Four Types of Business Leverage To Build Wealth

This is the last part of my two-part series on the mental models behind wealth creation and effective long-term decision-making. In it, I will discuss:

1)        The Marvels of Compounding

2)        Four Types of Business Leverage To Build Wealth [This Post]

Let’s dive into part 2…

How I thought about wealth creation:

A 2023 article on HR Dive breaks down the compensation of Jamie Dimon, the CEO of JP Morgan Chase:

“…the CEO’s salary shows $1.5 million in base salary and $34.5 million in performance-based variable incentive compensation — $5 million of which will be in cash and the rest in stock.”

I want to point out two things:

1)        JP Morgan can afford to pay its CEO $36 million in total compensation with its $48 billion profit. Dimon’s compensation represents 0.075% of JP Morgan’s profits. That percentage is less than what most small and medium-sized businesses compensate their CEOs with.

2)        Dimon received $29.5 million in JP Morgan stock. The value of the stocks will continue to compound over the years as the bank grows its profits.

The larger the ship you steer, the larger the compensation you can reinvest and grow through compound interest.

Because of my background in finance, I used to think that wealth creation are results of two conditions that reinforce each other over time: compound interest and carried interest.

Or more specifically, carried interest, compounded over time.

We covered compound interest in the previous blog post. It’s exponential (non-linear) growth due to reinvestment of earnings at a given rate.

In finance, carried interest is a synonym for performance fee. It is the share of profits from a given investment paid to an investment manager.

Carried interest typically occurs within the context of an investment fund. My definition included all companies that compensate their management with a percentage of revenues or profits. (I use the words management and operator interchangeably.)

But the way I thought about wealth creation was incomplete.

Building wealth involves being a surplus producer of something. You must produce more than enough to sustain yourself and your team.

You can’t accumulate wealth by being a farmer who can only produce enough crops and dairy to feed his immediate family.

Surplus production is a function of leverage, and leverage helps explain how wealth is built.

How I currently think about wealth creation:

To build wealth, you need to own assets.

The Oxford Dictionary defines an asset as, “any item owned…by a firm or individual which has an economic, commercial, or exchangeable value.”

The definition of an asset is broad, and there are various types of assets.

Broadly speaking you can categorize assets into real assets, and capital assets.

Real assets are physical assets such as real estate, natural resources, and commodities.

Capital assets contribute to a business’s ability to generate profits.

They are longer-term assets used in business operations.

A capital asset has intrinsic value because it can generate output.

Its value is based on the cash it can generate over its useful life in today’s (risk-adjusted) value.

People combine real assets in unique ways (i.e., technology) with capital assets to produce goods and services.  

Assets produce wealth, and leverage can help explain how to generate and accumulate assets.

The four types of leverage:

Four types of leverage help explain the levers used to build a valuable asset.

My thinking on leverage is influenced by Naval Ravikant. Alex Hormozi expanded on and further popularized Naval's ideas on leverage.

In this post, I’ll attempt to further expand on their work.

Leverage is a relationship between outputs and inputs. It is a multiplier on effort.

Leverage allows you to create asymmetries between inputs and outputs. With leverage, outputs far exceed inputs.

In physics, we use levers to gain mechanical advantage (the amplification of force achieved by a tool) to easily move heavy objects.

There are various forms of leverage in all human endeavors. Leverage results in significant progress within a relatively short period of time.

The four types of leverage used in business are labor, capital, media, and code.

Let’s dig deeper into each component of leverage.

1)        Labor

Labor is the oldest form of leverage.

It is how things got done since the beginning of humanity and how civilizations were built.

Labor refers to the people who work together to achieve a common goal.

Naval argues that it is the least efficient form of leverage in the modern world. It requires other people’s permission, and managing labor is messy and harder to scale.

Three factors determine how effective labor can be. These are division of labor, tools, and judgment.

i.                         Division of labor

Division of labor allows people to increase their output using specialization and separating tasks.

Adam Smith, dubbed ‘The Father of Economics,’ popularized the concept of division of labor as a necessary component to creating wealth in a free market economy.

He lays out these ideas in his book, An Inquiry into the Nature and Causes of the Wealth of Nations.  

Smith shows how people can multiply their productivity by focusing solely on one task.

With the division of labor, humanity can produce more and better things. Doing everything yourself and trying to be self-sufficient does the opposite.

Smith uses the example of a pin factory to demonstrate this phenomenon.

If each worker in a pin factory were to complete every step of making a pin, each person might produce only a few dozen pins per day.

