SETTING UP PROFIT FIRST FOR YOUR BUSINESS

SETTING UP PROFIT FIRST FOR YOUR BUSINESS

When I was a teenager, my mom had a part-time job working for Lenze Corporation, a German-based company that distributed proprietary machine parts. Every other week, after she cashed her paycheck, she would divide up her money. I can still see her sitting at the kitchen table, placing fives and tens into envelopes labeled “Food,” “Mortgage,” “Community,” “Fun Money,” and “Vacation.” She had one other envelope labeled in a German phrase, which roughly translated to “In case of emergency.” Half of her money went into the “Mortgage” envelope. Then she’d put 15 percent into the “Vacation” envelope, 5 percent into “Fun Money,” and 10 percent each into “Food,” “Community,” and that rainy-day envelope, Nur für den Notfall.”

Despite the fact that her hours fluctuated, Mom always had enough money for food. Now let me be clear about something—this did not mean she always had the same amount of money. She always had enough. Some weeks she worked fewer hours because she was sick or because she volunteered at my school. (It’s totally embarrassing when your mom shows up at your class with German puppets to teach German folklore . . . when you’re a senior in high school.) Other weeks she worked overtime. Her income varied (sound familiar?), yet Mom always had enough because once she put money into one of her envelopes, she kept it sealed until she needed it. She never borrowed from other envelopes if she was short. Instead, she drove to the grocery store, and only when she had parked the car would she open the “Food” envelope.

Mom shopped with whatever food money she had that week. If it was a light week, it would be PB&J for lunch and rice and beans for dinner. More money meant cold cuts for lunch and chicken and rice for dinner. And if she was rolling in dough, it was liverwurst all day long. No one but Mom liked liverwurst, so when she was cranking hours and sure to come home with more pay that week, my sister and I would try to get her to spend more time at home so she couldn’t afford liverwurst. As an aside, if you never heard of liverwurst, consider yourself blessed because it means “liver sausage.” See? Now you don’t like it either.

You might be wondering, “What about the mortgage envelope?” If her pay was light that week, it wasn’t as if she could go to the mortgage company and tell them she would have to pay less that month. Mom knew that when she worked a normal work schedule, 40 percent of her pay would be enough to contribute to the mortgage bill. But as we all know all too well, normal ain’t always so normal. Things happen. So she intentionally set up a 50 percent mortgage allocation. By always putting in 10 percent more than she needed, there was always a cushion for when “normal” contributions fell short. And when all hell broke loose (which it never did, probably because she was prepared for it), Mom had the “Nur für den Notfall” envelope for backup.

The envelope system is not unique to my mom. She is a member of the “greatest generation” and a survivor of the near-constant bombing of her town during World War II. Since I published the first edition of Profit First, I’ve received countless emails from readers whose parents or grandparents used similar systems. From envelopes to jars, to a nifty steel box with different compartments used by a reader in Sweden, many readers adapted these systems for their own use. Profit First is, in part, the envelope system applied to business and modernized by using bank accounts. The system worked flawlessly for my mom, and I suspect it has done the same for someone in your family tree.

How do you apply this system to your business? I’ve given you a step-by-step process below . . . no envelopes, jars, or nifty steel boxes required.

BANK BALANCE ACCOUNTING

The default cash-management system for most entrepreneurs is what I call bank balance accounting. Ironically, it is what our accountants tell us not to do. “Don’t look at your bank accounts,” they say. “Look at your accounting system.”

Right. Don’t you just love looking at your accounting system? Just like those one thousand “beautiful” vacation pictures your friend shows you, with a “funny story” about each one. You could look all day long. Not.

If you follow your accountant’s directions explicitly, this is what is expected of you when you review your accounting system to figure out how much cash you have—once you have reconciled all accounts for accuracy, reviewed your profit and loss (P&L) and cash flow statements and then tie the numbers into your balance sheet. Next, you’ll run the critical metrics, such as your OCR (operating cash ratio), inventory turn, and both the current ratio and quick ratio. Then you’ll tie those into your KPI (key performance indicators), and then you will know the health of your business. Oh, and before I forget, do that every week. Then you will have a clear understanding of where your business is. So says the accountant.

