(* See also: http://www.eqjournalblog.com/?p=526.)

Recently, Mark Sherboneau from Foundation Private Wealth Management and Susan Tataryn, Ottawa lawyer and CA, have been working with us on the issue of creditor proofing for entrepreneurs, even from the earliest stages of their careers.

Most financial planning groups are not interested in entrepreneurs until they have at least six figures or preferably seven figures of liquid assets. But Mark and Susan have worked out a system that will allow entrepreneurs to set up a trust at an early age with minimal startup costs.

The trust would be:

1. run by a trustee or trustees;
2. the trustee can be a corporation or a tripartite group of three (trusted) persons;
3. the beneficiaries of the trust would, in most cases, be the settlor (the person making the gift himself or herself) plus members of their family and possibly a charity or their alma mater, for example;
4. the division of the trust when it is wound up would probably not be specified as to which beneficiary gets what: this would be subject to discussion between the settlor and the trustee(s) at that time, with the trustee(s) making the final decision;
5. the settlor would set initial conditions for the trust such as it is not to be wound up until age 55 (60 or 65) which would prevent the beneficiaries from accessing the funds in the trust until a certain age. This is to protect the beneficiaries essentially from themselves since most people can not resist buying cool stuff if they could get their hands on the money;
6. the funds invested in the trust would most likely be invested fairly conservatively in vehicles like corporate class mutual funds so that almost all taxes are deferred to the trust windup and, when it is wound up, capital gains taxes would apply which improves tax efficiency by quite a margin;
7. the trustee(s) are obligated to protect the gift as best they can;
8. benefits are distributed according to the settlor grant, the settlor’s wishes and knowledge and best practice of the Trustee(s);
9. the Trustee(s) have legal title (not the beneficiary) so that the assets can not be attacked by creditors;
10. the diversity of interests of the beneficiaries means that a premature windup of the trust is unlikely since all beneficiaries in every Province of Canada (except Alberta) have to unanimously agree to a windup which means the trust is resistant to external pressures from, say, creditors or a money-hungry beneficiary.

This structure is designed to give the entrepreneur some financial assets that would be available to him or her and other beneficiaries at a later stage of life. These financial assets would be difficult for creditors to attack and, at the same time, they would be protected against premature disposition because the entrepreneur himself or herself wanted to use the funds for something else, like another startup or a trip to the DR or a new car…

The financial assets would probably not be invested aggressively in ‘Petrogold’ penny stocks on the VSE, say. This is supposed to be the third or fourth ’silo’ of personal investing, namely:

1. The first silo might be the matrimonial home which, at least in Canada, is likely to be owned directly by the spouse with the lowest risk profile. When it is sold, a principal residence in Canada is not subject to capital gains tax. Also, in most divorces, the matrimonial home is a shared asset so the value of the home (or a share in it) is not likely to run away from the entrepreneur.
2. The second silo is other real estate owned or controlled by the entrepreneur: perhaps a multi-residential dwelling and an office building that is rented to the operating company. This real estate is usually owned by a PHC, Personal Holding Company.
3. The third silo is the operating company where the entrepreneur expects significant returns on equity and where they have perhaps the most risk. The operating company is also likely to be owned by the PHC. This structure allows the controlling mind to move money from eligible Canadian Corporations (say the real estate company or the operating firm) to the PHC tax free using inter-corporate dividends. Funds are also moving from the operating company to the real estate company in the form of a fair market value rent. Real estate also generates CCA, Capital Cost Allowance, which creates a capital dividend account which can be divdended out to individual shareholders, tax free. Finally, the shareholders of the PHC (typically, the entrepreneur and his or her family) can be paid by the PHC or receive dividends from the PHC so as to minimize taxes overall. This is an efficient tax structure, creates diversity in the asset mix and works well operationally.
4. The fourth silo is the Trust we discussed above and it is obviously not owned by the PHC but by the Trustee(s).

These days, if you could see 5% to 6% returns over the long haul from your principal residence, 8% to 12% from your other real estate holdings, 18% to 22% ROE in your operating company and 3% to 5% from your Trust, that would be a realistic and satisfactory result for most of us.

Here is more information provided by Mark and Susan:

Prof Bruce

- SALES SALES SALES (moi)
- CHECK CHECK CHECK (my Dad).

As I have grown older, I have come to realize they are equally critical: without sales, all organizations will eventually disappear and, without attention to detail, they will fail to execute and just wither away.

Here is a Venn Diagram for Dad:

If it’s important, make sure you remember it: CHECK CHECK CHECK everything.

Prof Bruce

Postscript: Parents have been passing on this advice to children for generations if you can rely on the film ‘The Godfather (Part 1)’ as a guide. Near the end of the film, Vito Corleone goes over and over again possible scenarios with his son, Michael, on how he (Michael) will be able to recognize the traitor in the family and avoid the trap his enemies are preparing to spring on him. The Don gives Michael a lecture on being careful and checking everything, advice that will soon save his life. When I saw that, it had the ring of truth, at least to me.

Does this sound like a bad business? A business that hasn’t had a significant new revenue stream since the 1980s? Well, that would be the commercial real estate business.

Here is how it breaks down:

1. In the ‘olden days’, Commercial Landlords received rent, a gross rent.

2. From that they paid—their mortgage, property taxes, operating costs, insurance, utilities, repairs, maintenance and administration staff. And whatever was left, was profit.

3. Then inflation happened (in the 1970s and 1980s).

4. Interest rates went to 21%.

5. Landlords went out of business in a hurry as cities raised taxes, utilities raised rates, staff wanted more dough, …

6. The industry reacted—they went to net, net, net rents (triple net rents). That means that tenants paid their basic rent (or minimum rent) which went to the Landlord (from which they paid their mortgage). Everything else was paid by the Tenant in the form of additional rent so if costs went up, their additional rent went up.

7. Some Landlords ‘retailed’ their utility bills to their Tenants on the basis of what the Tenant would have paid for their consumption if they had been in a standalone relationship with the utility company and not buying wholesale as many Landlords were doing.

8. Landlord’s also grossed up their Tenant’s space so that the Tenants were also paying for common areas and even for vacant space.

9. Landlords would also charge a fee for their administration and management as well as recovering their insurance costs and maintenance and repair costs sometimes even collecting for structural and other major repairs.

10. So the minimum rent was truly ‘net’ to the Landlord.

Over the years, Landlords tried lots of other things to add to their bottom line. They tried charging for parking, introducing cable and telecommunications services that they controlled and charging for signage. For most locations, this did not amount to much and, in some cases, the results were negative—it turned out that running a cable system or telecom system was too complex for them and they were losers both financially and operationally.

Then along came the Internet—every developer was going to have a server farm in each of their buildings. That didn’t last long either.

Now in Ontario, here comes rooftop solar. Heavily subsidized by the Province of Ontario, solar looks like it might add 40 to 50 cents per square foot per year to the bottom line of commercial landlords with suitable roofs. These revenues are triple net and derived from (mostly) ballasted systems installed by third parties. The rooftop ‘gold rush’ might lead to the development of micro utilities with scale; some will control dozens or hundreds of rooftop installations in the Province.

