Hey business owners! This one is for you!
Have you heard the statistics about being an entrepreneur?
20 percent of small businesses fail in their first year, 30 percent of small businesses fail in their second year, and 50 percent of small businesses fail after five years in business. Finally, 70 percent of small business owners fail in their 10th year in business.
Investopedia says there are four common reasons why businesses fail.
- Lack of capital.
- Poor management.
- Poor business planning.
- Cashflow problems.
Basically, it's poor money management that causes the downfall of companies.
I read a great book called Profit First by Mike Michalowicz. In it, he talks about creating a system so that you can manage your business cashflow in a more realistic and repeatable way.
Michalowicz recommends opening at least five business bank accounts. I know it sounds crazy, but once I started I wondered how I even managed before!
The first bucket is a dedicated income and revenue account. This account is the one that takes in all incoming cash and receipts. Think of it like a funnel; this is where everything comes in before being siphoned off.
I like this method for a few reasons. First: Simplicity. This is the account where money comes in. If it doesn't have anything in it, you didn't make any money. This is a brutally real way to get a kick in the pants!
Think about it though, if you have $10,000 in your main account, and you don’t make any money for a few weeks, after expenses you might still have $7,500 in there. People tend to think, "at least I still have $7,500, that’s enough for three more months!"
If you see a big fat zero on your income account, things change quick! The other reason I like it for is security. If you need to give your account number out to receive Direct Deposit or ACH, this account will never have money in it for a long time, so the odds are that you'll transfer most funds away before getting hit with a fraud issue.
As the name implies, profit first!
You create an account (or at least an accounting bucket) to give yourself an owner's share of the profit.
The key is to set a percentage goal that you'd like in an ideal world, and then work up to that over time. So if your perfect percentage of revenue going towards profit is 15 percent, start with one percent and work to grow it by two percentage points for the next seven business quarters, or almost two years.
The main reason that businesses fail is that they don't make a profit. Mike Michalowicz's system helps business owners guarantee a profit.
3. Owner's Compensation
I think people get confused with profit and owner's compensation. Profit is income minus taxes and expenses. Owner's compensation is actually like an expense! Pay yourself some sort of regular income. If you are starting a business, you need to be sure that you can pay yourself something. The first few months or years may be small, but increase them from there.
There is no point in going into business if you cannot afford to make some sort of regular salary. I know, I know, we've all heard about the tech CEO that started their company in a garage and now they are worth billions… Warren Buffet, Phil Night, Steve Jobs, Jeff Bezos… they all have an interesting and amazing story, but they all did actually pay themselves something to live on while their company grew. They became wealthy, because of the equity in the company, not their salary.
Here is where most small businesses mess up. They say I'll put all expenses through the business. Then we can write off everything! Yay no taxes!
But that also means you didn't make a profit, and that’s the whole name of the game!
But Amazon didn't pay any federal taxes, you say?
Do you have thousands of employees and multiple headquarters allowing for tax credits, rebates, and multi-year depreciation?
Didn't think so…
So our goal is to pay ourselves a salary and show a respectable profit. There are payroll taxes, and some taxes on the profit. The sooner you accept that, the better. Sorry, I just got really aggressive, it's passion, not patronizing.
5. Operating Expenses
Okay, we've allocated a percentage towards profit, owner's compensation, and taxes, the remainder should be allocated towards your expenses.
All of the deductible regular business expenses that haven't been covered go here.
Leases, payroll, cost of goods, software, etc…
If you've already started your business, it may be hard to cut back on expenses, and that’s the point. The system that Michalowicz created forces you to right size all of your expenses so that you can run a sustainable business.
If you haven't started a business yet, you ought to forecast your numbers to make sure they would work with this model. Keep operating expenses as low as possible until your revenue grows enough to necessitate growing your expenses.
This system will take some getting used to for those who are starting out. There's some regular transfer activity, but it gives you confidence and clarity on where you need to focus your financial side of things. Check out Mike's book here.
I recommend paying yourself a salary, and then checking out my cashflow and budgeting post to learn about managing your personal budget after you set your business up.