There is just one problem: I have no idea how to truly read and tie in all those documents and ratios. In fact, that is why I hired my accountant and bookkeeper in the first place. My head is spinning just writing this down. In fact, I may be having flashbacks. It’s bad, my friends. Really bad. When I think about financial reporting docs I start to get the shakes, and if I look at numbers too long, I inevitably end up under my desk sucking my thumb (still a hundred times better than eating liverwurst).

So what do I do? What do most entrepreneurs do? We revert to bank balance accounting. What is that? We log into our bank accounts, make note of our balances, and then, based upon what we see, make decisions on how to proceed. When our balance is low, we make collection calls and sell hard. When our balance is high, we invest in equipment and expansion. It works. Kinda.

Bank balance accounting seems to work because it is how we are wired to look at quick indicators (e.g., “Does my bank account have enough money?”). Then we trust our gut and take action. This system doesn’t work perfectly, though, because it seems that we never have enough money left to pay ourselves. That’s why I created Profit First.

Profit First is designed so that you can (and should) continue doing bank balance accounting. The system is set up with your bank accounts so that you can log in, see what your balance is, and make decisions accordingly. This is what you are doing already, so you don’t need to change. Profit First just has multiple accounts at your bank so that when you log in, you know what purpose that money is meant to serve. You open your “envelope,” see what you have to work with, and make your decisions. Will it be rice and beans or Wiener schnitzel?

With Profit First, we are not going to change your behavior; we are going to put guardrails around it. We are not only going to allow you to do what you always have done; we are also going to encourage it.

THE FIVE FOUNDATIONAL ACCOUNTS

If you’ve made it this far into the book, I assume you’re on board with the idea of Profit First. It’s time to take your first step: setting up your envelopes, or plates. Do this now. Don’t put it off for later. It’s time to get your ass in gear.

What you are about to do is the foundation of Profit First. This is the structure your profits will be built on. All the muscle in the world is useless if it isn’t connected to a strong skeletal structure. These accounts are the bones.

Here are the five checking accounts you need to set up:

1.              INCOME

2.              PROFIT

3.              OWNER’S COMP

4.              TAX

5.              OPEX

Make sure you set these up as checking accounts. The flexibility offered by checking accounts far outweighs any minuscule interest you get by using savings accounts. Call your bank and set up the foundational five accounts. Most banks allow you to assign a nickname to the account that is displayed online and on statements in addition to the account number. Just as Mom labeled her envelopes, name your accounts according to their purpose.

You can use your existing primary bank account as one of the five accounts. Rename it your OPEX account because you are likely paying all your bills from that account. Going forward, we are just going to move deposits to your INCOME account. That should be a no-brainer for check deposits; simply put them into a new account. For other types of deposits, such as credit card or ACH payments, you’ll have to update your bank information wherever necessary. The process will take about half an hour—if you have a lot of automated payments, maybe an hour. Make the effort and get this done.

TWO “NO-TEMPTATION” ACCOUNTS

Now that you’ve set up your five foundational accounts at your primary bank, your next step is to set up two “no-temptation accounts.” We are going to get your taxes out of sight and out of mind. And we are going to do the same with your PROFIT account.

You may be thinking, “Why do I need to do this? I already have a TAX account and PROFIT account at my primary bank. Why do I need a duplicate?” The reason we have these secondary accounts is to keep the money that you allocate and reserve for tax and profit out of your sight. Because when something isn’t available to consume, you don’t consume it.

If something is not readily available, we are unlikely to go through an extraordinary measure to consume it. Your profit is for you, and if you can access it easily, you might be tempted to “borrow” from it to cover expenses. And the tax money? That belongs to the government. We are going to make sure you never borrow (a soft term for “steal”) from these accounts.

