"Putting your nose to the grindstone is a really easy way to cover up for an unhealthy business."

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My first foray into entrepreneurship was surprisingly successful. At least it started that way.

My business partner and I hung our shingle as Hearsay in 2008 (now Hearsay Interactive), and we quickly began scheduling one project after another, making enough to live on almost immediately. And it felt really good for a while. The problem came when a huge flat-rate project dragged on four months longer than expected and we had no margins—in terms of time or money—to absorb the blow. When the dust settled, we looked up to see nothing on the books and a few hundred dollars left in our account. By this time it was 2010, and businesses were still reeling from the Great Recession. No one wanted a new site. Everyone was just barely holding on. We were stuck, so we swallowed our pride and started applying for anything that offered a paycheck.

In hindsight, of course, we had gotten lucky early on. The initial success blinded us to our ignorance about the business side of things. Turns out my business degree had been preparing me for a management position in the corporate world, but it hadn't done much to get me ready to start and run a business of my own. My partner wasn't in any better position, and eventually he sold me his shares of the business for a pittance and moved on.

I kept the company and took on side projects when they came along while I worked retail jobs and whatnot for a few years. As soon as my finances and connections looked promising, I jumped back into the solo development world again.

I've been at it almost a year and a half now, and this time around I'm determined not to make the same short-sighted mistakes. I've taken my licks and learned my lessons. I'm now seeking out advice from others who have seen success in similar areas, reading business books that come highly recommended, and staying flexible enough to change when a strategy isn't working.

Profit First

So I was delighted to see several fellow small business owners recently discussing a book called Profit First by Mike Michalowicz. The author's way of handling business finances promised to address one of the biggest issues I faced 6 years ago: the seemingly never-ending feast or famine revenue cycle. He also talked about measuring the health of the business by profitability rather than busyness, which was very appealing. I bought a copy from the iBooks store that night and began digging in.

I started implementing the strategy as soon as possible, and I must say I'm very happy with the results. Finally, my business has a solid plan for paying me, saving for taxes, and for the first time, paying profit distributions. I'm no longer flying by the seat of my pants!

This Could've Been a Pamphlet

I've got a couple problems with the book, chiefly this: there's simply not enough substance here to fill a book. What follows is part book review/part system summary. I think the system itself, distilled down to its fundamentals, could be helpful for some of my fellow entrepreneurs. I hope to do some of distillation here.

There are a few core concepts that form a very helpful strategy for structuring business finances, but it could've been covered in a single blog post. One could argue that some storytelling and positioning are necessary to really sell the system, but even then, a blog series or a small ebook would've been more than enough.

But a 191 page hardback? No sir. Less is more, especially in this case.

The book is rife with meandering off-topic stories, strained analogies, and awkward, inappropriate jokes that make it impossible to recommend to a fellow professional. Like this one:

If you don’t know your exact numbers, your mind goes wild and says crazy things (like. . . “Ahh. . . I am going broke. . . ahh. . . the only thing worse is Mike dressed up like Scarlett O’Hara. Ahh. . . what the hell am I thinking? Ahh!”). You can’t change what you don’t acknowledge, so you need to know exactly what you’re dealing with.

– Profit First by Mike Michalowicz, Chapter 6

And that example was tame. A good editor helps a business book like this stay focused. I got the impression several times while reading that this book was self-edited and self-published.

At its core, the system is a good one. My problem is the long and unfocused book. Even still, he has some gems in there; like the quote from his introduction that I used as the title for this blog post. It perfectly captures the predicament of a lot of failing small businesses.

All You Need to Know

If you want to follow the system yourself, here are the important bits.

Inverting the Equation

The thesis of the book is this: the typical business model of Sales - Expenses = Profit is wrong, and it leads you to make all those bad financial decisions you've been making. The supporting argument is that as sales increase, expenses inevitably increase because the money's there and hey, why not. If you don't intentionally set money aside for profit, you'll never have it.

No arguments there.

Michalowicz recommends flipping that equation on its head: Sales - Profit = Expenses.

