What Is the Cash Flow Business?
The Concept of Cash Flow
Every day you encounter the concept of cash flow without even realizing it. If you've ever deposited a paycheck or paid a bill, you've dealt with cash flow. Money comes in, money goes out -- that's cash flow. Cash flow simply means getting income in the front door in time to pay expenses out the back door.
Have you ever written a check, knowing full well that the funds needed to cover that check wouldn't be in your account until the next day? It's okay, you can admit it. Most of us have. Someone (maybe your employer) owed you money, but it wasn't available yet to pay the bills. I'll bet you were holding your breath, hoping your deposit would go through without a hitch so your check wouldn't bounce.
Or maybe you've had to wait for a tax refund. You sent all your forms to the IRS in April, expecting to get a June refund that you could use for a summer vacation. Someone -- the government, in this case -- owed you money, but it wasn't yet available for you to spend. And if you had already promised your kids a trip to Disney World, I'm sure you were anxiously checking your mailbox every day.
In both of those cases, someone owed you money, but that money wasn't available yet to pay your bills or spend on things you wanted. The problem that arises when money is owed, but not yet available, is called a cash flow concern.
What is a cash flow concern? Sometimes it's a need, like the need to pay rent. Other times it's a want, like the desire to take a vacation. Cash flow concerns occur any time people owed payments due in the future have needs or desires they want to fulfill today.
Businesses face the same types of cash flow concerns individuals face, but on a much larger scale. Cash flow means life or death -- basic survival -- to a business. Lose a customer, and your business probably won't collapse. But miss payroll a few times (or payroll taxes!) and your business will go down the drain faster than you can spell "IRS."
I learned about cash flow concerns the hard way about twenty years ago. In the late 1970s, fresh out of law school, I started investing in real estate. I bought numerous properties over an eight-year period. That was during the glory days of real estate, when everything you bought went up in value, and nothing went down. You could buy a piece of property for no money down and expect it to increase in value 10 percent to 15 percent per year. You could leverage the appreciation on your invested capital as much as 100 percent or more annually.
The only problem was that you could rarely collect enough rent on your properties to cover your mortgage payments. That created negative cash flow. Buy one piece of property, and you'd end up with a little negative cash flow. Buy a number of properties, like I did, and you'd get stuck with a lot of negative cash flow.
If you could hang on to your properties long enough, the appreciation would certainly be worth enduring the negative cash flow, assuming (1) you had the ability to cover the negative cash flow in the meantime; and (2) appreciation continued in the future the way it had in the past. Unfortunately, a lot of investors in the 1970s didn't have the means to support the negative cash flow.
At the same time I was investing in real estate, I was also trying to operate a law firm. By 1983, my real estate was draining cash from the firm. My properties were going up in value more than I had ever hoped, but appreciation couldn't pay the bills. And it certainly couldn't cover payroll!
My father, born and raised in South Philadelphia during the Depression, handled the accounting for my law firm and real estate investments. Dad kept warning me that I was getting into rougher and rougher cash flow waters. That didn't stop me, of course. I kept on buying real estate as often as I could.
It's not that I ignored his warnings. It was just that I knew my real estate had real value, and it was appreciating far faster than the negative cash flow. What I didn't count on, however, was how long it could take to sell a piece of real estate at that appreciated price -- especially if I needed the money. Eventually the day of reckoning arrived. I remember that desperate day in June, when Dad came to me and said that we had spent every last dime we had to make payroll for that Friday. We had no cash left to operate the law firm or cover anyone's paycheck the following week.
I had assets, of course. I just didn't have any cash. I looked around at the real estate I owned and realized that even if I got lucky, it would take me sixty to ninety days to sell enough to put cash back in the bank. However, one asset I had bought about six months earlier -- a private mortgage note -- stared back at me as I frantically picked apart my financial statement. It was the only mortgage note I owned, and I had come across it casually through a referral from an acquaintance of mine.
