Business Buying Techniques: “The Back Door”

The battle cry of investing is “Reduce risk while at the same time increase the yield.”  This is the game that people with money to invest try to do everyday.  In the end it is difficult if not impossible to measure risk, so many decisions are made based on emotions or feelings about an investment or stock.

One of your friends, comes to you with a new business start up

Joe (your friend) tells you that the profit potential is a return of 100 times your investment.  You ask Joe “what is the probability of success or failure.”  Joe does not have a clue how to answer that.  Joe has hatched this idea and it is all encompassing in his life.  Joe thinks it is a sure thing.  If he didn’t think that way he would not be risking his home, marriage and his children’s future on it.  You look at Joe’s determination and you come to the conclusion that with that level of commitment it must be a sure thing.

You think “No one would risk their whole financial future if they had not covered every angle of this venture.”  So you invest.  You did not check out the viability of the deal yourself, but relied on others to have done their homework.  This is not the way to go.  In truth most everyone, except the very successful in life, do any real checking themselves.  They ask or hire experts to do their risk review, but the real risk is your money not theirs.

I never understood why stock market investors ask their stockbrokers advice on stocks.  The stockbroker is a salesman not an analyst.  The analyst at the brokerage does reports but they are given to millions of people and are for long term investing not short term.

We upper middle class investors need a sure proof method of making sure we do not make those major mistakes in our lives that wipe out 10 years of savings, or takes our retirement fund and cuts it in half.

When I was 24 years old and lost my life’s savings, which was substantial for my age, I was devastated.  My father complained I had lost his money—because he had been paying me a salary since I was 13 years old working in the family business.  My girlfriend’s parents told me that I was young and had time to make the money again.  This is all true but that doesn’t reduce the pain that I had worked years for that money.

In the 15 years to follow I continued to make both right and wrong decisions.  I found that the right decisions were because I used my head and the wrong decisions were because I used my heart.  Then in 1990 I was going to build a condo project.  If I were right it would mean that I would make millions and if I were wrong it would put the nail in my financial coffin.  The dilemma was that the real estate market was at its peak and showed some signs of breaking.  (I had been burned before when doing real estate development deals when the market was turning downwards and it was ugly.)  I was ready to break ground on construction and I had to make a go or no go decision.

In a situation like I am describing it was more important not to make a mistake then it was to be right.  If I was wrong, I had to be alive to fight the next battle.  If you are wiped out the game is over.

This is where I developed my risk avoidance program, which has served me well.  I have noticed 20 years later in 2010 that when I look at big mistakes made since 1990, I failed to use my technique.  I assumed nothing could go wrong, even though in my heart I knew they might.  The deadly enemy is using your heart to make decisions instead of your head.  These techniques are to help you use your head, but it only works if you use it.

It has two variations to it.  You should not switch the techniques.  Each one is for a specific purpose and does not work well if you use it for the purpose it was not intended.

The first is for the businessman who is starting a venture or expanding into a new territory of business.  This technique I call the “Back door.”  The other is for the passive investor who is looking to put his money in an investment and does not intent to be involved.  This technique is called the “What if?”  Both are simple to do but I have found that many people would not use them because the technique results did not agree with what the heart kept telling them to do.  Business and investment decisions based on the heart are very high risk indeed.

What if I am Wrong?

If you looked at this with each and every investment, you would find your whole investment philosophy would change.  Let me give you some real life examples.

Moshe had borrowed $15,000 from an equity line of credit on his house.  He invested all the money in the stock market in the hope that it would go up.  The market had been going up for 15 years during the Ronald Regan administration and there were indications that the top of the market was near.  When Moshe and I met he asked my opinion of the real estate market, he did not ask my opinion of the stock market.  I personally felt that the market was going to drop in the near future.  Of course I could be wrong, and have been many times.

I suggested to Moshe he sell his stocks, pay off his line of credit and keep working.

Moshe wanted to make a big profit in the market.  I asked Moshe the following questions.  “Moshe, you think the market is going up, and I think it is going down. What are the odds in each of our favor of being right or wrong?”  He agreed that the odds were 50/50 at any specific time.  I then asked, “If you are wrong can you afford the loss?”  He said absolutely no.  He could not afford for the stock to go down and he lose money.  I then suggested, “If you can not afford to lose, do not play the game. Your odds of winning are only 50% and you can not afford to be wrong, which has a 50% probability.”  He did not want to look at the truth of my statement and would not sell the stock.  I know the market crashed one year later.  I do not know if he was in or out when that occurred.

