Part II · Chapter 3 · Human Capital · lesson 1
Four ways to be paid
10 min
Builds on Cash flow and net worth are different things
Part II · Chapter 3 · Human Capital · lesson 1
10 min
Builds on Cash flow and net worth are different things
Four people each received 60,000 last year.
The first was paid a salary. The second owns a third of a small company and took a distribution of the profits. The third lent money to a property developer at a fixed rate. The fourth wrote a piece of software eleven years ago that other people still license.
The number in each account is identical. Almost nothing else about their situations is.
Income has four sources, and they behave nothing alike.
Labour is payment for your time and attention. Ownership is payment for holding a residual claim on something that produces. Capital is payment for lending, at a rate agreed in advance. Rent is payment for controlling something scarce that other people need to use.
They differ in what stops them, what scales them, who is ahead of you in the queue, and what happens while you sleep. Confusing them is how a person with a large income arrives at retirement with nothing.
Labour income is paid for hours. It is the most reliable of the four in a normal month and the most fragile against a single event, because it stops completely when you do. It scales with your rate and your hours, both of which have ceilings. It is also the only one that cannot be inherited, seized or transferred, which is a genuine advantage that nobody counts.
Ownership income is the residual: revenue minus every other claim. It is the last to be paid and the first to be wiped out, and in exchange it takes the whole of any upside. It does not require your presence, though it usually requires somebody's. It can be negative.
Capital income is contractual. A lender is paid a stated amount at stated times and stands ahead of the owner in the queue. The upside is capped at the agreed rate no matter how well the venture goes, and the downside is a default, which is rarer and much worse when it happens.
Rent is payment for access to something that cannot be easily reproduced — land in a particular place, a licence, a catalogue, a patent, a brand people already trust. It is the strangest of the four, because the payment is not compensation for current effort by anybody. It continues as long as the scarcity does, and it ends abruptly when the scarcity ends.
Predict
In any business that produces anything, the money arrives in one pile and leaves in a fixed order. Suppliers, then wages, then interest, then whatever the state takes, then the owner.
Being early in the queue means being paid in bad years. Being late in the queue means being paid a lot in good ones. There is no position that is early and takes the upside, because if there were, nobody would take any other position.
Not the same thing
A right to a stated amount at stated times, agreed before the outcome is known.
A right to whatever is left after every fixed claim has been satisfied.
Which is which? Put each one on a side.
A salary of 4,000 a month with a contractual notice period
A share of the profits of a restaurant, paid annually if there are any
Rent on a shop unit, payable monthly whether or not the shop trades well
Two confusions do most of the damage.
The first is treating owner income as if it were a wage. Someone who owns a business and draws a monthly amount from it experiences that amount as a salary, because it arrives monthly and covers the bills. It is not one. It is a residual that happens to have been positive twelve months in a row, and it will behave like a residual the first time revenue drops.
The second is treating a wage as if it were an asset. A salary is not a thing you own. It is a stream that continues while a particular relationship continues, and the whole of the final track of this course is about what happens when someone builds a life on the assumption that it will not stop.
There is a useful test, and it takes one question.
If you stopped answering the phone for six months, what would this income do?
Labour income goes to zero. Owner income depends on whether the business is a business or a job with better paperwork. Capital income and rent are unaffected, because the obligation is to a contract rather than to a person.
The test is not a ranking. It is a description of which risks each income is exposed to, and most people are holding one type while assuming the properties of another.
Rent in the everyday sense means the payment for a flat. Rent in the sense used above is broader: any payment that flows from controlling something scarce, rather than from producing something now.
The important property is that it does not require ongoing work, which makes it the most durable of the four and the most exposed to a single kind of event. A catalogue earns until tastes move. A licence earns until it is revoked or duplicated. Land near a station earns until the station moves or a competing one opens.
Rent-like income tends to be stable for a long time and then to change discontinuously. Labour income is the opposite: variable in small ways constantly, and rarely gone overnight.
Check
Not because labour is undervalued, but because of a property in the definitions.
Labour income is bounded by hours. There is a highest rate anyone will pay for an hour and a largest number of hours in a week, and their product is a ceiling. It is a high ceiling in a few fields and it is still a ceiling.
Ownership and rent are not bounded that way, because the thing being paid for is not your time. A claim on something that scales can grow without you working more, which is the definition of leverage and the subject of a lesson later in this track.
This is a statement about arithmetic, not about what anybody should do. Owning things badly is an extremely reliable way to lose money, and the ownership track of this course spends most of its length on that.