There were nine years of payments left on the note, and it was providing me an income of $1,000 a month. A nice investment for sure, but I needed a whole lot more than $1,000 to cover payroll and expenses that next week.
Uncertain of what to do, I contacted someone I thought could help. I didn't really know if I could sell my mortgage note, and I wasn't sure what kind of price it would fetch even if I could. At any rate, I told my friend what I was holding, then kept my fingers crossed and hoped for the best. The next morning, that person made me an offer that knocked my socks off. He gave me $53,000 for the note by the following Friday -- the same day I had to cut the payroll checks.
As Dad and I walked away from that deal (and I'm not sure which one of us was gloating more) several things occurred to me. First, I discovered, probably for the first time, how vital cash flow is to a business. Second, I realized that having assets and having cash are two very different things. And third, I figured that hundreds, if not thousands, of other business owners like me had experienced the same problems I had with cash flow.
Ever since that day, I have been fascinated with the concept of cash flow. Thirteen years later, I'm intrigued with the business that has evolved to meet cash flow needs and how it offers a win-win-win situation for everyone involved.
The Cash Flow Business
The cash flow business is all about solving cash flow concerns. It's about getting cash into people's hands sooner rather than later. The way the business does that is by buying payments that are owed in the future for a lump sum of cash today.
Suppose you own a construction company. You win a $50,000 government contract to build city tennis courts, under the condition that you won't be paid until the courts are complete. Those are the terms, take it or leave it. However, you need at least $25,000 of cold hard cash immediately in order to buy materials for the courts, lease the equipment you need, and pay your employees each week while they're working. And you simply don't have $25,000 sitting in the bank.
You've got a serious cash flow concern.
Now, suppose someone offered to give you $25,000 in cash today, plus $20,000 when you finish the courts (for a total of $45,000), in exchange for the $50,000 you will receive when the city takes possession of them. Would you accept the offer?
Of course you would. With $25,000 in cash today, you could buy materials, lease equipment, and pay your employees. And out of the $20,000 you would get later, you could collect your profit.
You would accept that offer because it would give you the means to accept the city contract without going in debt. You would -- and other people would too -- because it just makes sense.
It makes so much sense, as a matter of fact, that individuals and companies throughout the country are doing business exactly this way. Transactions like the one I just described are occurring every day in the United States. Individuals and businesses are opting to collect future payments sooner, rather than later, by selling their future payments to a third party. While the people and circumstances may vary, the principle is fundamentally the same. That principle -- the buying and selling of future payments -- is the basis of the entire cash flow industry.
The Definition of the Cash Flow Industry
The textbook definition of the cash flow industry is the "buying, selling, and brokering of privately held income streams in the secondary market." If that sounds complicated, it really isn't. By the end of this chapter, you'll know exactly what I'm talking about.
Let's consider each part of the definition in the context of another example.
Suppose you have a boat for sale. You're asking $10,000 for the boat, and I decide to buy it. I write you a check for $10,000 and sign it. Once you own the $10,000 check, you can do whatever you want with it. (If you don't know me very well, you'll probably take it to the bank and cash it right away!) The bank will require only that you endorse the check on the back. Then, provided I actually have $10,000 in my account, you can walk out of the bank with ten grand in cash.
Now let's change the scenario a bit.
You have a boat for sale, and I want to buy it. However, instead of giving you a check for $10,000, I write you a note that says, "I owe you $10,000. I'll pay you $475 a month, including interest, for the next two years." By signing this IOU note, I make a promise that you are going to get your money, plus interest, over time. Now I have a debt, and you have an income stream.
An income stream is simply another word for a future payment or series of payments. Essentially, an income stream is money that one individual or business is receiving from another individual or business as a result of a debt. For that reason, we often refer to income streams specifically as debt instruments.
The income stream created when I buy your boat is privately held, because the IOU is held by you, a private individual, not by a bank or lending institution.