He then showed what would happen if the process was broken down into 18 distinct tasks, with each worker focusing on a single task.

The result: a group of ten workers produced a total of over 48,000 pins in a day.

The multiplication in output per worker demonstrates the effects of the division of labor.

The modern assembly line is based on the concept of the division of labor.

ii.                       Tools

People can build tools to magnify human effort.

Mechanical leverage wouldn’t be possible without the right tools.

Tools vary in size and complexity. They have developed over centuries to help people build the modern world.

The earliest tools were hand tools that helped extend a person's physical influence. These tools were made from wood and stone and later metal.

Machine tools emerged during the 18th and 19th centuries to handle the more complex equipment of the Industrial Revolution.

The tools of the 21st century went beyond amplifying our physical strengths.

Steve Jobs built iconic computers because he saw them as tools that could extend our mental capabilities.

Human-made tools are designed to amplify specific human capabilities, physical and otherwise.

For example, levers, engines, and motors amplify our strength and power.

Ladders and prosthetics extend human reach and accessibility.

Computers, telephones, and software extend our ability to communicate and assimilate information.

On the other hand, microscopes, telescopes, and diagnostic tools extend our sensory capabilities. 

These tools leverage our inherent capabilities, allowing us as a species to generate outputs that far exceed our inputs.

For a more comprehensive list of the human capabilities that tools amplify, refer to Appendix 1.

iii.                     Judgement

Human judgment and knowledge is a significant lever that labor can use.

The key to more leverage is earning with your mind. Trying to earn with your time or physical capabilities is more likely to result in balanced input-to-output relationships.

Minor improvements in judgment, creativity, and abstract thinking can lead to big improvements in outcomes depending on the problem they are applied to.

An incremental improvement in good judgment can yield significant results. If decisions improve from 51% to 52%, a benefit would be large for a $3+ trillion company like Apple.

If you can show good judgment over a long time horizon, labor and capital will likely find you.

That is because your superior judgment will result in asymmetric outcomes.

People seek out asymmetric outcomes in their lives and in their wealth.

According to Naval, the definition of judgment is applied wisdom.

I see wisdom as a combination of knowledge, experience, and an understanding of the long-term consequences of things.

This doesn’t only include the first set of consequences of an event or action. It also includes second and third-order consequences.

Judgment and the concept of experience curves taught in economics are related. Experience curves show how increases in production volumes lead to lower unit costs. As people produce more, they become more efficient at their tasks, leading to higher-quality output. They can also produce things faster. The experience curve suggests that people learn by doing and can improve processes over time.

Wisdom is knowing the many ways the dominos could fall, while knowing that unknown variables need to be accounted for.

Human judgment involves multiple dimensions:

·        Understanding the known options and predicting the consequences of each

·        Applying knowledge and information to specific situations

·        ‘Out of the box’ creative problem-solving

·        Making balanced decisions through appropriating weighting of inputs

·        Identifying risks and their respective mitigants

·        Awareness of social dynamics and human psychology

·        Awareness of self, including biases, capabilities, and limitations

·        Moral, ethical, and emotional considerations

Good judgment is not something that anyone can simply learn.

It takes time, experience, a healthy mind, and good character to be able to make good decisions that can stand the test of time.

Overall, labor as leverage is the most difficult to acquire and apply well.

Skillsets needed: Management and leadership

Permission: Required

Level of leverage: Low

2)        Capital

Capital is the financial and physical resources used to produce value or act as a means of exchange.

When someone raises capital to build a company, they're trying to use other people’s financial resources to produce economic value.

Ideally, the entrepreneur allocates these financial resources optimally.

The entrepreneur can use the cash to spend on labor, equipment, inventory, and anything else needed to build a valuable company.

There are several reasons why raising capital may be necessary.

Building a business in capital and R&D-intensive sectors is nearly impossible without raising capital.

Examples of such sectors include utilities, manufacturing, and telecommunications.

Also, building and growing a company would take much longer without funding. This can be an issue in emerging industries where there is a race for market share.

Capital as a means of business leverage can be divided into two broad categories: equity and debt. Other forms of capital can be derived from either of the two.

i.                         Equity

Equity is the owners’ interest in an asset.

When investors fund a company, they exchange cash for ownership (equity).

Ownership entitles owners to a certain level of control and financial reward. 

Leverage through capital takes place when the entrepreneur’s compensation is:

·        a function of the capital base (like with sweat equity where shares are given to the operator), or

·        a function of the profits generated (like with a profit share agreement where the operator receives a percentage of profit or revenue).

Because of this, an entrepreneur’s (or operator's) compensation grows with the size of the capital raised.

