What You KNOW About Passive Income Is Wrong And How To Really Make It

How many times have you seen an Internet Marketer or MLM marketer saying how easy it is to earn passive income from a business?

Everything you know about passive income is wrong.

If people say they are making passive income from a business they run, then they either don’t know what passive income means or they are trying to sell you something or both.

If what they are selling is a business opportunity, then RUN!!! Don’t waste your money.

I’ve been pissed about this passive income thing for a long time and the reason I’m pissed is that it is used to separate people from their hard-earned money with the false promise of easy-earned money.

I want to address what passive income really is and how you can make it.

Passive Vs. Earned

Passive Income is money that you received without working for it.

Earned Income is money that you received from engaging in labor or management of labor.

Everyone of those people who claim they earn passive income (and that you can too) are actually working to get their money. They are getting Earned Income.

See there is this super-loose definition of passive income that says any money you didn’t directly work to receive is passive income such as making an ebook sale on the Internet while sleeping or getting an affiliate commission several months after making an affiliate sales site.

Some people will say that their employees are doing most or all of the work and they just make sure it runs smoothly (management of labor) and call this passive income.

People who are actively running their business (even part time) are engaged in work and any money that business makes is Earned Income for that business owner.

The ONLY kind of business owner that earns true Passive Income is the owner who is retired from that business and the business is run 100% by others.

You could also be a business owner who inherited shares of the company such as the heirs of Proctor & Gamble or S.C. Johnson. These heirs earn passive income from the companies they are significant shareholders of, but do not engage in work including the management of labor.

Leveraged Income

What those who use the term Passive Income really mean (unless they’re trying to sell you something) is that they earn Leveraged Income.

They are using their organizational and managerial skills to leverage the labor of other people, machines & software to generate more income than they could earn through their own individual labor (selling their time for money).

Leveraged Income is what all active business owners are receiving. When you hire someone to do a job for you (an employee or subcontractor) then you are leveraging your capital & management time to gain revenue from the hired labor.

The more capital and management you can profitably invest in hired labor, equipment and software, the more you can grow your business and your income.

That sure isn’t as sexy or easy sounding as Passive Income.

If what everyone is calling Passive Income is wrong then what is Passive Income and how do I get me some?

As I stated above, passive income is money that you didn’t work for. It was earned through royalties, interest, dividends, or pass-through income from an S-Corp/LLC or partnership.

To actually make passive income you need income-producing assets.

(I don’t include capital gains in this definition of passive income because to get capital gains, you must sell the underlying asset to realize the increased value of the asset. Once you’ve sold the asset to get access to its value, you will no longer have future income from that asset.)

Income-producing assets are things like rental properties, bonds, dividend stocks, treasuries, intellectual property that you have licensed. There are thousands of sites and books and courses that can teach you about those types of passive income so I won’t go into them here, but I will cover the one type that doesn’t get covered — passive income from a business you own.  (Read “Rich Dad, Poor Dad” for an introduction to income-producing assets.)

Foolish Adventure is all about making a living from building your own business and we haven’t covered making passive income because there is so much to say about how to first get Earned Income.

But today, I’m addressing Passive Income.

To get passive income from a business you must own the business (asset), have positive net income and a management team to run the whole thing.

  1. If you don’t own the asset, you don’t have any right to it and therefore won’t have passive income.
  2. If your business isn’t earning a profit, then you won’t have any income from the ownership of it.
  3. If you don’t have a management team in place to run the business, it will either fail or you will need to manage it and then it won’t be passive.

Look at everyone who is promoting passive income on the Internet and you’ll see that not a one of them is earning passive income.  If they stopped working in their business, the business would fail.  Maybe not immediately, but in time it would.

Their AdSense sites would start losing rankings and their click-throughs would drop and their income would plummet.  Or if their outsourcer realizes that the owner isn’t paying attention anymore, may just change the AdSense account to himself or just copy the whole thing and do his own.

Nearly everything that Internet Marketers claim is passive like iPhone apps, AdSense sites, affiliate marketing, ebook sales, etc all need constant maintenance and vigilance since the Internet changes.  Customers want different things.  Google tweaks its algorithm.  Competitors knock off your sites.

