Just like when it comes to investing, in business, most of the time, success doesn’t happen by following the latest and greatest fad pitched by the guru of the month. But instead, it comes by getting the fundamentals right and doing the things most people ignore.
With that in mind, here are three critical financial strategies that most business owners miss.
1. Pay yourself first
The first strategy missed by many business owners is critical to building an enterprise that is sustainable, resilient, and valuable. However, most people miss it because it’s not taught. The typical way an income statement is taught is:
Revenue – Expenses = Profit.
Profit comes last and is a byproduct of your sales and the expenses it takes to run the business. By leaving profit last, it’s an afterthought. Expenses are justified to drive growth, however profitable that may be.
On the other hand, in his book Profit First, former accountant, Mike Michalowicz argues you should flip the equation around to be:
Revenue – Profit = Expenses.
Set a target for profits and let that dictate what you have left to pay expenses.
This works based on the theory of constraints. By setting a constraint on the level of expenses you are willing to accept in order to drive your desired profit level, your mind will focus on solving the problem of delivering a certain level of sales at a certain level of expenses.
If you’re skeptical about the value this approach can actually provide, read this account about how a business with a $1.4m loan called by their local bank was saved using the strategies uncovered with a profit-first approach.
2. Self-fund your buyout
According to Josh Patrick, only 1% of businesses will get their owner to retirement. Meaning after transaction costs and taxes, 99 out of 100 business owners shouldn’t plan on their exit from their business to fully fund their retirement plan.
Instead, he argues, business owners should devote the business profits (step 1) into one of four buckets: emergency funds, lifestyle, business growth, and retirement plans. By funding your retirement plan, or “pre-funding your buyout” as he calls it, you build the flexibility into your plans to leave your business on your terms.
Additionally, you buy the ability to be flexible on the timing of when you sell your business. With retirement assets to support your lifestyle, you avoid the necessity of becoming a forced seller when you want to exit.
For more on how to fund a retirement plan and sort through the variety of different options available to you, see our post on retirement plan options for business owners.
3. Increase the valuation of your business without growing it
And lastly, once you’ve paid yourself first and devoted some of these profits to self-funding your exit strategy, it’s time to optimize the value of your business itself.
Making sure it’s profitable (step 1) goes a long way to making it attractive to a buyer, but there are two things to keep in mind about how a business is valued.
The first key driver is the growth rate. The higher the growth rate, the higher the sales (and hopefully profit) in the future, therefore, the more money someone should be expected to pay for that business. This is the driver most people think about when increasing the value of their business. Grow, grow, grow…bigger means more value.
However, the other crucial lever in valuing a business is the risk of these cash flows. The less risky the cash that your business generates, the more someone is willing to pay for your business.
So, here are a few ways to “de-risk” your business and increase its value without growing revenue.
- Increase your recurring revenue – Instead of starting each year at zero in revenue, under a recurring revenue model January starts where December left off. One strategy to increase the value of your business is to convert revenue, where possible, to a subscription or other recurring form. There is a reason most Silicon Valley startups are built on the back of the subscription model, and there is a good reason you should consider it as a way to increase the value of your business too.
- Reduce revenue concentration – Landing a big client or account is typically a reason to celebrate, however, from a buyer’s perspective, the more revenue concentrated with a few big clients, the riskier your business. As a general rule of thumb, no more than 20-25% of income should come from one customer. If so, take action to diversify your revenue or be prepared to accept a lower valuation or more contingencies as part of any transaction.
- Make yourself operationally irrelevant– If you plan to exit your business, in order to achieve full value for your business, it must be able to survive without you. There is no time like the present to make sure others at your business can service key accounts, keep operational functions running smoothly, and develop the next generation of leadership. In addition to having a more successful company today, this approach will increase the value of your business by decreasing the risk that comes with having all the knowledge, skill, and relationships tied to the owner.
Hopefully, this has been helpful, and if so, I would encourage you to pick one of the three strategies and start there. And if this is something you’d like help with, you can get in touch here.