Sunday, June 07, 2009

Linear vs. Passive Income

You may not know this about me, but I went to business school.

Actually, I went to a special one-year program here in Toronto that incubates small businesses and trains them in entrepreneurship. While I was there, we frequently had business owners come in to do guest lectures. One of the lecturers was the owner of a rapidly expanding bakery who told us a story that I've thought about a lot lately.

The story was about the first few years of his business and how he barely made a living running a small shop selling his baked goods. One day, finally fed up with not having any money and with a baby on the way, he decided something had to change. He started trying new things, altered his business model and starting selling his products wholesale to supermarkets and other stores. This worked really well because the supermarkets and stores could sell a lot more of his products to the public than he ever could. As an additional bonus, because the stores and supermarkets now took care of most of the sales work he was able to focus on his real passion, making food.

Not long after he made the change he was out with his wife one night and they stopped at a supermarket to pick something up. He saw people buying his products and realized that he was making money right then and there even though he was out on a date with his wife!

In business there are two types of income - linear income and passive income. Most people make a linear income. If you have a job and work X number of hours to get paid X number of dollars or if you make something (like a puppet) and then sell it, you make a linear income. There's nothing wrong with a linear income per se, but the difficulty with it is that in order to make more money you usually have to do more work. At a certain point you just can't work any more hours so there's a pretty firm ceiling on how much money you can earn from a linear income source.

By comparison, a passive income is money that you make with little to no effort. Advertising is a good example of a passive income source; it takes about the same amount of work to write a blog read by one million visitors as it does to write one read by ten people, but you can make a lot more money advertising to one million readers than ten. Other good examples of passive income would be selling merchandise through Cafepress or selling a puppet pattern that people can download from your online store. A passive income scales much better than a linear one does, so in theory you can make more and more money without having to do more and more work.

Selling baked goods wholesale probably isn't a textbook example of a passive income source, but the underlying lesson of the bakery story - maximizing profit while minimizing effort - is what passive income is all about. It's also something that I think all artists need to understand. After all, if you look at puppetry or just entertainment in general, the most successful companies all rely on passive income streams like licensing and advertising to make most of their profits.

I know his might seem really simple and an obvious thing to point out, but if it's common sense then it's not so common. Think about how many people you know who are struggling and make a linear income? Are you? Earning any kind of income - passive or linear - takes hard work, but the more I think about it, the more having a passive income seems like a better, smarter way to work.