Or the Landlords can install the systems themselves and make more money (cap rates are probably in the order of 10 to 11% p.a.). Of course, they will then be on the hook for the capital costs and operating costs of these systems. Big Landlords can borrow money a lot cheaper than most entrepreneurs so a cap rate of 11% looks mighty tasty to them when their borrowing costs could be less than 4%.

Risk averse or capital short Landlords may prefer the triple net, money for nothing approach. 40 to 50 cents may not sound like much but, at least for industrial buildings which yield around $8 per square foot per annum, triple net in places like Ottawa, that’s a raise of 5% to 6.25%. And don’t forget, the IRR on that marginal revenue is infinite since they are paying 0 dollars for the installations.

Prof Bruce

Postscript: there is another new revenue source on the horizon for commercial landlords, at least the ones with superior locations and lots of drive-by or pedestrian traffic. But that is a story for another day.

Postscript 2: the commercial real estate biz is today mostly reserved for large scale enterprises. Regional malls and mega office towers are almost exclusively the preserve of Banks, pen finds, insurance companies and publicly traded REITs with very low COF (Cost of Funds). Entrepreneurs have to find a different playground where returns are higher and elephants stay out. Industrial condos, self storage, land development, apartment hotels and resorts are some of the areas where entrepreneurs can hope to find a piece of the action.