It makes sense, though it seems like his equation is overly simplified. That's because as you plod through the book, you'll discover there are some expenses that are more important than other expenses. The equation should really look more like this:

Sales - Profit - Taxes - Owner's Pay = Operating Expenses

As sales come in, take a certain percentage out for profit, then taxes, and then owner's pay. Whatever's left is all you have available for operating expenses, so you'd better make sure you've cut the fat. Pretty straightforward.

For some reason, Michalowicz spends an whole chapter laboriously stepping through what I can only imagine is the unabridged thought process that lead him to the realization that a business should use percentages to divvy up incoming money. It's helpful to have the structure he eventually arrives at, but the complicated spreadsheets and mind-bending explanations in the book just aren't necessary. It essentially comes down to these guidelines:

  • Set aside a small percentage for Profit, starting at only 1% or 2%. Cautiously and modestly increase the percentage over time.
  • Find the percentage of last year's taxes paid compared to overall revenue. Set aside that percentage for Taxes. This should include the owners' personal taxes if the business is set up as an entity with pass-through taxation.
  • Use the percentage of overall revenue that went to owners last year as a basis to determine the percentage to set aside for Owner's Pay.
  • The remainder is for Operating Expenses.
  • If your business cannot stay afloat on what remains for Operating Expenses, you'll have to drastically cut costs.

The Four Accounts

You could use complicated spreadsheets or accounting programs to try to keep track of all those guidelines, but it's a lot easier to just set up separate bank accounts for them. Here again Michalowicz gets overly complicated, but I sorted through it all and got down essentials:

  • Keep your existing checking account as your Operating Expenses account.
  • Open up a new checking account at the same bank for Owner's Pay. You'll need check writing privileges and/or bill pay to pay yourself and any other owners, but don't get a debit card with it. You'll be too tempted to use it if you're ever in a crunch.
  • Open up 2 savings accounts at a different bank for Profit and Taxes. You want to make it difficult to get this money, so don't allow yourself a checkbook, debit card, etc. If it's too easy, you'll inevitably use it when you're short in Operating Expenses, and you need to know from the outset that you won't be able to do this. I set it up so that I can deposit checks through their mobile app but I'll have to physically go to the bank to make a withdrawal in the form of a cashier's check.
  • If your bank's online interface allows giving your accounts nicknames, you might want to give them nicknames like "Taxes [20%]" as a helpful reminder of the percentage you'll be putting in that account.

Find a Rhythm

All your revenue should be deposited to the Operating Expenses account. Obviously moving money from that account to all the others every time you get a deposit would maddening and completely unsustainable, so Michalowicz recommends doing it every few weeks: on the 10th and 25th of every month. Just total up all deposits since the last time, split it up by the designated percentages, and move it to the appropriate accounts.

For some reason, the author felt the above explanation was worthy of the lion's share of a chapter.

Every Quarter

When the 10th of the month in a new quarter arrives, the very first thing you should do is take your profit distribution, pay your taxes, and re-evaluate.

  • Withdraw 50% of the balance in the Profit account, and split it up amongst the owners. Do something unique with it: enjoy the fruits of owning a successful business. Whatever you do, don't put it back into the company. If you find yourself forced to do that with your personal distributions, it's a signal there's something rotten elsewhere in your business model.
  • Leave the remaining 50% in the Profit account as a rainy day fund for the company. 
  • Withdraw from the Taxes account however much is necessary to pay the owners' quarterly taxes.
  • Examine your current percentages and make sure they're still working for the company. Adjust if necessary.

The Rest of the Story

The above is exactly what I implemented for my company, and it's working really well for me. Above all, I learned why it never felt like I was making financial progress with my business even though I was making enough to live on.

I wrote this post in part because I believe the system could be very helpful to a lot of folks in my position, but for a variety of professional and stylistic reasons, I just can't recommend the book itself.

While it seemed to take forever for the author to get to his main idea, the system was fully explained by the time I reached the middle of the book. What remained were more convoluted tips and tricks and oddly placed motivational stories. To my mind, there's really no reason to read past chapter 5.

Do yourself a favor and take a hard look at how your company is dealing with its finances. Use the above guidelines if they're helpful. Make sure you're billing more than just enough to get by. There's nothing quite so empowering as having enough money to turn down work, so sock it away.