In the second scenario, you will receive a series of future payments. You will get $475 a month for the next two years, for a total of $11,400. Not a bad deal, considering that you will receive your $10,000 asking price plus $1,400 in interest over those two years.
However, suppose that after holding on to this "IOU" note for a few months, you decide you want cash immediately in order to buy a new car. Could you take my "IOU" to the bank and cash it in? Of course not. Your local banker would laugh at you if you tried.
However, there is a place where you could get cash for your boat note. That place is called the secondary market.
The secondary market refers to individuals and companies that are set up to buy notes just like the IOU you're holding and not just notes secured by boats, but notes secured by homes, airplanes, mobile homes, cars, and even businesses. In the secondary market, we don't deal with banks. We deal with private investors and investment companies, which we call funding sources. Funding sources buy future payments for hard cash.
At a bank, you can cash a check you own today, earn interest on money you own today, and -- if you're lucky -- get a loan based on collateral you own today. But in the secondary market, you can get cash today for payments owed to you in the future.
Here's how it works.
In the secondary market, a funding source would give you cash in exchange for your boat IOU. The amount the funding source would give you would depend on the likelihood that I would continue to make the payments on the boat (in addition to several other factors, which I'll discuss later). The important thing to note is that the funding source wouldn't really buy the balance on the note; it would purchase the value of the payments due in the future.
In this example, you would walk away with a lump sum of cash today that you could use to pay your bills or reinvest. I would continue to make my $475 payments, only now they would go to the funding source. And finally, the funding source would earn a yield on the note over the next two years as I continue to pay it off.
A boat note (in the business, we actually call it a marine note) is just one type of debt instrument that can be bought and sold in the secondary market. Almost any income stream -- whether it is an invoice to be paid in 30 days, or lottery, winnings to be paid over 20 years -- can be sold to a third party for cash.
In the cash flow industry, we recognize more than fifty income streams, or debt instruments, that can be transacted for a profit. The most well known are private mortgage notes and business invoices. Dozens of other debt instruments are lesser-known, but even more profitable. A handful of acknowledged instruments have never been transacted to date, but could be under the right conditions. In Chapter Four, I'll list and describe the more than fifty specific debt instruments we have identified to date.
Why do people sell income streams?
Individuals sell income streams for three basic reasons. The first is access. People need or want access to their cash. Sometimes they have a serious need -- to pay off credit cards, finance long-term medical care, or to settle a divorce. Other times, they simply have a desire -- to purchase a dream home, take a vacation, buy a new car, finance a wedding, or start a business, for example.
In some cases, people want access to their cash just for peace of mind. They no longer want to worry about liquidity issues, collection hassles, or the financial strength of the person who owes the debt.
In the case of my law firm, I needed access to cash in order to make payroll, and $1,000 a month income from a mortgage note wasn't going to cover it. Yes, it would have been more profitable to have held on to that note for the next nine years and collect the interest. But I needed immediate access to cash, and selling my note was the perfect solution.
The bottom line is this: People sell income streams because they need or want access to their cash immediately, not months or years from now.
The second reason people sell income streams is interest or yield.
If I gave you a choice of receiving $100 today, or $100 next year, which would you choose? The logical answer is $100 today, even if you don't need access to the money. Why? Because of interest or yield. Interest or yield is what gives you the ability to invest money this year and turn it into an even larger amount of money next year. When we talk about interest or yield, we're talking about the earning power of your cash. When you have cash, you can produce income on it. When you don't, you can't. It's that simple.
If you received $100 today, and invested it at a rate of 10 percent, you would end up with $110 next year. But if you waited until next year to receive your $100, you couldn't earn interest or yield on it until the following year.
When you're dealing with the choice of investing $100 today and earning 10 percent interest on it, versus receiving $100 next year, you're talking about a difference of only $10.