1. “No one can really save their way to wealth but you can invest your way there,” Prof Bruce.
2. “Entrepreneurs would rather ask for forgiveness than beg for permission,” Anon.
3. “Fall down seven times, get up eight,” Japanese Proverb and part of the successful Entrepreneur’s Credo.
4. “Whether you believe you can, or whether you believe you can’t, you’re
absolutely right,” Henry Ford.
5. “Dump the losers and keep the winners,” Prof Bruce’s Dad, Professor O. J. Firestone.
6. “People like to buy from people they like and trust,” Prof Bruce.
7. “An entrepreneur is a person who can create $2 of revenue for every $1 that any fool could generate,” Prof Bruce.
8. “Every business has a ‘magic marketing button’—something you do and clients and revenues appear. If you don’t have one, your business will disappear,” Prof Bruce.
9. “If you can’t market your business in a cost effective manner—if it costs too much to acquire a customer, your enterprise is dead anyway,” Prof Bruce.
10. “If you bootstrap your business, you end up owing it instead of the VCs,” Prof Bruce.
11. “The optimal number of partners to have in a business—zero,” Prof Bruce.
12. “There are still two chairs in Heaven waiting for the first two partners to get there and still like each other,” Anon.
13. “It’s OK to trade your way to success as long as you know when to stop, build and hold—in other words, don’t flip until you flop,” Prof Bruce.
14. “The difference between being rich and being wealthy is that Shaq is rich but the man who signs Shaq’s paycheck is wealthy,” Chris Rock.
15. “Negative cost selling is a fancy way of saying: ‘I’ll pay you to hire me,’” Prof Bruce.
16. “ABC, Always be Closing,” Ben Affleck’s character in the Film, Boiler Room.
17. “The VCs Golden Rule: ‘He/she who has the gold, rules.’” Prof Bruce.
18. “Asymmetric information is another way of saying: ‘I know more than you do and so I can profit more than you from this transaction.’” Prof Bruce.
19. “If you’re not an expert in what you do, you’re a dilettante and just food for sharks,” Prof Bruce.
20. “Every successful business looks easier than yours … from the outside,” Prof Bruce.
21. “Guerilla Marketing is just another term for smart marketing,” Prof Bruce.
22. “Selling is telling,” Mark Gencher.
23. “Accretive selling happens when you buy an asset and you have more cash on hand after you buy it than before,” Prof Bruce.
24. “If you focus on getting real clients and customers and building cashflow, you’ll get financed today not the other way round,” Prof Bruce.
25. “Forget about all the studies on why businesses really fail. Have you ever heard of one that failed from having too many sales?” Prof Bruce.
26. “Guerrilla Marketing research happens when you fool people into thinking they are buying the real thing—then you really know if your product or service has any value in the marketplace,” Prof Bruce.
27. “The market is always right, even when it’s wrong,” Prof Bruce.
28. “You are not the market,” Prof Bruce.
29. Upon seeing his very first web page, Lou Gerstner, former CEO of IBM asked: “Where’s the ‘buy’ button?”.
30. “The harder you work, the luckier you get,” Anon.
31. “If you set, visualize, verbalize and monitor your goals, you will achieve them,” Prof Bruce.
32. “Under promise and over deliver,” Anon.
33. “Ideas are cheap, execution counts,” Prof Bruce.
34. “Deal with it,” Sigourney Weaver’s character, Ripley, in the film series, Aliens.
35. “Branding creates trust and trust creates the opportunity to actually make a sale,” Prof Bruce.
36. “If you see someone with a biz card that says: ‘VP of Marketing and Sales’, you’ve just met a person who doesn’t know what he/she is doing,” Prof Bruce.
37. “Buying low and selling high is actually quite hard to do—we are all subject to herd instincts—there is enormous, systemic pressure to sell whenever everyone else is selling and buy when everyone else is buying,” Prof Bruce.
38. “Be more afraid of ‘Fear of Success’ than ‘Fear of Failure’.” Prof Bruce.
39. “Surround yourself with positive people—at home and at work,” Prof Bruce.
40. “Entrepreneurship is an exercise in positivist thinking. If your partner or employees are negative, dump them,” Prof Bruce.
41. “Never tolerate people who make the same mistake over and over again,” Prof Bruce.
42. “… with product innovation, it’s a certainty that your competition is shortly going to copy what you have done. With business-model innovation, though, if you can come up with a unique way of doing things, it’s much tougher to react to,” Sam Palmisano, Chair of IBM.
43. “Success comes from, in part, just showing up. Business people can learn a lot from show biz folks—who know that the show must go on,” Prof Bruce.
44. “Never start a business with the idea that it is OK to lose money because it’s a tax write-off,” Prof Bruce.
45. “Track the amount and direction and velocity of cash—cash doesn’t lie/accounting statements sometimes do,” Prof Bruce.
46. “If you don’t learn to control your costs, you’re sunk. Costs always seek to rise until they exceed revenues,” Prof Bruce.
47. “Don’t forget to reverse sell—people you buy from should also buy from you,” Prof Bruce.
48. “Profit is not a dirty word—you make a profit not just to have a nicer car and a fancier home but also so you can sustain your enterprise, invest in it and in your employees too,” Prof Bruce.
49. “If you ever get into trouble, the first place to look for help is from your existing clients and customers as well as your suppliers—they want you to stick around,” Prof Bruce.
50. “Check, check, check… everything. There are no ‘fire and forget’ missiles in business,” Prof Bruce.
51. “Don’t take ‘no’ for an answer,” Prof Bruce’s Dad, Professor O. J. Firestone.
52. “Turn cost centres into profit centres or sell them,” Prof Bruce.
53. “You make money in real estate when you buy, not when you sell,” Barry Lett.
54. “If you are making a sales presentation and the client is saying ‘Yes’, stop, get the contract signed, thank them and leave. The only things that can happen after you hear a ‘Yes’ if you keep going are bad,” Prof Bruce.
55. “You are never too busy to return a sales call,” Prof Bruce.
56. “Entrepreneurship can be a lonely life. Just knowing that other entrepreneurs are experiencing the same thing, helps,” Prof Bruce.
57. “There should be a 3 am network for entrepreneurs—they are all up writing notes to themselves as ideas bubble up from their subconscious,” Prof Bruce.
58. “Get the business model right so that the harder you work, the more money you make,” Prof Bruce.
59. “Twitter has legs, I think, as long as you are answering the question: ‘What are you thinking?’ rather than ‘What are you doing?’” Prof Bruce.
60. “Gizmos or gadgets almost never underpin a sustainable business,” Prof Bruce.
61. “The best trades you make are often the ones you don’t make,” Glen Sather, former GM of the 1980s Edmonton Oilers.
62. “Successful entrepreneurs know they have to do many things in parallel,” Prof Bruce.
63. “Your priorities should be: 1. take of your business so 2. it takes care of your family and then 3. your family can take care of you,” Peter Patafie.
64. “You want to know the real cause of most divorces in Canada? It’s financial stress,” Peter Patafie.
65. “I’ll tell you a secret about competition in business—I like it,” Prof Bruce.
66. “Maybe the reason no one has ever done this before is that (your new business model) is a bad idea,” Prof Bruce.
67. “Maybe the reason that you don’t have any competition is your idea is a bad one. If it’s a good one, you will have competitors,” Prof Bruce.
68. “Remember that the world is a tough competitive place and entrenched business interests don’t want you to succeed,” Prof Bruce.
69. “Never fire people for making a mistake. Always fire them when they make the same mistake over and over again,” Prof Bruce.
70. “There are no rules in a knife fight,” Butch Cassidy.
71. “If you want your media relations to be successful then you better understand smart truth and spin,” Prof Bruce.
72. “Pricing is an art,” Prof Bruce.
73. “The three most important things in business to remember are: sell sell sell,” Prof Bruce.
74. “The three most important things in business to remember are: check check check everything,” Professor O. J. Firestone.
75. “Entrepreneurs know that they deal with ambiguous situations almost daily… and they can cope with that,” Prof Bruce
76. “Customer Service is not a cost centre,” Prof Bruce.
77. “The easiest, best and least expensive place to look for new clients is old clients,” Prof Bruce
78. “Your AP is a great place to look for new people you can sell to,” Prof Bruce.
79. “If you knew just three things: your Bank balance at the beginning and end of each month, your AP and your AR, you would know practically everything you need to know about your enterprise because you would know your cash position,” Prof Bruce.
80. “I pay everything COD because I hate owing anyone anything… plus when I look at my Bank balance at the end of the month, I know whatever is there is mine,” Jay Curry, owner of the Barley Mow chain of pubs.
81. “Cash is King,” Ken MacMillan, Prof Bruce’s father-in-law.
82. “Litigate only as a last resort and not even then,” Prof Bruce.
83. “When entering into a negotiation, know your BATNA so if the deal falls apart, you are prepared for your next step right away,” NLP. (BATNA: Best Alternative to a Negotiated Agreement. NLP: Neurolinguistic Programming.)
84. “If things go horribly wrong, I give you three days: one, to feel sorry for yourself, one, to get some exercise and clear your head and one more, to get on with your next startup,” Prof Bruce.
85. “Help your clients sell their products and services—find them customers and they will never forget you,” Prof Bruce.
86. “Turn selling into buying,” Trevor Wilkins.
87. “I am the world’s worst salesman, therefore, I must make it easy for people to buy,” Discount Retailer F. W. Woolworth.
88. “Always volunteer to write up the deal. He/she who holds the pen, wields the power,” Prof Bruce.
89. “Selling isn’t about taking advantage of people, it is about communicating and informing them,” Mark Cuban, Owner, Dallas Mavericks.
90. “Follow the fastest (least effort) route to revenue,” Sir Terence Matthews.
91. “Get close to your customer, early and often,” Sir Terence Matthews.
92. “Focus on your core competencies, outsource all the rest,” Prof Bruce.
93. “Bundle complementary services provided by others (even your competitors, it’s called co-opetition) into your business model: make money for nothing,” Prof Bruce.
94. “If you have a choice between using OPM or your own, I vote for OPM,” Prof Bruce.
95. “Understand that there is bad debt and good debt. Bad is unsecured and good is secured. The latter disappears when the underlying asset disappears, the former lives on long enough to ruin you,” Prof Bruce.
96. “Debt is usually cheaper than equity but bootstrap capital is almost always cheaper than both,” Prof Bruce
97. “The reason you build a brand is to build trust. The reason you want to build trust is to build sales which happens because, as it turns out, people want to buy from people they trust,” Prof Bruce.
98. “You trust your clients to pay you and they trust you to produce on time and on budget,” Prof Bruce.
99. “What’s more important in life: love or trust? It’s trust all the way. Think about it for a minute: what type of relationship would you have if you couldn’t trust your spouse?” Prof Bruce.
100. “Your suppliers trust you to pay them and you trust them to produce on time and on budget,” Prof Bruce.
101. ” The road to success is lined with many tempting parking spaces,” Robin Chahal.
102. “Do the little things right, and the big things will take care of themselves,” Prof Bruce.
103. “Try to do things right the first time and you will be amazed at how your productivity will jump,” Prof Bruce.
104. ” If you TPO (touch paper once), your personal productivity will double. Don’t procrastinate,” Joe Kowalski, Wilderness Tours.
105. “Never become an entrepreneur if the best you think you can do is produce the same value as if you took a JOB. With all the stress involved, stick with the JOB,” Prof Bruce.
106. “Get the Biz Model right so the harder you work, the more money you make,” Prof Bruce.
107. “Even Charities and Non-Profits need a biz model these days: people like to give money to efficient and effective organizations not those that burn up a ton of their money in admin and overhead,” Prof Bruce.
108. “We live in a cynical world and we work in a business of tough competitors,” Jerry Maguire.
109. “If your biz model is a good one, you will have competitors. If it’s a bad one, you won’t but so what, it’s a bad biz model,” Prof Bruce.
110. “Why do you think that petrol stations, hotels, restaurants, outdoor equipment suppliers, dress shops, home builders co-locate? Is it because they hate competition? No, it’s because they understand how to use co-opetition to their advantage and so should you,” Prof Bruce.
111. “Never drink and think,” Prof Bruce.
112. “The moral underpinnings of entrepreneurship and business are based on Adam Smith’s principal that your first duty to society is to ensure that you and your family do not become a burden on your fellow humans,” Prof Bruce.
113. “If your marketing plan says that all you need is a Super Bowl ad to get a launch client, you’re dead on arrival,” Prof Bruce.
114. “Don’t push on a string: there is no substitute for ’shoe leather’, face to face meetings and one-on-one phone calls to get your first launch clients,” Prof Bruce.
115. “Make sure you don’t fear success,” Prof Bruce.
116. “The best decisions you will ever make occur when your head, your heart and your gut all agree,” Prof Bruce.
117. “You cannot let fear stand in the way of realizing your dreams; if you do not believe a business will work for you – do not even bother pursuing it. At the end of the day, it is all about believing that you are the right person to launch the business and keep it running,” Kevin O’Leary.
118. “While there will always be projects and ventures that are best let go, perseverance, even in the face of adversity, tends to distinguish dreamers and managers from true entrepreneurs,” Rich Becker.
119. “Take advice from people who’ve done big things or what you’re hoping to do; don’t take advice from armchair executives or older people who just refer to “experience” in vague terms,” Tim Ferris.
120. “Under promise and over deliver to your customers, investors, employees, and yourselves,” Guy Kawasaki.
121. “For startups, SM is now crucial: it has never been cheaper and easier to reach one’s customers. Entrepreneurs should thank God for Twitter, Facebook, and MySpace,” Guy Kawasaki.
122. “Don’t kid yourself. Entrepreneurship is an absolutely brutal lifestyle that will demand everything you think you’ve got to give and more,” Geoff Livingston.
123. “Do or do not… there is no try,” Yoda.
124. “You can stand me up at the gates of hell but I won’t back down. No I won’t back down,” Tom Petty.
125. “Once you become an entrepreneur, it’s almost impossible to become an employee again—it’s a one-way journey,” Prof Bruce.
126. “Almost everything humans do is ultimately an act of faith despite all the analysis and debate,” Prof Bruce.