If you can afford to lose, you can afford to ride out your mistakes until they turn back into a profit.  If you cannot afford to lose, then you cannot afford to play.  It is at those times when you are playing a game you can not afford to lose that you almost guarantee you will lose.  This is because the market will go with you sometimes and against you other times, but if you get thrown out of the game when you are losing you are not in the game when it goes the other direction.

At the moment I am writing this two of my close friends are involved with a company called DieselTEK. This is a small non public company that after years of trying to raise money has received a very large purchase order that will allow them to now raise funds.  One of my friends is the controller of the company.  He believes the returns will be over 100 times the investment.  That means that for every $1,000 invested he thinks the stock will increase 100 times in value.  I was thinking of buying some stock.  (In the past I have had very bad luck with stocks even when I had “inside information.”  I am now looking closely at not at what I can make-enough to retire, but at how would my life be changed if the company failed and I lost the whole investment.  If I pass the “what if it fails” test then I will buy some of the stock, and only the amount I can afford to lose.

Think this out. Try it on your current portfolio and see if it changes the way you look at investing your money.  Email me what you find out, I am very interested in hearing from you.

Back Door

My father in law is a long time fireman in the LA Fire Department.  When there is a big fire in a building the fireman always look for the back door into and out of a building.  If one exit is blocked they want to know there is another way out of the building.  One of the big problems with skyscrapers is there is no back door in them.  If there is a towering inferno, how do you get out of the building?  When the planes hit the Twin Towers on 9/11, the lower floors walked down the stairs and left the building.  The people on the upper floors had no way out of the building.  They either burned to death or jumped out of the windows to their death.  Over 3000 people died because there was no back door to escape in those two buildings.

That is how it got its name, “the back door.”  I guarantee you that if you looked at every major and many of your minor financial decisions this way, you would look at the world much differently.

Lets go back to 1990 when I was ready to break ground on the condo construction

My goal was to build and sell the condos.  I looked for a back door and found it.  If I rented the building and let the construction loan automatically turn into a permanent loan my negative cash flow would be $1,000 per month.  I decided that I could afford $1,000 per month for the 10 years necessary for the real estate market to recover.  With that decided, I moved forward with the project.  The week I received my final sign off from the building department the real estate market crashed.

I quickly rented the building and my back door became the only door.  I still own that building today.  I almost lost my residence in the down turn but the mortgage on that building was never late.  I supported a negative cash flow on that building for 7 years before it became a positive cash flow.  I have never had one sleepless night because of that building.  Yes I had many sleepless nights because of other activities but not this one.

There is a second part to this story

Bruce, a friend of mine had bought up a block of apartment buildings in Brentwood.  He was working on building Brentwood’s premier condos.  I had heard that he was close to starting construction.  My building was half completed at this time.  I called Bruce and suggested we go to lunch.  The market was looking shaky.  I asked Bruce what he thought of the market and of his chances of success.  He was optimistic, while I was pessimistic.

I asked him if he had a back door

He asked me what I was talking about.  I of course explained the whole concept to him.  He responded, “I have no back door.”  I was shocked.  I asked if he could rent them and keep them.  He responded, “No, I can not get enough rent to cover the debt service.”  I suggested he not move forward with the project because he could lose everything.  Bruce explained the construction loan was in place and he had to proceed.  I could not stop him.  Two years later my building is rented and the bank is foreclosing on him.  I do not know who finished the project but he and his investors were all wiped out.  He also disappeared off the face of the earth, never to be seen again.  I never understood how he could move forward when the odds were so stacked against him.  He must have been blinded by the profit potential and since it was not his money in the project he did not think failure was an option.

This is new way for us to live our lives.  When you go into a movie theater, all the exits are clearly marked so you know every way out of that theater in case of a fire.  In hotels on the back of the doors is a map of all the staircases going out of the building.  There is a real feeling of comfort in knowing you have a ways to get out of trouble, if it occurs.  I have found that when I am prepared for an emergency the emergency never happens.  The reason it is called an emergency is because no preparation for it was taken ahead of time.  With preparation we only have game plan changes no emergencies.  Life is much more comfortable when you do not wake up and find the world has thrown you another fast curve when you only know how to hit slow balls.  I found my blood pressure stays down, my health is much better and I sleep much better, when I know all of the exit strategies out of any building and out of any business activity.

What is your back door for each of your business ventures?  Too many people use the ultimate back door, when things go really wrong.  They drop dead and let it become someone else’s problem.

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