If you take money from your PROFIT account and put it back into the business, you are basically saying that you are unwilling to find a way to run your business with the operating expenses you allocated for it. If you take money from your TAX account, the money you have reserved to pay the government, you are stealing from the government. And I suspect you already know this, the government doesn’t like that too much.

Find a new bank that you have never worked with before. In this case, you will not be moving money too much, and you will rarely bring the two accounts to a zero balance (unless you are short on tax). So with this bank, you can be less concerned about any minimum balance fees they have.

At the second bank set up two savings accounts (this is where you will collect interest because of your money will pool for a while). The two accounts are PROFIT HOLD and TAX HOLD. Then link these two accounts to the respective PROFIT and TAX accounts at your the primary bank so that you are able to transfer money.

I will explain shortly when to transfer money and how often you will do it. But for now, I want to address one question you may have. You may be thinking, “Why should I set up PROFIT and TAX accounts at both my primary bank and my no-temptation bank? I’m an entrepreneur! I like shortcuts! Can’t I just transfer money from my primary bank’s INCOME account to the PROFIT HOLD and TAX HOLD accounts at my no-temptation bank?” While technically speaking you can do that, it is a bad idea for two reasons.

1.              Transfers from one bank to another are not instantaneous. It can take three days or longer (weekends and holidays add time), and when you log into your primary account, the money looks as if it is still there.

2.              The goal with Profit First is to give you instant and accurate knowledge on where your case stands. When you move money from one account to another at the same bank, the transfer usually happens instantaneously. By first moving money from your INCOME account to the PROFIT and TAX accounts (along with the other accounts), you will instantly see where your money stands, on their respective plates. Now that your money is clearly on the right “plate” at your primary bank, initiate the transfer to the PROFIT HOLD and TAX HOLD accounts at the second bank. Now, anytime you log into your primary bank you will know exactly where you stand, even if the transfer to your no-temptation bank hasn’t completed yet.

TWO FREQUENTLY ASKED QUESTIONS

I speak about Profit First at roughly thirty major conferences a year, as well as a number of smaller conferences, webinars, and lectures. Inevitably, when the Q&A part of my Profit First speech starts, one or two questions always come up:

1.             “I haven’t ever been profitable in the past, so how can I take my profit now?”

People have difficulty accepting the notion that they can start taking profits right away because it seems like some kind of woo-woo accounting trickery. It’s not (in fact, it’s regular accounting that employs trickery). By taking profit first, you’re fundamentally changing the way you run your business. When I hear this question, I always explain Parkinson’s Law: you spend every penny you have available and stretch every dollar in the lean times to keep your business moving forward. I’m simply asking you to remove the profit first, and operate on less. You’ve done this already, and you’ve found a way. There is a saying: “Nothing changes if nothing changes.” If you don’t change the way you take your profit, you will never take a profit.

2.             “Can’t I just do this on a spreadsheet or in my accounting system? Why do I need to do this at the bank?”

I answer this question by asking a question: How has that served you so far? Aren’t you already following your cash flow every day on a spreadsheet? Are you not checking your accounting system daily, reviewing the numbers? No? Exactly. So setting up Profit First in your accounting system is only a slight modification over something you are supposedly “doing” already and failing at.

No matter what those spreadsheets or monthly reports say, your current bank balance is always going to be a stronger determinant of your behavior. The reason you must set up your Profit First accounts at your bank is because it is the only way to insert the system into your normal path of behavior. By setting it up at your bank, you cannot miss your allocations when you log into your bank.

PICKING THE BANK

When choosing your banks, focus on convenience options for one and inconvenience options for the other. At your primary bank, you want easy access to view your accounts (plates or envelopes). You want the easy ability to transfer money from INCOME to your other accounts. And you want to be able to pay bills out of OPEX. At your secondary bank, you want no convenience options. Remember: out of sight, out of mind. What we can’t see or use, we don’t worry about. You work with what you have here and now.

Peter Laughter, a longtime friend of mine, knew the power of removing temptation. When he set up Profit First for his company, he went to a new bank and asked the branch manager for assistance in setting up the accounts. The manager was more than excited to talk with Peter because a good chunk of money would be deposited into the bank. In his salesmanlike way, the manager shared all the wonderful convenience options that Peter would get with his new bank accounts: online banking, starter checks, and that shiny new ATM card.