If you have any you would like to add, please use the comments section below.

Thanks, Prof Bruce

Here are ten things entrepreneurs can learn from him:

1. One controlling mind is needed. (If you have a partnership, make sure you agree, in advance, that one of you will have the final call on big decisions.)

2. Leadership counts. (JJ understands both big action scenes and small intimate moments, rare in film Directors. Demonstrated competence is key.)

3. Inspiration is important—high EQ counts at least as much as high IQ. (Can’t get along with colleagues, suppliers, peers, sub-ordinates, clients, direct reports, superiors, investors? You won’t get far in life. Abrams insisted on shooting the film using widescreen anamorphic lenses and hellated lighting—despite pressure to use digital cameras. Anamorphic lenses gave the film imperfections and a grittiness you cannot get from digital cameras. He persuaded the studio to back him on this and many other controversial steps he took to rescue the franchise.)

4. Keeping your cool under pressure matters. (Mastery of the Seven Deadly Sins (see: http://www.eqjournalblog.com/?p=32) including anger is important. If you can’t master yourself, you won’t others. Despite the pressures of a big budget film, a large cast and a huge audience of potential critics, Abrams kept his cool throughout production, another rarity amongst Directors.)

5. Putting round pegs in round holes… getting the most out of your team is paramount (so to speak). (Don’t ask your team members to go to Mars without providing them with a rocket ship. Abrams wanted to add more life to the film using light flares. These were produced using a simple device—manually shining flashlights into the lens at key intervals. Get in the trenches with your team and make it happen.)

6. Innovation is vital—magic is regularly pulled from a hat. (JJ used an old technique—he shot the space jump and the Kirk/Sulu fall from the Romulan platform with the actors standing on mirrors on a sunny day. The result—a realistic sense of the actors falling head first from the sky: cheap and effective. This is an important skill for successful entrepreneurs who are regularly called on to innovate in the face of ‘certain’ death of their enterprise.)

7. Doing things in the real world gives authenticity which people crave today. (Whenever possible, JJ shot the film on location instead of on a sound stage—initially thought to be 20/80, the released version of the film was shot 40% on location. This opened up the film and gave it an expansive, realistic feeling. He also used sets and puppets whenever possible instead of green screen. Zappos.com never requires their call centre staff to use scripts or hurry a customer off a call because of time constraints. Clients know, understand and appreciate the fact that they are talking to a real person who has real authority to deal with any issues that come up during or after a transaction. For a deeper sense of what the search for authenticity means in today’s world, read ‘Shop Class as Soulcraft: An Inquiry Into the Value of Work’ by Matthew B. Crawford whose journey from motorcycle mechanic to PhD to head of a high profile Think Tank and then back to motorcycle mechanic provides an interesting perspective on this.)

8. Youth and energy count for a lot. (JJ’s joy in the doing of the thing was contagious.)

9. Pursuit of excellence is widely recognized. (There is a market for things done very well. Design matters. Insanely great design matters even more.)

10. Human spirit and life force shine through. (Abrams shook the camera manually to give scenes a sense of random motion and extra drama. The strange frequency of his shaking came from inside him and produced an effect that could not be replicated by computer. People like to deal with empathetic people.)

Prof Bruce

I wrote the following article more than ten years ago. At that time, we made an effort to determine the rate of return on tertiary education, namely, the value of an architecture degree from Carleton University. Depending on our assumptions, we found that the IRR (Internal Rate of Return) was in the range of 9.2% to 14.4% p.a.

More recently, a Seattle-based company (PayScale) estimated that the 30-year return on investment for students graduating from US Colleges (they included more than 550 institutions in their sample) was 9% p.a., obviously similar in scale to the study we did from 1997 to 1998.

At the time, we were surprised to find that the IRR of education was significantly below student personal discount rates (typically more than 20% as students predictably value ‘a dollar today much more highly than a dollar received tomorrow’.) This finding would still appear to be as valid today as it was in 1999.

This has some important policy implications for governments, higher education institutions and parents: young people want to enroll in Colleges and Universities, at least in part, for non-financial reasons. After all, if their motivations were solely financial, they would follow their own imperatives and just get a paying JOB as soon as possible and not forgo significant wages for four or five years while attending University. For Carleton’s SOA, that wait in 1999 was even longer: five years for a B. Arch. and two years for a M. Arch. (Today, students can do it one year faster: four at the Undergrad level and two at the Master’s level.)

It is possible that students everywhere are deciding to attend university to obtain professional degrees in greater numbers, despite the disparity between their personal discount rates and the rate of return on tertiary education, because they fear that, without a higher degree, they will be left further behind as the divergence in incomes between those with university-level education and those with High School becomes more pronounced. They may also fear disruption in income in future years since joblessness in lower skilled occupations is generally higher and they are more subject to layoffs and other market changes such as increased competition from China and other developing nations in a more closely interconnected global economy. Of course, there are also the intangible returns from exercising one’s mind and talents to the greatest degree possible.

In any event, there appears to be no better predictive measure of the performance of a nation state’s economy than the proportion of the population with tertiary education. More persons with university-level education and more knowledge workers are important determinants of future prosperity, more so than, say, ownership of natural resources.

Here is the work we did and published in 1999:

Why Try to Measure the Value to an Individual of their Education?

To some observers, the value of tertiary education and, indeed, all levels of education cannot be truly measured. Education serves a wider social purpose and so the measure of its costs and benefits may be less important than the belief that education is a good thing. Thus, individual and social investment in education is, ultimately, an act of faith.