And it’s usually all of the changes happening at once.  Google is always changing its search criteria.  Customers are always looking for the next great bargain or cool gadget.  And competitors are always trying to make more money and take more market share.

Burn this into your brain: THERE IS NO SUCH THING AS A PASSIVE BUSINESS.

All businesses are Active.  None are Passive.

Management Teams & Passive Income

Either you or your management team must be actively working on the business or it will collapse.

You may have noticed that I’ve not said “manager.”  I have written only “management team.”

If you have a single manager running your business, then you will always have to be engaged with the management of that company.  One person is not a system.

One manager is a single point of failure.  This means if the manager gets sick, quits, dies or does a poor job, your business will suffer and you’ll have to jump into action immediately.  And if you’ve been on vacation for the last two years and don’t know anything about your company anymore, then your business will probably fail before you get up to speed on how to run it again.

To get Passive Income from your business, you must have a management team with systems in place that will improve, or at least, maintain solid management over time.  A solid management system will probably include a board of directors.

Here’s the thing, if you are capable of building a business that can be large enough to support a solid management team, you probably don’t want to retire especially if you’re a young go-getter.  But, okay let’s assume you’re going to retire from this business.

I would recommend that you at least sit on the board of directors and read the quarterly and annual reports so you know what’s going on in your business.  If you’ve also got a solid board of directors, you may feel comfortable that your business will last at least until you die or hopefully last for many generations.

If you read the above and thought that all that management team and board of directors talk sounded like a lot of work, then you’d be right.

I can just hear some people saying that they wanted to get into this whole Internet thing so they can make Passive Income and not have to work hard to build all that corporate mumbo-jumbo.

Well here is the truth: 

If you don’t build a company big enough to support a solid management structure, then you will NEVER earn passive income from your business.

You can earn more than you spend, though.

When you earn more money than you spend on your lifestyle, you can invest that money into income-producing assets that will generate passive income.

This is the reality for 99+% of all business owners.  Most of us will never build a big company so we better make sure we are investing our hard-earned dollars into assets that make us money.

Now that I’ve told you the truth about Passive Income, you have a choice…

Do you stick to the fantasy being sold by Internet Marketers or do you pick one of the paths that actually lead to true passive income?

 

  • Todd

    Tim,
    Great post and I couldn’t agree more. We are mesmerized by easy money and Tim Ferris didn’t help either!

  • http://tigermuse.com Johan Woods

    Love it. And I think the creation of assets is the most important thing
    you can do, and then you manage them, which is still active but better to do for 30 hours/week than 60 hours being a slave, in my opinion.

  • Bobby Pulte

    Thankfully I haven’t been duped into anything promising passive income. But now I’ll know how to avoid it! Thanks!

  • http://FoolishAdventure.com Tim Conley

    Yeah, it’s the lottery mentality.  If we could just pick the winning numbers our lives would be perfect.  Tim Ferriss’ Four Hour Workweek was just misunderstood.  Tim does say that management is a requirement of a successful muse.

  • http://FoolishAdventure.com Tim Conley

    Managing assets won’t take more than a few hours per week and in many cases only a few hours per month.  Just got to make enough scratch to buy the income-producing assets.

  • http://FoolishAdventure.com Tim Conley

    A few of my friends say I’m playing with semantics, but I think a solid definition of passive income versus leveraged income is really important.  This way ethical people won’t use the term passive when they really mean leveraged.

  • Vlad

    Good points Tim. Passive is only from assets that you worked for and invested. Real estate, hard earned business and money lending at some point. Everything else is not passive at all.

  • http://FoolishAdventure.com Tim Conley

    Exactly. Thanks for bringing up lending. This isn’t passive income if you’re managing your lending, but this is a business concept that doesn’t require you personally to run.

    Financial instruments are the easiest assets to make passive since there are professional money management companies out there who are very happy to take a small slice in exchange for management.

    The best money managers don’t make an income unless your account is making money.

  • http://www.tropicalmba.com Dan

    Interesting how people toss around words, I just learned recently (and you mentioned above) that ‘passive’ income is an official type recognized by governments  and tax agencies. That aside, I agree that the worst part of the way the word is used is to meslead people into thinking what the prospects for running businesses really look like. I do know a few people who have gone into 2 year holes on ebook businesses, but it’s really really rare. most of the times if you find a golden goose, you spend your time polishing it. 

