Paying Yourself First: Turn Your Business into a Money Making Machine
Is your business predictably profitable?
If not, you definitely have a problem.
Good news though — it might be a simpler fix than you think.
Recently I sat down with author and entrepreneur Mike Michalowicz to discuss his modern classic business book Profit First.
(Click here to skip straight to the video interview I did with Mike)
You might have heard of GAAP (General Accepted Accounting Principles). This is the traditional method for managing business financials.
According to GAAP, your profit comes after you subtract expenses from sales.
Sales - Profit = Expenses.
Logically this is accurate but in practice it’s actually nonsense. There’s a lot of financial myths we need to unlearn because they just don’t work for small businesses.
Get this, 83% of small businesses, that’s any business with a revenue of under $25 million dollars, are not profitable.
Why though?
We are serving the community, running our operations and teams.
Why can we never get this part right?
We have a lot of terms for profit (i.e. bottom line, year end, something left)
Do you notice something? It seems like profit is the last consideration.
From a human behavioral standpoint, if something comes last it means it can wait, it’s not that important.
Profit is why we got into business in the first place!
So if profit is so crucial for the survival of a business, why do we have to wait 365 days to consider it?
Mike Michalowicz has spoken to thousands of business owners and taken different surveys and the outcome is always the same — most small businesses are run paycheck to paycheck.
In Profit First, a book Mike Michalowicz has authored, the formula is flipped to:
Sales-profit = expenses.
This is the “ Pay yourself first” principle applied to business.
How does this work in practice, you might wonder?
As you generate revenue from your business, you set aside a predetermined amount of money and assign this to a bank account called “profit”.
This should be a hidden account.
What happens in the long run is that we then prioritize the most important thing and treat it less like an event and more like a habit or a muscle that we are constantly working on.
When we do this, we take the profit out of any transactions we make, then whatever remains is used to run the business.
Now you might be thinking, “well I need lots of money to run my business.”
You want to make X profit but you can’t afford to run your business?
Check your costs, margins and adjust.
Being an entrepreneur is about being able to operate the business with the least resources possible, but with awesome results.
According to Parkinson's law, if we have more at our disposal we will consume more. As our cash supply increases so does our demand for it.
Forced frugality suggests that if we constrain the supply we will consume less.
How do you come up with innovative and creative ways to drive the same results less expensively? This is the great challenge of an entrepreneur.
Innovation, creativity and efficiency.
Where do I start?
Overhauling the way you have been running your business for years is hard. However, you can do it.
Most people run their lives and essentially their businesses through “bank balance accounting.” We check our bank balances and if we have money “hurray!” we spend it and if we don’t we panic.
What we need is a system that mimics our natural behavioral patterns. If you run your business out of your bank account, then that’s what you should align your business to.
An adjustment to make would be to check not just the balance but all the numbers, ratios etc
Here are two steps Mike gives to make it all less overwhelming:
Set up a separate savings account just for profit.
Start by putting only 1% of your income in this account and build from there.Your business can run on 99%
What’s the outcome of profit first?
What happens as you keep on doing it is that you’ll start seeing cash in your account. Eventually you will develop the confidence to increase this percentage gradually.
There are over 300,000 businesses using the profit first method today. The most successful ones are not the ones that when in full force but the ones who started with little, then built up on it.
Start slow and let it grow
It’s like a weight loss journey or running a marathon. If you decide to go on a diet full force and cut out all carbs, fats , fried foods etc in one day. It will not happen, you will revert back to your old ways.
Similarly you don’t just wake up one day and run a marathon. You build up to it.
When you start small, you have the chance to adjust your costs and come up with creative ways to reduce them thus increasing the percentage that you set aside for profit in a gradual manner.
Your confidence will grow slowly and eventually you’ll take much bigger steps to 2%, 3% and so on.
By intercepting what you currently do anyway and seeking out the small steps, you get the momentum that you need and higher chances of success.
Profit distribution and rewarding yourself
So what next after profit accumulation? Should we hoard it or spend it all?
We always have to reward ourselves. The dopamine response is important.
Every time we get a profit, we reward ourselves and build the desire to experience it again.
In the book, Instead of hoarding and trying to preserve this cash, Mike recommends taking a portion of it, 50%, not all and rewarding ourselves.
Note that this is not a normalized compensation. It’s a business owner's compensation.
Most of us struggle with how much to responsibly pay ourselves. Profit is a reward for being a shareholder in the business. After all ,only 7% of the population will start a business.
You are supporting a global economy so this risk requires a reward.
This is not a get rich quick option but a get wealthy over time process and build momentum for your business.
For most businesses, if the business struggles so do their lifestyles. With profit first, you set expectations for your salary.
So should there be a downtime, there’s an amount that comes out of your profit account to maintain your life. You are also forced to live within your means.
Tax account
What is the biggest but most neglected bill business owner’s have? It’s the tax bill.
It’s a Shocker every time it comes.
Financial freedom means not having to worry about bills. So have an account set up for that and set that amount aside according to the type of business you own.
You have to pay your taxes. Of course you can use legal ways to minimize tax but don’t take reactive measures e.g spend as much as you can, buying stuff, get in debt just to reduce your tax bill. This will be counter-productive for your business in the long-run
When you reserve your taxes, the money never comes to you then you have to give it away so there’s no loss aversion. The business pays it. Tax season will become fun actually.
You will discover that every concept in the book “Profit First” makes so much sense because it aligns to our human behaviour and how we are all wired.
See the video below for my full discussion with Mike Michalowicz.
In this episode we cover :
Unlearning the mythology and stuff knowledge we have accumulated that isn't practical and doesn’t serve us or help us move forward.
Just buy more stuff or rack up some debt! Have you heard that “tax advice” before? Learn how to tackle the dreaded tax bill by avoiding reactionary, counterproductive actions that are bad for business in the long run.
Why should you pay yourself first? The psychological benefits and the importance of dopamine response.
What does being an entrepreneur actually mean?
Sales - profit = expenses? Learn why we have reverse engineered this accounting equation
The two simple steps you need to take to begin this journey to financial freedom.