This is a view that the author subscribes to. The purpose of this paper, however, is to measure from a student’s point of view their perception of the value of their education. This is a factor in determining their participation in university programs. Education is an important national objective for almost all societies and it is generally agreed that there are significant externalities for society as a whole generated by increasing levels of participation in university programs. Therefore, it is important to determine the perception by students (and, by extension, their families) of the value of their education since this will, in part, determine enrollment levels.

Perception of Value

Students do have a sense of the value of their education. They have a sense of what they are gaining and losing during their university years.

Students in the Carleton School of Architecture come from all parts of Canada and they are joined by foreign students from overseas who make up a significant part of undergraduate enrollment (around 15%).

Students, in this non-scientific poll we conducted, are in their second, third and fourth years and typically range from 21 to 30 years of age. They are mature persons with firmly held beliefs. They are highly motivated individuals. Their sense of the value of their education is partly based on their perception of what they expect to earn as architects versus what they would have earned without their degrees. It is most often based on the difference between what they would have earned as an architect as compared to a technical position; they are, in most cases, not comparing their futures as architects with, say, a future as burger flippers.

Students generally have a quite accurate picture of their costs: tuition, extra travel, books and supplies. These are costs that they would not otherwise incur if they were in the work-a-day world instead of studying. They also have an understanding of how much they would earn if they were in a job instead of at school.

Further, the author has found that his students have a sense of their own personal discount rates. The author has measured this by administering a brief test. The students are asked to loan their professor (in theory only) a meaningful amount of money ($1,000) for a year. No interest payments are made. After 12 months, the students get their principal back with an interest kicker. How much does this ‘kicker’ have to be before the students will part with their money? The ‘kicker’ is raised in increments of $50. When students feel that the amount is high enough, they so indicate.

The results in our non-scientific poll suggest a student discount rate of about 23% per annum. Prima facie, this tends to make sense- students are not inclined to part with their money without the promise of a substantial return. Students and young people generally place a high value on cash in their jeans as opposed to a promise of future returns. One may assume that as they grow older, their personal discount rates may decrease somewhat but one can usefully conclude from this data that immediate gratification plays a significant role in the decisions taken by young people.

If the perceived rate of return on their education is found to be less than their personal discount rates, how do they justify their investment in their education? There is evidence in our data that a high percentage of students also place a non-monetary value on their education: just under 84% of the respondents indicated thusly. They feel that continuing their education provides them with other benefits such as expanded consciousness, quality of life improvements or less likelihood of periods of unemployment.

Also, we found that a greater use by students of OPM (other people’s money) in the form of student loans and parents’ funds leads to a greater willingness to enroll in the program. Student loans are interest free and require no principal payments while the student attends university. With a personal discount rate of 23%, the typical student looks at student loans as near to ‘free’ money. A student with a personal discount rate of 23% pa., who obtains $35,000 of student loans during a five year architecture program and begins repayment after graduation, places a present value on the student loans of just $12,432. The results of the survey suggest that few of the Carleton students surveyed would place a lifetime value on their degree of less than $12,500.

The Survey

The survey took place in calendar years 1997 and 1998. Eighty-five questionnaires were distributed to students by students in the Real Estate Development class. We received 58 responses.

The sample size of 58 is a significant proportion of the total number of undergraduate students enrolled in the program (292 in 1997/98). The 16 question survey was designed to measure the perceived value (from a student’s point of view) of an undergraduate degree in architecture for students enrolled in the Carleton University program.

Students were told that to help us in our research into the value of education, we needed to obtain a comparison between the ‘earnings of Architecture Graduates, with what they would otherwise earn…’. They were also told that we need to ‘ascertain what typical student costs are while at the University’. Students were assured of complete confidentiality.

Question 1 asked each student what they would be doing if they were not studying in the School of Architecture. Included in the multiple choice answers was ‘a) lying on a beach’. The purpose of this was to determine if respondents were expecting to engage in non-commercial activities during these years of their lives if they were not studying (only one respondent was in this category).

We also included a veracity test in the questionnaire. This test demonstrated that there was internal consistency in the survey results.

The survey did not include a question as to how much ‘free’ financial support was obtained by the students from parents or family or other sources. The survey attempted to measure only the amount of student loans. The thinking behind this was to treat money from parents or other family members as if it were the students’ own. In the event that they did not obtain this support for their studies, the assumption was that they would benefit from these funds in some other way (for example, by way of assistance in purchasing a first car or home). So the money expended was, in fact, theirs. Other researchers may wish to extend this work by taking the opposite view.

Q12 measured the amount of student loans each student has obtained or expected to obtain. 36 students out of 58 respondents obtained or expected to obtain a total of $33,143 in student loans by the time of graduation. The other 22 students either expected to have no student loans or did not respond. For the purposes of this calculation, we did not average down the results.

We first looked at the rate of return on investment in education on the basis of a student with no student loans (Case A). Each dollar invested in education was treated as equity, either cash in or money not received from employment. In Case B, we looked at a student profile based on binary decision tool- if students did receive student loans, the average amount was approximately $33,000 (or $6,629 per year on average for five years). This all or nothing (0 or 1) treatment of student loans means that, where student loans are incurred, the equity invested in education is reduced by $6,629 annually for each of the five years of the program. As we will see, the favorable financial terms of the Canadian student loan program increases the internal rate of return on equity of a university education when compared to students who do not participate in this government supported program. From the point of view of the student group, the rate of return is actually somewhere in between.

If family support was equivalent to student loans for the other non reporting students, then the Internal Rate of Return (IRR) of education is further boosted (see Case C). However, this could be construed as a bogus calculation since the ‘free’ money provided by family has an opportunity cost associated with it (at least, as far as the parents are concerned) and, indeed, may have an opportunity cost to the student as well if these are funds that they would otherwise obtain from their families for other purposes.

Methodology

We used the internal rate of return to measure the value of education. The IRR is the interest rate at which future earnings (the difference between earnings as an architect and earnings in alternative employment sans degree minus student loan repayments, if any) can be discounted to today’s value such that they are exactly equal to the investment in education discounted using the same interest rate. Investment in education was measured by adding tuition, travel, books and supplies costs to expected earnings lost from not being in full time alternative employment and deducting actual earnings from part time work.

Private sector firms target return on equity in the 14% to 22% range with most looking for 18% to 22% p.a. With discount rates this high, events that occur after 20 years tend to have a small impact on rates of return. In this example, we have used a rate of 12% p.a. to discount net benefits over the 20 to 39 year time period. The discounted value of additional earnings (in the amount of $474,400) was added to the net benefits of year 19. We used a 12% personal discount rate because we felt that it was compatible with the lowering of personal discount rates as people age.

Including earnings from the latter stages of a career had a significant impact on the rate of return on investment in education, as we will see in one of our sensitivity tests. Our model shows an increasing net benefit is derived from education as time passes; so despite substantial discounting, the later years have a significant impact on estimates of the value of education. It truly is a lifetime investment in human capital.

The Data

Tabulating our data from the survey yields average results as shown below for the costs (including opportunity costs) of attending the University in the Architecture Program.

