personal corporation.” And I talked about how differently I started thinking when I set up my company. You’re set up (and incentivized) to deploy resources more effectively. It’s a very interesting shift.
There’s no better Profit Proximity than being the 100% shareholder and principal of your own company. You control your salary, your expenses, and your vendors.
Why does that matter?
Because when you control your own expenses, you can be your own expenses.
If you look at the financial statements of a well-run small business, you will likely see multiple places where the business is paying the owner.
Examples:
Purchasing a building, then paying rent to themselves from the business
Vehicles and vehicle expenses
Devices and Cell phone bills
Choosing vendors or suppliers run by friends/family
Expensing work-related meals and services
Small Business Income Statement Example
You will notice many people with an average small businesses doing incredibly well, personally. This is why. Their Proximity to Profits is maxed out. Small business owners can reach cash more efficiently than anyone else.
And it’s not just that the business is paying them, but that the business is paying them with pre-tax money. More on that in another post.
An interesting parallel, this is the same basic idea Amazon used at a huge scale — they turned expenses into businesses and became their own vendor while creating new profit centers. This is the same way a clever small business owner uses to turn his costs or vendors into ways to access profit personally.
Partnership in a small private business
Many of the same ideas as the above apply, with one important caveat: Owning <=50% of a small business may seem to be nearly as good, but I suspect it’s a larger step down in Proximity to Profits than most expect.
100% ownership is *complete* control of expenses and vendor decisions, instant decisions, and never having to backtrack to ensure a fair resolution. This isn’t to discourage partnering, merely to illustrate the difference in Proximity to Profits.
There are plenty of ways to work with people other than co-ownership (like commissions, profit-sharing, bonuses) and ways that both partners can own 100% of their own business and still work together.
Proximity to Profits as a Common Shareholder of Private Company
The world of “Private Companies” is wide, from Trillion-dollar behemoths to incorporated individuals, to well-funded billion-dollar startups. Across this landscape, ownership can take many forms. It is a bit futile to lump all of these experiences into one bucket — with one caveat. As a shareholder in any company, but especially in a private company, you live somewhere in a “capital stack.” The capital stack dictates who gets paid what, when, and in what order from company earnings.
I showed a little bit of this in my post about the value of Stock Options — but to summarize this in one line: it is important to know where you are in the food chain of capitalists.
Proximity to Profits as a Common Shareholder of Large Public Company
Shareholders of Public companies are the farthest Proximity to Profit within the world of Equity.
Common Shareholders benefit from maximum simplicity and minimal effort — they can go into their brokerage account, buy shares, and not think about it again for decades.
To get this simplicity, they accept many layers between them and profits… experiencing a minimal Proximity to Profits.
Who sits between public company profits and the common shareholders?
Executives, who often have misaligned interest w/ Shareholders with a focus on getting paid new shares, not driving the price up)
Employees, who are often motivated to increase salary and perks rather than the share price.
Landlords, who are motivated to maximize value extracted from the company.
Managers, who are motivated to spend their surplus and keep their budget
The government, who wants their tax money.
Service Providers, accountants, auditors, lawyers, lawyers, lawyers…
Transfer Agents, Brokers, and Fund Managers who enable you to buy and manage shares
The list is long and varied, and could in some cases also include insiders, lenders, preferred shareholders, debt holders, suppliers, key vendors… and plenty more I’m not aware of.
Common shareholders also experience limited information and very limited control.
In contrast to being an insider in your own small business where you are the most informed person in the world… as an investor in a public company, it’s actually illegal (insider trading) for you to know things that others do not. You’re limited to working with public information or insights via scuttlebutt, which you have to earn the hard way.
Common shareholders also have very little control in the company, limited basically to voting on a few key issues (like board members). It’s almost like a representative democracy — no direct control over operations, investments, or expenses.
That’s a known and accepted (even obvious) part of the compromise of being a common shareholder — simplicity for control, ease for proximity.
This is not an indictment of being a common shareholder… we’re damn lucky to live in an era where anyone can so quickly and easily share in the wealth created by companies. The fact that you can buy some Amazon stock, sit on your ass for 20 years, and have generational wealth is a modern miracle. Even with lower proximity to profits, wonderful outcomes happen.
Profits are good, at any proximity
There’s no “to-do” in this conclusion — though I do plan to further explore the power of personal incorporation because I believe it’s often underestimated — but there is no hierarchy implied here. The market tends to (roughly) price risk/effort/ownership commensurate with your proximity to profits. And certainly, people have been wildly successful all across the spectrum.
If there were a recommendation, it would be to have a variety of relationships with companies. If your wealth is concentrated in a small business — awesome, go buy some index funds too. If your main income is a career — maybe a small side business would complement your wealth-building efforts.
I’m exploring new ways to think about various businesses and my relationship with them. I hope this serves you, too.
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