This is a great situation to be in if you are a capable steward of capital since the upside gain can be enormous.

Note: Managing a large sum of capital requires excellent judgment, good character, and a strong sense of fiduciary duty.

ii.                       Debt

You can also raise capital through debt.

A business can raise funds to start a company without giving up ownership.

Instead, they give up their souls (just joking, but not entirely).

Since debt is a loan, the borrowed amount must be repaid to the lender, with interest. That also means that the cost to borrow money is predetermined.

Anything the business earns after paying off interest belongs to the shareholders.

The value of the firm’s assets after subtracting debt belongs to the shareholders.

However, there are risks involved with taking on debt.

In the event of a default*, lenders can force bankruptcy, seize assets, or take control of the company.

Debt capital is regularly used to acquire resources beyond the capacity of any single individual, company, or entity.

This is a frequent phenomenon in the acquisition of companies.

According to a McKinsey & Co. report, private equity buyout funds had almost $3.3 trillion of assets under management (AUM) as of June 2022. These funds focus on buying companies using debt, improving operations, and selling the business for a profit.

Debt is an attractive form of leverage because it has the potential to enhance returns to investors.

In the example below, a company examines the effects of taking out debt. The debt scenario assumes the company borrows the equivalent of 50% of the value of its total assets.

Because of interest expense, its earnings are reduced from $20m to $15.75m.

The capital shareholders need to keep in the business has been cut in half from $85m to $42.5m. Because of this, the return on their equity has increased from 24% to 37%.

An investor (or operator) can benefit from debt as financial leverage in two ways:

·        Through equity ownership. Debt can enhance returns because of financial leverage.

·        Through carried interest. This is a percentage of profits generated by a company. Acquiring the company would have been out of reach for the investor (operator) without the use of debt.

A word of caution:

Any type of leverage works like a double-edged sword.

This especially applies to debt (financial leverage), which typically comes with tight restrictions.

These restrictions mean that financial performance cannot deviate from the lenders' expectations. Any deviation can result in financial ruin.

iii.                     Hybrid and derivative securities

Hybrid and derivative securities combine features and characteristics of both equity and debt.

Employee Stock Options (ESO) is a form of derivative security that is commonly used as compensation in North America.

ESOs give employees the right to purchase a share of equity at a given price and within a specified period of time. Even if the stock price increases, employees can still purchase the shares at the original ESO price.

Employees can profit from the difference between the discounted price they can buy the shares for and the current market price of the shares.

ESOs are more often used in cash-poor start-ups and venture-backed companies which need to attract top talent. The possibility of a large payout has drawn many talented individuals to these companies.

Many of Nvidia's employees have reportedly become millionaires through ESOs after shares grew by 34 times since 2018.

Overall, capital as leverage is moderately difficult to acquire and apply well.

Skillsets needed: Finance, sales

Permission: Required

Level of leverage: Medium to high

3)        Media

Media refers to the tools and channels used to share information as well as the content that is being shared.

Media has existed for as long as humans have been around.

It has evolved from painting on cave walls to writing on tablets, leather, and paper.

Advancements in communication technology have expanded the reach of content through radio, television, and the internet.

The internet has given rise to media platforms like YouTube. These platforms allow anyone with internet access the ability to create and share content with a global audience.

This new type of media has enabled the democratization of content creation because of two unique qualities.

It has also transformed how we present ourselves (personal branding) and how we conduct business (digital commerce).

i.               Two unique qualities of New Media

The two unique qualities of new media are that they incur no additional cost of replication and that they require no permission to use. Let me explain.

Naval calls the newer forms of media “products with no marginal cost of replication.”

This means that the content creator only incurs a one-time cost when creating the content. They can then distribute that content widely without incurring additional costs.

Creating a YouTube video costs time and energy (and potentially money, depending on the production quality).

But that cost only needs to be incurred once.

The video can then be distributed to millions of people, making the cost per view negligible.

Hundreds of years ago, anyone who wanted to share an idea would have to write a book, which took months or even years. The author could only publish a limited number of books since the cost of creating each book was high.

Media before analog and digital communication was costly and had a much lower reach.

New media requires no permission to use; anyone with internet access can create and share content through social media platforms.

Traditionally, gatekeepers, such as publishers, television networks, and radio stations, controlled what content could be produced and distributed. They decided who got access to platforms, what stories were told, and who's voices were heard.

With new media, there are no gatekeepers. Content creators no longer need approval from traditional institutions to share content.

ii.               Personal Brand

New media has created unique opportunities for individuals to establish themselves as influential figures at little cost.