Year Tuition Books, Supplies Travel Alternative Employment
1 $3230 $1740 $2221 $22217
2 $3424 $1482 $2283 $24400
3 $4061 $1472 $2018 $25712
4 $3994 $2105 $4530 $28584
5 $4325 $1981 $2409 $31271
6-20 nil nil nil $31271*
* We have assumed that lower skilled employment remains flat in constant dollars.

The average offsetting revenues (from part time work while attending university) and average salary expectations after graduation are shown below.

Year Part Time Salary Expectations Year Part Time Salary Expectations
Employment After Graduation*# Employment After Graduation*#
1 $5800 na 11 na $48402
2 $6374 na 12 na $52482
3 $6729 na 13 na $56562
4 $7004 na 14 na $60642
5 $8013 na 15 na $64722
6 na $29669 16 na $69334
7 na $33332 17 na $73947
8 na $36995 18 na $78559
9 na $40658 19 na $83172
10 na $44322 20 na $87784**
* The questionnaire asks for salary expectations upon graduation, after five years, ten years, 20 years and just before retirement. Interpolation is used for intervening years.
** An additional amount of $474,400 must be added; this represents the present value (discounted at 12% p.a.) of the difference between expected earnings as an architect and expected earnings in alternative employment in the ensuing 20 years.
# It should be emphasized that these figures are based on the students’ expectations of future salaries. Student expectations are based on what they expect to earn after graduation practicing not only in Canada but also in the USA and overseas where salaries are often higher. As we will see in the Results section below, rates of return based on these salary expectations are in the 13% range. To the extent that Canadian architects actually earn less, their rates of return on their investment in their education will be lower as well.

The Results

From the above data, it is possible to calculate the rate of return on a student’s investment in a degree in Architecture from Carleton University over their career.

For students with no student loans and with the above profile, their IRR is 13.4% per annum (Case A).

For students who have student loans at Carleton in the School of Architecture, their average amount of student loans (a mix of actual and expected numbers) is $33,143 upon graduation or an average of $6,629 per year of debt. Thus, we reduce their equity investment by this amount in years one to five and add principal and interest repayments after graduation. The average expected interest rate on these loans is 7.4% and the average time of repayment is nine years (this works out to annual payments of $5,002 for nine years).

The use of student loans increases student rates of return on their education to 14.4% (Case B).

If parents give students the money equal to student loans with no repayment expectations, the student’s IRR increases yet again to 16% (Case C).

If we restrict our analysis to 20 years and ignore the balance of their careers, IRR drops to just 9.2%.

If parents pay all tuition, books, supplies and travel costs, the student’s IRR is 16.1%. Our survey shows that there is a very close correlation between these hard costs (books, supplies, extra travel and tuition costs) and the total average amount of student loans. This raises the confidence we have in the survey results.

The author was somewhat surprised to find the IRR of education to be significantly below student personal discount rates. This finding has some important policy implications for governments, higher education institutions and parents.

There appears to be no better predictive measure of the performance of a nation state’s economy than the proportion of the population with tertiary education. More persons with university level education and more knowledge workers are important determinants of future prosperity, more so than, say, ownership of natural resources.

These facts are supported by the increasing divergence between the earnings of university educated persons and those without a college degree. The value of a degree is known by young people- the percentage of high school graduates enrolling in college has increased in the USA from 52% in 1970 to 66% today. We can hope that similar trends are occurring in Canada as well.

Has the increase in enrollment experienced in the USA occurred in the face of an IRR of education below personal discount rates there? One would suppose that the IRR of architecture education in the United States might be lower since tuition and other costs associated with attending university there are substantially higher than comparable Canadian universities. However, salaries for professionals also tend to be higher in the USA so we are unable to come to any kind of informed speculation about rates of return there.

It is also possible that students everywhere are deciding to attend university to obtain professional degrees in greater numbers because they fear that, without a higher degree, they will be left further behind as the divergence in incomes become more pronounced. They may also fear disruption in income in future years since joblessness in lower skilled occupations is generally higher

Certain countries appear to recognize the fact that students need encouragement to attend university. Australia and France make tertiary education available to qualified students who are citizens for free. Young people have very high personal discount rates- certainly higher than the IRRs shown here. They place a very high value on immediate gratification. They enjoy the benefits of immediate employment such as owning a car, living independently from parents and so forth. Anecdotally, males appear to have even higher personal discount rates and even less tolerance for a four or five year wait for a ‘real’ pay check. Perhaps that is, in part, why relatively fewer males and relatively more females are enrolling at universities.

In any event, there can be no doubt that investment in human capital has both individual benefits and significant externalities for society as a whole. The numbers suggest that parental and family financial support for university bound high school students is crucial to the decision making process of young people. Parents and governments have their responsibilities to extend support whether it is ‘free’ money, student loans, reasonable or zero cost tuition, bursaries and scholarships. By extending these initiatives, they are increasing the personal rate of return on education to something closer to the student’s personal discount rate. However, even with ‘free’ education, only those young people who are highly motivated and willing to defer gratification for a number of years will attend university- the determination to succeed still must come from within.

Letter to the Editor- Do the Data Sometimes Hide the Truth?

In an article I wrote last year for ORSA, I concluded that the rate of return on the investment students make in their degrees at Carleton’s School of Architecture was in the order of 14% p.a. What I found remarkable was that this was considerably less than their personal discount rates, which we estimated were in the vicinity of 24% p.a. This meant that students were enrolling because they were “other” directed and motivated.

This year, my students and I considered another possible explanation for this discrepancy. The scenario runs something like this- although only one student polled said that he/she would, if not enrolled at the School, spend their five years ‘lying on a beach’, it is possible that more of these young people would, in fact, while away this time in not very fruitful pursuits.

Students, when considering alternative employment, factor in, subconsciously, their education. Thus, their estimates of their earning power in alternative employment, as, for example, design/build contractors or renovators, are higher than what would actually have eventuated had they never attended the School. That is, they may have spent their late teen years and early adulthood (from 19 to 23) as, say, lift operators at Whistler, earning just enough to live and play.

If we change the model to conform with this view (i.e., their income earned in alternative employment would be equal to their actual part time student earnings) then, voila, the internal rate of return on their architecture degrees becomes 23% p.a., matching their personal discount rates to a fare-thee-well.

This might mean that the students have a better intuitive grasp of the economic fundamentals than the model, which we originally constructed.

Dr. Bruce M. Firestone, Adjunct Research Professor, School of Architecture, Carleton University, Ottawa, Canada. 1999.

On the for-profit side, we run real estate and mortgage brokerages and, on the not-for-profit side, we run an organization dedicated to furthering education, research, mentoring, early stage funding and incubating of startup enterprises. Most of what we do does not directly contribute to ’saving orphans in Africa’. I get this.

But I told her that when, say, a new pub opens that we helped with or a new tech venture gets off the ground that hatched out of our incubator, I do get a great feeling of pride; I am pleased that people who might not otherwise be working, now have a job. And indirectly, we are helping to save children since taxes paid by employees and owners and investors help Canada do its share of good works around the Globe.

And it also warms my heart when I get a note from a former student of mine like I did recently from Kanika Gupta who is directly working to make the world a better place for kids.

