Three Theories for Defining Passive Income

Let’s be really clear - there is no such thing as free money. To ‘coin’ a phrase, money simply does not grow on trees and yet, the concept of a passive income is often confused with this idea that an indie hacker can do ‘nothing’ and receive an income.

A decent discussion developed on Indie Hackers this week in which the question was posed: Is Passive Income a Myth?

The post implies that it is and that passive income no longer exists. And this is true if we think that having a passive income truly means doing nothing but in reality it’s not that simple. Surely you always have do ‘something’ to create or sustain a passive income?

So what exactly is passive income? Can it be precisely defined?

I gave it some thought and I think there are three main ways to think about what passive income is and I would love to know what you think about these ideas.

1. Passive income is income that is not directly related to the amount of work that you do.

One thing that definitely isn’t passive income is working for someone else. That is to say, exchanging hours of your time for payment. In that supplier / customer relationship the amount of money earned by the supplier is directly related to the amount of work that they do.

For a long time, this world has been my world. Writing invoices to customers for 10 hours spent on this, 5 hours spent on that etc.

A passive income, therefore, cannot be defined in the same way. Swapping hours for money should be called ‘earned income’. You earned it.

Passive income is therefore income that is not directly related to the amount of work that you do.

Perhaps you sell an eBook, manage a web server with hosting contracts or sell subscriptions to your app. These income streams undoubtedly require effort to create and maintain but you could put in 100 hours of work and sell 1 eBook or put in 100 hours of work and sell 10,000 eBooks.

2. Passive income is sovereign.

The word passive is used in loads of different ways. You might consider a family pet to behave passively. For example, your dog lets you have authority over its day. You define what time and where walkies take place, you decide how much dog food to serve and whether today is dog shampoo day or not. The dog is not sovereign in this relationship, you are.

This way of living suggests that rather than taking an active role in deciding how much money to earn today, a passive income income stream decides for you.

Exactly how much income is provided will vary over time and your attitude to that source of income is similar to that of your dog’s attitude to walkies, que sera sera. What will be will be!

Sure there are things you (and your dog) can do to influence desired outcomes. You can stare longingly at your dog lead if you really fancy a run in the park or you can tinker with your eBook website’s SEO to get more backlinks but ultimately it’s not up to you how much passive income arrives. It is outside of your control.

This is in stark contrast to earned income where you turn up for work, 8 hours a day and fully expect to earn an agreed amount for your time. If you don’t want to earn that money, you don’t show up. If you want to earn more money, you work more hours. You are the master of earned income, you are sovereign whereas with passive income, you are not.

3. Passive income is income that is received for life from an asset.

Regardless of exactly how much work is required to create and sustain an income, passive incomes are always derived from something you actually own for as long as you go on owning it.

Whatever asset it is you own, it has some kind of value and that value is realised when others pay to access a piece of your asset. Your eBook is an asset belonging to you, readers pay to have access to its contents but they don’t own the contents.

If you build a website for someone and they pay you for 50 hours of work, when all is said and done, the website belongs to the client, not you.

Some assets might take years to build in the first place and become a full-time job to maintain but the income derived is still created by customers renting access to your asset and therefore this income is passive.

Logically we imagine the more time and effort we put in to creating a passive income, the greater that income will be but this isn’t necessarily true. It will be true in some cases certainly but we’ve all had experiences of putting a lot of work into a project only for it to fail before a single dime of income has been received.

Conversely, I’ve set up hosting contracts with clients that have gone on earning income for years and years with the smallest amount of effort imaginable.

What defines a passive income for me is the ownership status of the asset which delivers the income not the amount of time put into creating it. Owning an asset should also mean that the income will continue for the life of that asset.

Testing passive income theories with examples

Those are my theories about what passive income is. Do you relate to them? What have I missed?

I thought a good way to figure out if the theories are any use is to test them with some examples of what usually consider to be sources of passive income and feel free to do the same in the comments. It will be interesting to see different models explored.

An app with subscription charges

Plenty of Indie Hackers have built apps that charge for access. Is that income passive? Yes it is:

One, the number of subscriptions sold is not directly related to the amount of hours worked by the founder(s).

Secondly, as customers come and go, the income will fluctuate and, while there are things the founders can do to influence this, they do not have direct control over who decides they want to pay for access to the app or not.

Thirdly, the founder(s) own(s) the app and as long as they go on owning it there will be some income derived from it that is not directly related to the amount of work they do to maintain the app.

A website serving ads

Is this a source of passive income? Certainly.

First, advertising revenue is dependent on website traffic which is largely determined by the website’s performance on the SERP. The founder(s) cannot directly associate amount of work done with the advertising revenue earned.

The founder(s) don’t have any real control over the amount of traffic that visits the site, they can attempt to influence it but they do not control it.

Finally, the website is an asset owned by the founder and as long as the website is live there is potential for an income to be received from it.

Entitled vs passive income

One kind of income that is really similar to passive income is entitled income from things like shares and interest earned on money.

I think arguably entitled and passive income are the same thing but I’d like to propose that they are subtly different. I do, however, think there is a very fine line between the definitions so feel free to disagree.

If you own shares in a company that pays dividends and this in my opinion should be called ‘entitled income’.

For me, trading shares in a company you do not own is not passive. You are entitled to that income through your ownership of the share.

However, share dividend income does kind of pass the three tests for passive income that we’ve come up with:

  1. The dividend paid doesn’t relate directly to how much work you do.
  2. You have no control over how much the payment will be.
  3. The share is your asset and should pay dividends for life.

But, you didn’t do any work at all. You also cannot influence the performance of the company that your share is in like you can with a passive income and, to that end, the source of the income isn’t actually your asset. You’re really just an investor who owns a share, not a controlling share of the asset. It’s gets complicated.

For me, when an income is derived purely from financial transactions such as buying and selling shares then this stops being passive income and starts being entitled income.

For example, would you consider interest paid on your savings account passive income? I consider that entitled income. I am entitled to the interest paid on my money because I have title over that money.

Passive and entitled income are very similar and there will definitely be grey areas, particularly if you take dividends from a company that you own 100% of. Anyway - ask an accountant!

In conclusion, passive income is not a myth but earning money from doing absolutely nothing is

Passive income definitely exists in plentiful quantities under these definitions. I would go further and argue that passive incomes are essential for an economy to work (but maybe that’s another post).

However, I do think there are also degrees of passivity depending on your outlook, attitude to work and the kind of work / life balance you want.

If your passive income source meets the tests of these definitions but you still have to turn up for work every day at 9am working 8 solid hours for an amount of money that doesn’t change very much then maybe deep down, the income shouldn’t be considered passive because that looks a lot like a regular (earned income providing) job to me.

Then again, your passive income might be a lot more hands off and ultimately look more like an investor’s portfolio rather than a entrepreneur’s trophy cabinet.

One thing I do think is absolutely true though about degrees of passivity is that the scale runs from 1 - 100. How much work you do to get your passive income might be tiny (1) or massive (100) but it is never, was never and can never be zero.

Post Script

I really enjoyed thinking about passive income, what it means to me and writing this post. I run a little (and it really is little) business working for clients (not passive income) and selling web hosting contracts (passive income) but just lately I have started to experiment with generating more passive income by building simple websites that will ultimately serve ads.

This relies exclusively on my SEO skills which I’d like to think are at least improving the more I try!

This is my project, it’s called HTML Buttons and it’s aimed at beginner web developers to help them to make buttons more easily.

In addition to arguing with me about the definitions of passive income (please do) I’d also love to argue about the usefulness of this website to the development community and whether it was a big waste of time or possibly valuable in the future. Thanks!