    I like these types of posts! 

  • http://blog.michaelmichelini.com Michael Michelini

    Hi Tim,
    I knew I shoulda bought real estate ;)  - I’m an internet entrepreneur and keep seeing these real estate guys getting into nice cash flows….especially Chinese businessmen…..

    Maybe I should invest into real estate with my earnings on internet…..its much more stable and reliable – I totally agree that we need to constantly stay on top of our internet businesses to make sure we are doing the right thing and using the newest technology …

    I also leanred the hardway outsourcing my whole ecommerce biz and being reliant on 1 manager and when she couldnt work anymore i got screwed….

    thanks for this post! 
    Mike

  • http://FoolishAdventure.com Tim Conley

    I should have better defined the terms I was using. I came up with Leveraged Income to define a level of work that is different from what many call Passive. I also should have said I’m not using the definitions the government uses to define income since it isn’t useful when talking about levels of work versus income.

    But the biggest thing that really pisses me off is Internet Marketers using the term Passive Income so that it attracts people to their sales pitch to get their money.

  • http://FoolishAdventure.com Tim Conley

    Mike,

    If real estate is your asset of choice then it would be a good idea to learn the market (and not just the asset type) you’re going to invest in.

    I prefer investing in other people’s businesses and financial instruments.  Bonds and dividend stocks are easy to learn and manage.  Other businesses is tougher, but I look for low capital needs and high margins.  Local service businesses are good for this because you get decent cash flow if they are managed and marketed well by the owner.  

    Some types of Internet businesses make decent investments if they have recurring revenue models or have a system for replicating sites into different markets like the AdSense Flippers guys are doing.

  • Anonymous

    Ack…Tim!  I think you just helped me realize I’m one of those using “passive income” improperly!  I think the term you used “Leveraged Income” much more accurately describes what we do at AdSense Flippers…I’ll try to remember that in the next few blog posts we write…definitely a better description.

    I think that you’re wrong, though, in saying that people use the term “passive income” to necessarily dupe or mislead people.  (In defense of your position…there are PLENTY of people that do use it nefariously)  I think those like Pat Flynn, Spencer from NichePursuits, etc. don’t use it to mislead…they simply use it because it’s well understood (and misused) to described “Leveraged Income”…and that’s what they and their readers would categorize their income and process as.

    Thinking about it, not only is ours leveraged, the work/cost is heavily front-loaded, increasing the risk factor for those attempting to get started.  At one point, we were down 10K or so when getting started and I think to get it up to a decent sized income level that’s basically required.  (That, or take a much longer time getting there)

    Anyway…great article!

  • http://FoolishAdventure.com Tim Conley

    I have had a bunch of conversations with Dan Andrews about this Passive Income thing, but at the time the only alternative I (we) had was Earned Income, but that doesn’t distinguish between a wage and money generated from leveraging others’ labor.

    Then it hit me… Leveraged Income. I think the reason it was so hard for me to come up with an alternative phrase was that Leverage is used in finance to describe debt. Those finance guys kind of own that word.

    But leverage is the right word for this kind of income and it doesn’t have a quality that could be used to dupe or accidentally dupe someone. It doesn’t hide the work involved.

    I don’t know Spencer or his content so I can’t speak to that, but I’ve followed Pat Flynn and I’ve interviewed him. I think Pat is a genuinely nice guy who doesn’t intend to dupe anyone.

    Pat has come out and said he doesn’t earn Passive Income, but that someday in the future it would be.

    This would be a true statement if Pat Flynn intends to retire from SPI in the future and receive dividends from the company otherwise the income he receives from it will be Leveraged Income.

    As for people searching for Passive Income, they think they can start a business and make Passive Income from it and there are people selling Internet Marketing stuff claiming it is possible to own a business and the income is passive.

    I hope to get legit people to drop the Passive Income phrase since it is so misleading and can dupe people (even accidentally) who don’t realize that all businesses are a lot of work.

    Thanks for the input Justin. I like it when people challenge my ideas especially when they say I’m wrong. Makes me go back through my thought process to see what I’ve missed.

