Most entrepreneurs fall for the idea that the only way to build wealth from their business growing is to sell it. Since very few sell for the mega millions they dream of, I think they are missing out on the real secret. A profitable, well-capitalized business can be your ticket to a life full of wealth building. Here are 6 keys to make your business work for you.
Key #1 – Get profitable
Entrepreneurs often sacrifice profits in the name of growth. Most do this as an excuse because they are not willing to make the hard decisions to get profitable or have no clue as to how to do it. If you make the statement that you are “reinvesting in your business” it should mean you have left all of the after-tax profits in your business to help fund the lag between cash flow and profits, not that you are accepting losses.
There are times when you will have a period of losses before you grow to the level that can be supported by the infrastructure you are building. However, many businesses can grow and still remain profitable as they do so. You should challenge any assumption that you should accept losses until you grow big enough to cover them. If you are convinced there is no other way, then prepare the company with enough cash reserves to get through the loss phase or be prepared to raise capital to fund it.
Key #2 – Don’t cheat yourself with owner wages
If you are playing the typical games with owner compensation by paying yourself a low salary and taking distributions to cover your living expenses, you have just distorted the true profit picture of the business. Stop lying to yourself and take a true market wage for the role any of the owners are truly working for in the business. You may find that you will make your true salary plus have profit on top of that!
Key #3 – Live off your salary and leave the profits in the business
Now that you are taking a real market-based wage for the “job” you have in your business, you need to live off the net wage and leave all of the after-tax profits in the business to let it grow. It may sound enticing to borrow funds for growth or even attract investors, but both of those complicate your life as an owner and add to your risk, because of the expectations banks and investors have for repayment.
A business that has 10% or better profit can provide a return on equity of 50% to 100% per year, so why would you want to starve your business by taking unnecessary distributions out of it until it is mature? I think it would be tough to replicate that rate of return in other investments.
Key #4 – Profit patterns
Once you establish your initial profitability, you want to grow by gravitating your focus toward the patterns of profitability that exist in your business. Whether it is by customer profile, location, line of business, product, or service, analyze what works and move towards the most profitable pattern that can be repeated. You will always have a few patterns that are one of a kind, or even the foolish customer that overpays because they can. But you cannot build your business on a pattern that cannot be replicated. Also, you have to isolate the bad patterns and either fix them or eliminate them.
Key #5 – Get fully capitalized
The simple definition of fully capitalized for most businesses—what I call your “core capital target”—is having two months of operating expenses in cash with nothing drawn on a line of credit. This also means that you have set aside and excluded any taxes due from this calculation. The quarterly drill becomes a series of five steps:
1. Are you at your core capital target? If not, get back to work and fix profitability. If yes, go to step 2.
2. Is there any big expenditure you need to keep accumulating capital for (i.e. equipment, building or acquisition of competitor)? If yes, keep accumulating, if not go to step 3.
3. Take excess funds over your core capital target and get your personal wealth healthy (get out of debt, pay off house, build your emergency fund of 6 months living expenses). Once completed, go to step 4.
4. Identify a core wealth target external to the business and build financial assets to that target (typically $1 million to $5 million).
5. Once you are above the core wealth target, consider expanding into other businesses and becoming a “portfolio entrepreneur” instead of a serial entrepreneur. Most small businesses have underutilized executive talent and they can be used over multiple businesses to add value to you and their careers.
Key #6 – Manage your portfolio
Whether you only have one business or many, they need grooming and your attention. If you are drawing a salary, earn it. If you have become an investor with hired management, be Chairman of the Board. When one of your businesses has run its course, selling often maximizes the net outcome. If you have someone that comes along and wants one of your good businesses more than you do, definitely consider selling. But once you have established your financial foundation, consider the options of selling versus having an active business to be involved with. Many entrepreneurs sell their best business creation and never find another business as good. Consider that having a great business to be involved with has value beyond money. Weigh the option to sell carefully!
Follow these steps to build wealth from your businesses and leave the option to sell as a last resort instead of the first idea. You may find you enjoy your business more and that you are building a stable foundation of wealth that will last for your lifetime as well as your heirs’.
GREG CRABTREE has worked in the financial industry for more than 30 years. He founded Crabtree, Rowe & Berger, PC, a CPA firm dedicated to helping entrepreneurs build the economic engine of their business. Crabtree leads the business consulting team, helping clients align their financial goals with their profit model and their core business values. He is the author of Simple Numbers, Straight Talk, Big Profits!