Here is Kanika’s report on her two-year old, not-for-profit organization, Nukoko:

“Hello Prof Bruce,

It was nice to see you at CASCO on Monday night.

Below is a short description of Nukoko and why our work is important.

To break the systemic cycle of poverty and inequality, Nukoko (a Canadian registered not-for-profit organization) works in west African villages (which have some of the lowest female school enrollment rates) to make primary education more accessible to girls. Through paying school fees, purchasing books and supplies, providing teachers with better resources, girls are now able to attend school, a fundamental right that their families could not otherwise afford.

A large part of the program is also conducted through outreach and awareness initiatives to educate parents and members of the villages about the importance of girls’ schooling.

Through the efforts of Nukoko and their partnering organization overseas, primary education is now accessible to over 500 girls in eight different villages in Togo, thus ensuring better future livelihoods for these girls and their families.

“If we fail to invest in girls, we not only harm them and their future children, we also squander a golden opportunity to reduce poverty, raise productivity, improve governance and advance global economic progress,” Plan International.

Nukoko, which means smile in a Togolese dialect, was founded by University of Ottawa Telfer School of Management graduate, Kanika Gupta, and has been in existence for two years. Being an entirely youth-run initiative with corporate supporters, Nukoko prides itself on ensuring that 100% of all individual donations go directly towards its projects overseas.

For more information, visit www.nukoko.org.

Kanika Gupta
Director, Nukoko
Tel: 613.983.3474 | kanika@nukoko.org | www.nukoko.org

Nukoko means smile in Togolese, and smiles are what we strive to bring to girls in Africa.

Celebrate the success of Nukoko and seek the opportunity to be the reason of a child’s educational accomplishments.”

Prof Bruce

ps. Trying to get your crew to buy in to the mission of your organization is very important. Most people want to belong to something bigger than themselves; when they have a feeling like that, it empowers everyone inside the enterprise, in the supply chain, in the customer base, even in the media and results can be astounding. Humans when they put their mind, body and soul into a thing can achieve greatness, alone and together*.

I am not sure if I was able to convince our young employee on this score and, to a degree, I think that comes from the general cynicism of our age. The modern sense of humor is based on put-downs, sarcasm, scorn, jaded negativity and general distrust.

It takes a lot of maturity to get past this and, until a person does, I can’t see how he or she can be a useful part of society.

I understand that bad things happen to good people and that there are bad people out there, maybe even a lot of them. But I have a theory that no society can have a ratio of bad people to good people much higher that 1:19 or civil society would be impossible.

If much more than 5% of the population decides that the laws of the nation don’t apply to them, civil society can not work. Most people obey the law, not because they are afraid not to, but because they have chosen to do so.

If someone decides to abrogate a contract, there isn’t much that most people can do about that since a lawyer and lawsuit are out of the price range for the vast majority of Canadians. So we enter into agreements on the basis of trust in each other.

If you are disappointed in business, life or love because 1 out of every 20 people you meet are scoundrels, that is not a reason to take up the mantel of the cynic. Just be more discriminatory: find the 19 good folks out there and just associate with them.

(*When I worked for the Senators, I would try to be in on the last interview for each prospective hire. Among other things, I would try to impress on them that working for a NHL team was not unlike work pretty much anywhere: 97% hard work, 3% glory. Maybe working with the Sens provided a bit more glory than, say, working for a life insurance company but still, putting on 42 events per year (home games) plus (hopefully) some playoff games, takes a lot of work. Malcolm Gladwell says it takes at least 10,000 hours to master a craft and, in my experience, it takes at least that long to build a great enterprise. Fitting in and contributing to the greater good of the organization where you work takes time too… and commitment.)

[Note: we also include (in one of the postscripts) a projection for the no. of Bond films that will be released between 2010 and 2100. See below.]

Well, we have a good data sample available to us which should permit some reasonable predictions to be made.

The first film, the pilot The Cage, was produced in 1966 (which we’ll call Year 1). Trekkers had to wait until 1979 for the next feature film, Star Trek, The Motion Picture. Thereafter, films were released quite regularly until a hiatus began in 2003.

In 2010, in what is now known as the franchise reboot, another film was released (the most commercially successful of them all). The next planned sequel release date is 2012.

So in all, we have a (nearly) 47 year history to draw on for our Star Trek Film Predictor.

A regression analysis of the data yields this equation:

No. of Star Trek Films Released = -1.2645 + 0.2941 x (Year – 1966 + 1).

This gives us the following predictions:

• By Star Date 2030: 18 films,
• By Star Date 2050: 24 films,
• By Star Date 2100: 38 films.

In graphical form, we have:

This type of analysis, apart from being fun for Trek fans, might also serve some useful commercial purpose by informing a studio about when it might release new films—at what intervals does it make sense to do that.

Obviously, they would have more sophisticated tools at their disposal such as revenue maximization and optimization programs that they can run. But given Hollywood’s terrible record of performance, I am not sure that anything more sophisticated actually works.

There are a lot of very smart people at work in the film industry and yet the bulk of their movies fail miserably. So some simple regressions and decisions that meet the three tests I have put forward for sound decision making (that your heart, gut and head must all agree) might be all you need.

Prof Bruce

Postscript: Oops, there is an error in the above analysis. I originally had the next sequel’s release date in the data stream as 2013 (instead of the expected 2012). But given that anything can happen in life, I did not correct for this discrepancy (which may not turn out to be a discrepancy at all). So there is an inconsistency between the graphical form shown above and the spreadsheet with the data and analysis in it plus an inconsistency in the spreadsheet itself. I posted the spreadsheet at: http://www.eqjournalblog.com/StarTrekFilmPredictor.xls

Anyone keen enough can correct for this error.

It could be argued as well that 2012 should not be included in the data sample at all since it has not yet happened.

In any event, the error is small and unlikely to have much impact on the predictions made here.

Postscript 2: Here are the films released (or soon to be) so far:

Star Date Year # of Films Title
1966 1 1 The Cage
1979 14 2 The Motion Picture
1981 17 3 The Wrath of Khan
1984 19 4 The Search for Spock
1986 21 5 The Voyage Home
1990 25 6 The Final Frontier
1992 27 7 The Undiscovered Country
1995 30 8 Generations
1997 32 9 First Contact
1999 34 10 Insurrection
2003 38 11 Nemesis
2010 45 12 Star Trek (Reboot)
2012 47 13 (Sequel)

Postscript 3: How about a prediction for James Bond films, another open-ended series? Well here it is:

As you can see, according to these calculations, there should be 35 films (up from 24 as of 2010) by 2030 and a whopping 66 by 2100!

The data and regression analysis are posted at: http://www.eqjournalblog.com/JamesBond2.xls.

As a response to the toughening of mortgage rules in North America and the collapse of individual credit ratings, more people, who want to fully participate in their national economies as homeowners, are going to turn to Lease-to-Own opportunities. On the surface this looks attractive to both investors and to renters.