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  • Anonymous

    Fair points, Tim…

    Continue to call anyone out if they’re promising the riches of “passive income” without actually putting in the work.  We’ll try to make sure to mention it as “Leveraged Income”…I prefer that term…much better!

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  • Alphaman84

    Rich dad sure talks alot about passive income, but if anyone really makes any passive income, even Robert himself (He seems to be working all the time, and loves it). Even Real Estate investments that produce cash flow is hardly passive. Its not like you can buy real estate with a couple of mouse clicks and get those fat cashflow checks every month. Buing a REIT might give you 0,2-1 % on your capital a month depending on leverage, which isn’t enough to live on unless you have lots of money. Doing Real Estate Deals like Robert talks about requires a lot of work, even if you hire all those property managers and other team members. And building a business is everything but passive. I even find it impossible to do part time, as you have to spend most of your time selling, and how can you do this if you are at work during these hours while your competitors are working full time? Another passive income myth is selling options, although done correctly a good trading strategy it is a form of trading, i.e. work none the less.

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  • Gordon Milton

    Actually, I wonder if people are getting confused between Passive income and Residual income.

  • http://FoolishAdventure.com Tim Conley

    I don’t like using residual income as it has been co-opted by the multilevel marketing crowd which is another group like the “how make money online” Internet Marketing gurus that use the term to prey on people’s dreams.

    Insurance agents still have a decent opportunity to earn residual income, but unfortunately it goes away if you quit your job just like in MLM.

    I’m seeking a new term that hasn’t been tainted by hucksters so this article plays with ‘leveraged income’ but even that isn’t very good as the term leverage means debt in finance.

    Maybe one day I’ll figure out a great phrase for it.

  • Gordon Milton

    If you quit any job your income goes away, doesn’t it?

    Leveraged income is getting paid off the efforts of others. Residual income is getting paid long after the work has been done. Passive income is derived from investments. In my view, it’s that simple.

    Tim, I think you are trying to complicate things and getting your knickers in a knot for no reason.

  • http://FoolishAdventure.com Tim Conley

    Well put, Gordon.

  • Rich

    Income is never passive. There is always some commitment required in order to establish an income stream, whether it be time, money or both. Many people throw around the passive income term, but much of the time they are referring to residual income. Residual income is created when you invest some time or money up front and then see beneficial returns after your influence has concluded. I rate income potential on a scale to determine the time/money needed in order to generate a desired return of income. It is similar to a risk to reward ratio when buying stocks, etc. Obviously the less time or money you have to spend in order to make the income you want, the better. The scale favors investments which are more capital intensive, as money is much easier to come by than time (the ultimate asset). Never make an investment of your time or money without analyzing the potential returns. The goal should be to work smarter so that your efforts today can translate into benefits for tomorrow and beyond.

  • http://www.twitter.com/JasmineSkyHigh JasmineLaBelleza

    This post is very old, so I hope you are still here to answer my question. I got to this site by googling “how to earn passive income from a small business”. I realize now that this was bad wording for what I meant.
    I read an article months ago, perhaps on Forbes that I think used passive income as a term, but maybe not. The article was talking about owning a small business, and then getting in to the point where you would only have to work 15 hours a week to manage it. Do you think that’s possible, or a pipe dream?

  • http://TimConley.co Tim Conley

    It is possible to manage a small business part time after you have built robust systems so that it can keep itself running.

    However, you can’t just walk away from it unless you have a solid management team in place. Without a management team, if something goes wrong you are immediately back to work full time.

    The possibility is there, but I have seen very few people who start with the dream of passive income ever achieve it.

    But I’ve worked with hundreds of business owners that have been able to start, grow and manage their businesses to where they could work part time if they wanted to.

    What happens is as soon as they have systemized themselves out of a task in their business they take they time to reach bigger vision of their future.

  • http://kylebumpus.com/ Kyle Bumpus

    Meh, but affiliate sites are extremely simple and quick to put up. If I spend a total of 1 hour doing work over the course of 5 or 6 years, I consider that passive income. No need to split hairs.

  • Alberto

    I have a little video production company, i work full time in my bussines, if i sell a licence from one of my videos, how is that income considered, a bussines income or a royalty?

    Thanks for any info.

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