Peter Drucker once said, “Profit for a company is like oxygen for a person.” You can’t hold your breath forever, and your business can’t survive for long without profit. Business owners often hire commission-focused intermediaries (like investment bankers and business brokers) whose influence leads many business owners to mistakenly overemphasize the importance of EBITDA (earnings before interest, taxes, depreciation, and amortization) and underestimate the importance of profit.
Profit is key
If you’re seeking to grow a small or lower middle market business profitably, it is often wise to focus on profit rather than EBITDA. Real cash outlays are tied to the payment of interest and taxes as well as the purchase of equipment used in the business. When you consider ownership transition options for your business, EBITDA may emerge as an important metric for many potential acquirers. But in the early stages of business growth, profit is key!
In this article, I emphasized the importance of paying yourself a market-based wage and obtaining a return on what you own (profit distributions). If your company is unable to pay you a market-based wage, it is crucial that you improve the profitability of your business. Focus on increasing your gross profit (sales minus cost of sales) before you fix your pretax profit (sales minus all costs except tax). Seek growth in gross profit rather than mere growth in revenue.
Breakeven = barely alive
The breakeven point for a business occurs when its revenue equals its expenses. But a business operating at breakeven for an extended time may already be dead! For many companies, pretax profit as a percentage of sales can be thought of as follows:
5% or less = your business is on life support
10% = your business is healthy
15% or more = your business is thriving
Certain businesses may be able to generate profits as a percentage of sales that far exceed 15% (for example, many software companies). But, many of the most profitable small and lower middle market companies tend to operate between 10% and 15%. This is a key data point to consider when thinking about the profitability of your business.
Who are the knights around your Round Table?
Around the $1 million in revenue mark, many Wealthpreneurs realize they can no longer fill all the functional positions in their companies. This is a normal and expected part of the Wealthpreneur journey, but it can present challenges. Consider who serves in the following roles in your business. Do you have the right people in the right areas?
- CEO
- Sales
- Marketing
- Operations
- IT and technology development
- Finance
- Customer service
- HR functions
The Wealthpreneur Lesson
Warren Buffett On Hiring
“Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you. You think about it; it’s true. If you hire somebody without integrity, you really want them to be dumb and lazy.”
A black hole or the Badlands?
Companies that generate between $1 million and $5 million in annual sales are sometimes said to be in a black hole. A Wealthpreneur I know says this phase of growth is like leading a group of westward-bound pioneers through the treacherous Badlands of South Dakota. In this stage, your business may be forced to add staffing and infrastructure before it can really afford to do so.
You need to hire people with the right skill sets to make the journey with you, and you must pay them a market-based wage. You must also continually upgrade your staff – if you fail to do so, you may not get through the Badlands in one piece!
The need to add management infrastructure seems to naturally develop when a company has about 20 employees. Typically, this is when annual sales are between $2 million and $3.5 million. Remember, it’s expensive to hire the wrong people and then replace them! A key piece of advice is, “hire slowly, fire quickly.” Find and hire the right people before your business outgrows your ability to manage all the functional areas by yourself.
With unemployment at historic lows, the battle for top talent is real. For a competitive edge, consider hiring people straight out of college and investing in their education. Although they don’t have much experience, they also don’t have any baggage to unlearn! Many Wealthpreneurs have reached great success with young talent who bought into the company’s vision.
Surviving the Badlands
American pioneers traveling through the Badlands prepared for their perilous journey by packing reserves of food, clothing, ammunition, and livestock. Modern-day Wealthpreneurs may not need rifles and cattle to succeed, but the journey from $1 million to $5 million in annual sales is much smoother with adequate capital reserves. Mounting your growth expedition without significant amounts of borrowed money will greatly reduce the financial stress associated with this phase of the Wealthpreneur journey.
Financial forecasting tools can help you estimate the amount of capital reserves necessary to sustainably operate your business. These tools also help determine key metrics (like the cost of hiring people and acquiring equipment you need to achieve growth goals) while maintaining company profitability. These projections comprise your Business Blueprint which provides insight on future sales, cash flows, and targeted profit outcomes.
Finding oxygen
The most successful Wealthpreneurs keep their businesses profitable while growing from $1 million to $5 million, even though their company’s net profit might be lower than during an earlier stage of growth. These business owners choose to leave the profits in their companies to fund growth rather than relying on hazardous debt capital or contributions from outside investors that would dilute the Wealthpreneur’s equity ownership. For business owners who lack adequate capital but have already started the hiring process, downsizing, fixing the business model, and regaining profitability may be the wisest course of action.
The insights above were inspired by the teachings of Greg Crabtree. For those interested in additional information, I recommend his book, Simple Numbers, Straight Talk, Big Profits!.