This is evident in the rise of influencers—people with a social media presence who can influence the buying habits and behaviors of others.

People become influencers after having gained credibility around a niche, subject, or message. This is typically done through regular content creation on social media.

Content creators can use their platform to tell stories, share expertise, and build a community. They ultimately gain the trust and attention of an audience who 'follow' them on social media.

You can also shorten the time it takes for a critical mass of people to trust your judgment using media.

Building a strong personal brand has multiple benefits.

People with strong personal brands attract more opportunities: they are more visible to employers, potential customers, and collaborators.

They also tend to have a higher earning potential and more opportunities to capitalize on their expertise than others.

There are many people who have built powerful personal brands which have turned into lucrative careers.

Gary Vaynerchuk leveraged his social media and entrepreneurship expertise to build a media empire. He has capitalized on his personal brand through speaking engagements, books, and other deals.

Logan Paul and KSI leveraged their massive social media audience to launch PRIME, an energy drink brand that reportedly achieved $250 million during its first operating year.

Mr. Beast used his large audience of over 300 million followers to launch Feastables, a chocolate brand, which reportedly sold over $10 million worth of chocolate bars within the first few months after launching.

iii.               Digital Commerce

The internet has changed how we do business.

The most powerful changes revolve around marketing and branding.  

Digital communication methods like social media, email, blogs, and podcasts have allowed businesses to directly and regularly interact with customers on a large scale.

The result?

A more meritocratic playing field, powered by new media.

Because anyone can create and distribute content, the best ideas and products can win customers' hearts (and dollars).

Historically, big companies could outbid their better (but smaller) competitors.

Their large advertising budgets would be spent on one-way ad channels like TV, radio, or print media. You didn't need to do more than that to crowd out viable competitors from the minds of consumers.

The most significant way the internet has changed commerce is by revolutionizing the sales funnel.

People and businesses can quickly and cheaply create content, direct internet traffic to their online stores, and track customer purchasing behavior—all while regularly communicating with those customers in a semi-personalized way.

People and brands can frequently communicate with customers through tailored content within narrow niches, which creates a strong relationship between the seller and buyer.

The advent of new media platforms like Facebook has also made advertising far more accessible to micro and small businesses. These platforms offer cost-effective and highly targeted advertising to many people.

Business operations is another area where media can be effective.

Businesses can operate with fewer people by leveraging media to manage operations through:

1)        Improved Communication:

Internal communication tools like Slack and Microsoft Teams enable seamless communication between team members.

Videos and documents can be created, shared, reviewed, and sent back with feedback. This leads to faster decision-making and better coordination.

2)        Knowledge Sharing and Training and Development:

Knowledge and expertise can be easily documented and shared. Employees can access resources and become more capable employees.

Companies can use media tools such as video tutorials to deliver consistent and engaging employee training.

These tools can be used to onboard new hires and provide specific types of training on demand.

The training content needs to be created only once. It can then be distributed across the organization, massively reducing the cost per hour of training and development.

3)        Efficiency and Automation:

Digital media platforms enable and automate certain functions and tasks.

Platforms like LinkedIn have made the HR process much more efficient. Customer onboarding can be done without hiring more people to service a growing number of customers.

Overall, media as leverage is easy to acquire and apply well.

Skillsets needed: Communications, design

Permission: Not required

Level of leverage: High

4)        Code

Code here refers to software.

It is a set of instructions given to a computer that tells it what to do under various circumstances.

Just like with media, code bears no marginal cost of replication and is a form of permissionless leverage.

Once the software is built, it can be used by a growing number of people at little to no additional cost.

A skilled software developer can build a basic tool or product worth billions out of his dorm room—no permission needed. (See: Mark Zuckerberg).

Code is different from media because it is interactive; it responds to a user’s input and allows for a two-way flow of information.

You can build a digital product (or a set of products) that can execute a specific set of tasks for many users.

And it can continue to work for 24 hours a day and 7 days a week without complaining or asking for days off.

Code is powerful because it provides the tools to conduct manual and repetitive tasks, quickly and without error. Code also enables creativity through design tools.

If you want to automate tasks and scale operations using significantly fewer resources, use code.

You do this by building software that works for you, to your exact specifications.

Venture capitalist and entrepreneur Marc Andreessen explained how software was shaping the business landscape in his famous 2011 blog post, “Why Software Is Eating the World.”

Andreesen pointed out how software was rapidly disrupting all industries. He could see how software enabled companies to scale while being able to reach an increasingly connected and global market.