But what if you were to add three zeros to that? The difference between investing $100,000 today at a 10 percent interest rate versus receiving $100,000 a year from now is $10,000. And what if I had the opportunity to earn a yield of 30 percent on my money? Now we're talking about a difference of $30,000! Clearly, one year can make all the difference in the world.
People will sell their income streams -- even for less than face value -- because they know that with cash in hand today, they can start earning interest or yield.
The third reason people sell income streams is inflation. Inflation eats away at the future value or "buying power" of money. I don't think anyone would dispute that you can buy more with a dollar today than you will be able to five, ten, or twenty years from now.
When my Dad retired from the Air Force in 1963, our family moved to New Jersey. I remember as a young child being told that the house we were buying was a newly constructed, split-level home on a lot in a subdivision. From the way my parents were talking, money was going to be tight. What did our new house cost? The princely sum of $14,999.
Obviously, $14,999 won't get you a home today -- it will barely get you a new ear. And thirty-five years from today, who knows if $100,000 will still get you a decent home? Inflation eats away at the buying power of money.
People sell their income streams because they realize that, over time, the payments they receive will drop in real value.
When you consider access, interest or yield, and inflation, it's a whole lot easier to see why an individual or company is often eager to receive a lump sum of cash today instead of a series of payments due in the future. They can count on cash; they can't always count on the promise of cash.
Why do people buy income streams?
It's clear why individuals or businesses would want to sell their income streams, but what about the other side of the coin? Why would anyone want to buy them? The answer is simple enough: Profit. Buying future payments is a form of investing, and it's incredibly profitable.
If I am an investor with a lump sum of cash in my hands, my objective is to get the highest rate of return I possibly can. What are my options? I can buy T bills. I can buy Certificates of Deposit. I can invest in mutual funds, stocks, bonds, real estate, and so on. In short, I can do any number of things with my cash.
My objective, however, is not to discuss the pros and cons of each of those investments. My point is that, as an investor, I want to maximize the amount of income my investment generates. Buying income streams is one way I can do that -- and do it very well. When I buy future payments, I earn pure, unadulterated yield on my investment. And I know in advance exactly what that yield will be, provided the payments continue.
Investors and investment companies buy income streams because it's a profitable way to invest their money.
Bringing Sellers and Investors Together: The Cash Flow Specialist
On one hand, individuals and businesses clearly are motivated to sell their income streams. And on the other, investors or investment companies have good reasons for buying them. But the backbone of the cash flow business is the cash flow specialist, who bridges the gap between buyers and sellers.
Cash flow specialists are professionals whose sole purpose is to solve cash flow concerns. They accomplish this in two ways. First, they operate as brokers, or "middlemen," connecting buyers and sellers and earning a fee in the process. We call these specialists cash flow brokers. Second, they operate as investors, using their own capital (or their companies') to buy income streams, earning a hefty yield (12 percent to 48 percent) for their effort. We call these cash flow specialists funding sources.
Some cash flow specialists solve cash flow concerns for individuals; others solve cash flow concerns for businesses. Either way, their goal is to locate people and companies with an income stream to sell. Then they either broker the income stream to a funding source (as a cash flow broker) or buy the income stream themselves (as a funding source).
By the end of this book, I would venture a guess that you will want to become a part-time or full-time cash flow specialist -- working either as a broker, connecting buyers and sellers, or as an investor, buying income streams for your own account. In either case, you can make a great deal of money in this business -- as you'll shortly learn.
Remember These Highlights
* Cash flow, in this business, refers to the movement of cash from an individual or business that owes a payment to an individual or business collecting a payment. The cash flow business involves the buying, selling, and brokering of privately held income streams in the secondary market.
* A cash flow concern exists when money is owed but is not yet available to spend.
* A cash flow specialist is a professional who solves cash flow concerns. Some cash flow specialists operate as brokers. Others operate as investors, or as funding sources.
* People sell income streams for three main reasons: access, interest or yield, and inflation.
* People buy income streams because they can earn a high yield on their investment.
Copyright © 1998 by Laurence J. Pino