For investors, they:

a. acquire properties at advantageous prices in this housing downturn;
b. land great, long term tenants who are just as committed (or more so) to maintaining and upgrading the properties they inhabit;
c. have locked in, guaranteed returns because they know the price at which they are going to sell and to whom;
d. benefit from real estate inflation, forced savings (paydown of the mortgage by their Tenants) and superior cash on cash returns as renters pay all costs associated with the properties (mortgage payments, realty taxes, maintenance, utilities, insurance and condo fees (if any);
e. have even higher cashflow because Tenants also pay a monthly amount over and above their rent which goes toward their downpayment when they complete their purchase and sale agreement;
f. may receive a downpayment when they sign a Lease-to-Own agreement with their Tenant which in turn may lower the equity they need to put into the transaction in the first place.

For Tenants, they:

a. have security of tenure;
b. have time to rehabilitate their credit ratings;
c. are making monthly payments, some of which will eventually be used as their downpayment;
d. have a locked in price for the purchase of their home—so that real estate values don’t run away from their ability to buy at some future point in time.

But for a Canadian like me with Canadian sensibilities about fairness and equity, all is not rosy for would-be home owners in a Lease-to-Own program. When I looked at typical agreements of this type, I found them to be heavily weighted in favour of the investor.

In a typical residential lease, the Landlord will pay property taxes, most maintenance, insurance, condo fees and even some utilities. In a Lease-To-Own scenario, the Tenant will probably be paying all of these costs.

In addition, the monthly payment that the Tenant makes over and above this which will eventually go towards their downpayment may be non-refundable and bear no interest. That means that if the Tenant can not complete the transaction (say, perhaps because they have to move to another city due to a job-related move or their credit rating has not bounced back enough) then they could lose their option fee.

So would a renter be better off paying lower costs on a monthly basis and simply putting away the difference in his or her own savings account, to be held for a future home purchase? The answer is maybe; it depends on the Tenant’s discipline. The problem I see is that most people, when they look at a juicy savings account, can almost always find another use for those funds: their car/PC/music player is getting old and my, doesn’t that Caribbean resort look nice.

In a typical commercial transaction, if you option a property at a fixed price to be paid at some point in the future, you know you won’t get your money back if you don’t close. You are paying for the privilege of buying at a price determined in advance. (If you do close, most option fees are credited to the purchase price on completion. Remember, in entrepreneurship, there are no rules—you get what you negotiate not what you deserve.)

But we are assuming that there is some equality in negotiating positions between the parties, hardly the case in most residential Lease-To-Own discussions. (The latest one I am working on involves a woman who is a single mom with six kids.)

So when I looked more closely at these things, what I found is that the investors benefit from most of the real estate inflation during the Lease-to-Own period, all the cashflow and all the mortgage paydown. This doesn’t seem fair.

So I redesigned the program and did a new spreadsheet that I think addresses these equity issues.

You can download it in .xls format from: http://www.eqjournalblog.com/LeaseToOwnSample.xls.

The property is located at: 124A Main Street, Anywhere. It was originally bought by the investors for $275,000. They are now in the process of selling it to their Tenant for $325,000. They estimate it will take six years for the Tenant to put together enough money for the downpayment by way of their monthly option fee paid to the investors as a form of forced savings. It will also take that long for the Tenant’s credit rating to rise to the estimated minimum 630 Beacon Score they will need to qualify for a conventional mortgage.

In this example, the Tenant is not able to put a downpayment on execution of their Lease-to-Own Agreement—which is usually standard in these sorts of deals.

What my model does is:

• Buyer gets all increase in value of property (over and above agreed purchase price).
• Buyer gets credit for portion of principal paydown.
• Seller gets option fee, increased cashflow.
• Seller gets option fee exactly equal to estimated increase in property value per year.
• Buyer gets no interest on option fee paid to Seller.
• Buyer has the option to assign the Agreement.
• Agreement is registered on title to protect the interests of the Buyer.
• Buyer also has option to convert this to a share of the equity on maturity: 35.3%.

The equities I addressed above include—the Tenant (aka the Buyer) can assign his or her Agreement. So if they get in trouble during the term of this Agreement, they can bail and hopefully recover their monies (deposit, if any, and option fees). Alternatively, I provided for another exit—they can turn their deposit and option fees into a piece of the equity at any time.

This has some salutary effects for the Tenant and the investors. The investors never have to cut a cheque back to the Tenant—they simply agree (at the outset and in the contract) to allow this conversion to take effect. My calculations for this example show the Tenant is eligible for just over a third of the equity after six years. But remember, everything is a negotiation—it could be higher or lower, depending on how good a negotiator you are.

For the Tenants, if life happens and they can’t close, at least they have a stake in real property which will yield value for them when the investor group (now including themselves) sells the home.

In my model, the Tenants (who by way of their monthly payments are contributing to the mortgage paydown) also benefit from that. I simply averaged their ‘ownership’ position over the six year agreement and made a determination based on that. (Their ownership position is somewhat overstated because I didn’t add their annual contributions in terms of their option fees paid to the original capital base of the investors so there is some bias in this model towards the Tenants. I leave it to the reader to make their own judgments and ‘fix’ this if they are so inclined. I calculated the actual conversion to equity on maturity exactly at 35.3%.)

I also added that their Lease-to-Own Agreement could be registered on title; this serves to protect Tenant interests. Unscrupulous investors will not (easily) be able to sell the property out from under the Tenant. In Ontario, leaseholders have a right to title superior to fee simple ownership. So, as long as they meet their obligations, Tenants can expect quiet enjoyment of their property and to benefit according to the provisions of their Lease-to-Own Agreement.

These things are much trickier to do than one might have thought and, since there is no regulation at all in this field, it is caveat emptor. Having said this, perhaps this post will help others explore the issues in a more thoughtful manner and arrive at an arrangement that is fairer to all parties. At least, that’s my hope.

Prof Bruce

Just when we think experts have a thing figured out, new evidence appears that upsets accepted wisdom.

Here is my Venn Diagram on the subject:

A true expert recognizes that application of the scientific method requires that he or she be ready to change conclusions as new evidence becomes available.

Business ecology is nearly as complex and every startup is an experiment until proven otherwise. That is why most market research can not predict success or failure; products must be tested in the real world.

Prof Bruce

Postscript: GMR (Guerrilla Market Research) has some hope of duplicating RL (Real Life). GM Research means that you basically convince subjects that they are making real world decisions.

For example, the software industry will sometimes announce release of a product that does not yet exist (vaporware) to make ‘the phone ring’ and gauge a market’s size and determine the price elasticity of demand for it.

We used this technique years ago: before we launched TCCL (Terrace Corporate Centres Ltd., a mini office provider) we ran ads in a local newspaper. People who called the number we provided were leaving messages (literally) on an answering machine stashed in a cupboard. We got a lot of calls and this helped us determine: a) that a market was there for this type of service, b) what price point people were prepared to accept and c) how to effectively reach our audience.

Unless you uncover a ‘magic marketing button’ that cost effectively connects your enterprise with potential customers, your business is dead. Using GMR, we solved all three problems including, perhaps most importantly, the latter.

The ethics of using GMR, like GM itself, is something that each entrepreneur must wrestle with himself or herself.