Warren Buffett is probably one of my favorite people to read about business. He’s not just a great investor, but he writes clearly and accessibly, even when dealing with difficult topics. Normally, he does most of his writing in his annual letter to the shareholders of Berkshire Hathaway, his company. Every CEO writes a letter to the shareholders, but I’m not aware of any that write like Buffett does.
I’ve been influenced a lot over the years by Buffett’s writings, including his discussions of how he chooses companies to invest in, which I’ve discussed previously. There’s a different topic I want to discuss today which Buffett has discussed before. This is the idea of “float”.
Float is an insurance term meaning the amount of money you have that is really other people’s. In insurance, you collect money from your customers as soon as they sign up in the form of premiums. You pay the money out in response to claims. Usually, people sign up for insurance because they expect or fear that they will need it. Or, in other words, that the insurance company will pay them more in claims than the customer has paid in premiums. Otherwise, the customer would just keep the premiums in a bank account, and pay all expenses out of pocket.
If the customer is right, this is bad news for the insurance company. No business can be run by giving more money to customers than they give you. One option for the insurance company to make money, therefore, is just that the customer is wrong. This is your “underwriting profit”. If, on average, the customer pays you, the insurance company, more than they receive in claims, and that extra amount is enough to cover all your costs of doing business, then you’ll have a nice business for yourself. After all, there are few businesses better than dealing directly with money, without the added inconvenience of other stuff getting in the way.
But there’s also another way of making money, even if you pay out more to the customer than you receive. There will always be some amount of time between when the customer first pays you a premium, and you have to pay that first claim. It might be a month, a year, or a decade, but during that time you have all the money they promised you, and they have none of the money you promised them. If you are good at making money from other money, then you can do very well on this money that they lent to you. One of the main sources of the cash that Buffett uses to buy whole companies is from this float, and he relies on the companies he buys to return the money back to him in time to pay out claims.
What’s interesting is that this model doesn’t just apply to insurance companies. It applies everywhere, to anyone who holds money that they eventually have to pay to someone else. For instance, Amazon sells products on their website and then pays the vendor 24 days later, with the money they got from the consumer. Even if a vendor just uses Amazon as a warehouse (“Fulfillment by Amazon”), the vendor has to wait 2 weeks to get their money, along with the fees they pay Amazon to stock their items.
These 2-3 weeks can make a ton of difference, if you know how to use that cash. You can use that to make your biweekly payroll, invest in a short-term investment vehicle to make 1% or 2% on it, or just hold onto it to smooth out any unexpected interruptions in your cash flow. It’s like free, unlimited payday loans, or maybe just your dad always willing to give you some cash when you need to pay rent.
If you’re interested in business yourself, any business where there’s a lag between when you get paid and when you have to pay out is a good one. If you’re writing a book, take pre-orders. If you’re holding an event, take deposits. Try your best to avoid selling tickets at the door whenever you can.
It’s not impossible to make alternative business models work, of course. Every business that accepts credit cards or checks is accepting some delay in payment, and people who sell through Amazon (or worse, supply to Anheuser Busch) accept a lot of delay in payment. You just have to plan for it, and be confident that payment will arrive when you need it to. However, if you need cash in the meanwhile, you’ll have to pay for it, and you’ll have to pay through the nose. Those companies with float, however, will be floating high and sitting pretty.