Peter looked at the branch manager and said, “I don’t want any of that. I am seeking the most inconvenient options you have. In fact, the only way I want to withdraw money from this bank is if I visit this branch and ask you to write out a certified bank check to me. And when that day does come, just to make sure I am only using it for the right reason, I want you to slap me in the face a few times when I ask you to write the check.”

For the Gene Wilder fans out there, this is like the scene in Young Frankenstein when Dr. Frankenstein locks himself in a room with his monster and says, “No matter what you hear in there, no matter how cruelly I beg you, no matter how terribly I may scream, do not open this door or you will undo everything I have worked for.”

The bank manager was befuddled, but he agreed to make things as inconvenient as possible for Peter.

Banks won’t always work with your needs. Back in 2005, when I had my forensics business, I deposited (and more often, withdrew and borrowed) millions of dollars every year. I was doing a lot of business with a certain bank, but they weren’t flexible and wouldn’t accommodate my needs. Then Commerce Bank came along. They were doing what was, up until that time, unheard of: they were open late at night every weeknight, and they were open on weekends. They were available to do business when I was doing business, which was after business hours. I went to my bank branch and told them I wanted to close all of my accounts because I wanted to switch to Commerce Bank. The manager came out and asked me why. She cackled like some villain in a movie and said, “You’ll be back.” She literally said that.

I have never been back, nor has my money.

You have the ability to change banks, too. Their job is to serve you. Just like you wouldn’t risk botulism and accept undercooked chicken from your local restaurant, why should you accept a poisoned relationship with a bank?

Feedback from so many people who are implementing Profit First demonstrates that some (but very few) large banks will work with you by cutting out the fees. But many regional and local banks and federal credit unions will be thrilled to work with you, and in many cases (like my own experience), they don’t have all those crazy fees in the first place. Small banks and credit unions are plug and play for Profit First. Select big banks are, too.*

Here’s how to proceed: if you like your current bank, tell them that their requirements for a “minimum balance” and “transfer fees” and all those rules they have don’t work for you. Ask them to wave the minimum balance requirement and other fees. Yes, you can ask that. Your bank will either comply with your request, or they won’t. If they do, kudos to you. If they don’t, move on to a new bank.

You’ve already taken three steps toward a profitable business: you emailed your commitment to me (Chapter 1), you set up one Profit First account, and you transferred 1 percent of your current money. You have the momentum; now it’s time to kick Profit First into gear and experience the simple, yet powerful transformation for yourself. I won’t say it works like magic, but it is pretty friggin’ amazing to watch your profit and your business grow day by day, deposit by deposit. Don’t stop now. Take action.

TAKE ACTION: GET YOUR BUSINESS PROFIT-READY

Step 1: Set up the five foundational accounts: an INCOME account, a PROFIT account, an OWNER’S COMP account, a TAX account, and an OPEX account.

In most cases, you will already have one or two accounts with your bank. Keep the primary checking account you already have as your OPEX Account, and set up the remaining accounts: INCOME, PROFIT, OWNER’S COMP, and TAX. For simplicity’s sake, set them all up as checking accounts.

Some banks may charge fees or have minimum balance requirements. Don’t let that deter you. Ask to speak to the bank manager and negotiate the fees and requirements. If the manager is unwilling to negotiate, find a new bank.

Step 2: Set up two more external savings accounts with a bank other than the bank you use for daily operations. One account will be your no-temptation PROFIT HOLD account. The second will be your no-temptation TAX HOLD account. Set them up with the ability to withdraw money directly from the respective checking accounts at your primary bank.

Step 3: Don’t enable any of the “convenience” options for your two external no-temptations accounts. You don’t need or want to view these accounts online. You don’t want checkbooks for these accounts. And you definitely do not want a debit card linked to those accounts. You just want to deposit your profit and tax reserves and forget it . . . for now.