It’s not a coincidence that the six largest companies in America are all technology-related. These companies provide most of the digital infrastructure that powers the world today.

Collectively worth almost 13.8 trillion (with a ‘T’) dollars, they represent 30% of the value of the largest 500 listed companies in America.

Overall, code as leverage is easy to acquire and apply well.

Skillsets needed: Software development, design

Permission: Not required

Level of leverage: High

Ascending the leverage ladder:

The more ‘leveraged’ the activities you engage in, the higher your earning potential per unit of time.

A lot of what used to be done by people can now be done by media or code.

It no longer makes sense to have excessive staff on your payroll. Many people today are top 1% earners even though they do not employ any full-time staff.

Alex Hormozi is a successful entrepreneur who now runs his own holding company which he uses to invest in other businesses.

In a presentation, he demonstrated how climbing up the leverage ladder affected his income.

He shows how he earned between $4,000 and $10,000 per month when he employed no leverage.

When he became the owner of a gym chain and employed people (labor), his income increased to $100,000 per month.

He then started a media-based company called Gym Launch, which taught other gym owners how to acquire and retain members. At Gym Launch, he made $1,000,000 per month.

Hormozi now uses the capital he got from his sale of Gym Launch, along with people and media, to build his holding company which makes $10,000,000 a month.

In his presentation, Hormozi questions what the next chapter in his leverage ascension journey will look like.

He states that to get to $100,000,000 in monthly income, he may end up using code as leverage, although he doesn’t need to.

He can continue to do what he’s currently doing and, because of compounding, he will likely get there eventually.

The key to building wealth is to choose high leverage activities, and to be consistent pursuing those activities to take advantage of compounding.

The ‘secret’ to building wealth can be summarized in two words: compounding leverage.

I’ve started to use the four types of leverage as a mental model when assessing the income-generating capacity of individuals (myself) or companies that I analyze or consult with.

I like to ask a few important questions when using the framework.

What types of leverage do I, as a person or company, currently employ?

What other types of leverage can I use to increase income?

What are the necessary skills or resources needed to apply more leverage successfully?

Where can I leverage my core competencies and what I enjoy doing, so that I can be persistent in the pursuit of compounding leverage?

I hope this post was useful in helping you think about using different forms of leverage to build wealth and increase your earnings potential.

 *Debt default refers to when a borrower fails to make the required interest or principal repayments. A technical default refers to a breach of the non-payment-related terms of the loan agreement (covenants) by the borrower.

Appendix 1:

Tools work to enhance specific attributes of human capabilities:

1)        Strength and Power

There are tools that are used to amplify human strength, such as levers, hammers, and hydraulic machines.

There are also tools that are used to multiply power. Examples include engines and motors that are used to convert energy sources into mechanical power.

2)        Precision and Accuracy

Tools like calipers, micrometers, and CNC machines enable precise measurement and intricate workmanship. These tools yield results that are far beyond the capabilities of human beings.

3)        Reach and Accessibility

Tools such as ladders, cranes, and robotic arms extended reach. This helps in moving and manipulating objects in ways that would otherwise be impossible.

Accessibility tools like prosthetics help people with disabilities to perform tasks that would otherwise be impossible or difficult.

4)        Speed and Efficiency

Power tools, assembly lines, and automated systems significantly increase the speed of production and construction.

5)        Sensory Enhancement

Tools that enhance human senses include microscopes, telescopes, and x-ray machines. These allow humans to see, hear, and sense things that go beyond the natural range of capabilities.

Sensors and diagnostic tools gather data that cannot be sensed by humans altogether.

6)        Communication and Information Processing

Enhanced communication tools have enabled the documentation and dispersion of ideas and information with a high level of accuracy and wide reach.

Information processing tools such as computer software applications can process and analyze large and complex calculations and problems.

7)        Environmental Interaction

Tools like thermometers, agricultural equipment, heaters, and thermostats allow humans to monitor and modify their environment to suit their needs.

There are also tools that are needed for exploring harsher environments. These include tools like waterproof material, scuba-diving equipment, and space suits.

8)        Safety and Protection

Protective gear includes helmets, safety goggles, and biohazard suits. These protect humans from physical and environmental hazards.

Security tools for protecting specific areas include doors, surveillance systems, and alarms.

9)        Creative Expression

Creative expression occurs in various ways and formats. Artistic tools such as paintbrushes, musical instruments, and digital design software expand and enhance humanity's ability for creative expression.

Prototyping tools such as 3D printers can facilitate innovation by rapidly creating and iterating with new designs and inventions.