There are many forms of investments, and owning your own business is one type of an investment. Most people would tell you they invest with a goal to maximize their return relative to the risk they’re willing to take. A very cautious investor may be satisfied with a 4% or 5% rate of return on their money while the risk taker may be looking for no less than a 15% to 20% return or greater. In either case, an investor is looking to put their money to work. While owning your business may also be your primary source of income, your business should also increase in value and, at some point, provide additional income beyond a paycheck.
If we think of our business as an investment vehicle, we should work on building value over time so that we’re primed to cash in when the time is right. Building business value takes steady reinvestment. Purchasing new equipment, building facilities and hiring key talent are investments in your business. Choosing to reinvest into your business should be deliberate like a decision to invest in other opportunities, such as mutual funds or real estate. You know how much you’re investing, the current value, and your exit strategy.
With your own business it may be a little more difficult to determine exactly how much you have invested, particularly if you’re looking back for up to 15 years or more. While you may be able to itemize paid in capital or loans you’ve made to the business, you may not have accounted for the reduced compensation that you took in order to leave money in the business. You’ve likely invested a lot of sweat equity to build your business and the value on your time, particularly when you haven’t tracked the hours, is difficult to assign value to. That’s why it’s called sweat equity - you’re working toward the goal of building a business and it takes that extra effort; hopefully the return will be there when you are ready or need to take it from the business.
How much money can you take out of your business today? It depends on many factors. Ultimately you have to find the balance. If you take too much and take it too early, you could harm your business growth and development, robbing it of future value. It is nice to pull money out of the business to live a little and enjoy the rewards of your hard work. But if you think of your business as an investment, would you pull earnings out of your IRA or 401K plan so you could enjoy another vacation or buy more toys?
Because of the seasonal nature of the snow industry, there is a mixture of business types. Some contractors are snow only while many have warm-season pursuits such as paving, landscaping, construction, or facilities maintenance. Borrowing benchmarks from other industries and their income surveys, an owner’s salary should not exceed 8% to 10% of revenue in order to allow the business to meet its other obligations. While this is a guideline, certainly some businesses that are more profitable and carry less debt may be able to pay their owners closer to 15% of sales - and potentially more during times of high profit - without bleeding the business.
When building your budget you are basing salary and profit on sales and production goals. Given the seasonal nature of snow and the difficulty of accurately projecting profit until the season is over, you may not know what kind of salary or additional draw you can take until the actual profit has been determined and the cash is available. If your current salary or draws are over 10% of business revenue, be conservative until you know the business can sustain a larger draw.
Business and personal goals
Do you own your own business or are you in a partnership that may influence the business goals? The desired rate of return will need to grow to support multiple owners and will, therefore, require more investment possibly over a longer time until your growth goals are met. If owners begin to take larger salaries or increase their draws instead of reinvesting in the business, they must consider whether future growth can be sustained to meet long-term sales and growth goals.
Are your personal investment goals synonymous with the business goals or are they separate? Our personal investment goals may be entirely in the business, or you may also choose to diversify by having other assets.
Stage of development
A business that is mature, established, and well capitalized is in a much different position to spin off additional income than a startup venture that swallows cash often faster than it can be generated. A business that has passed the infancy startup phase and is moving into adolescence may be making a profit but may not be ready to provide that additional income.
Earning a profit on paper does not mean the business has the cash to fund extracurriculars - either for the business or personally. Growing businesses suffer from the experience of often being short on cash. They must lay out more cash to pay for direct expenses like labor and materials to produce the revenue, but they may not be collecting receivables as quickly as they are consuming cash. On paper they look profitable, but the bank account hovers around dangerously low levels to meet current payables. If there is excess cash or working capital in the business, this is the time you can decide to pay down debt, take a draw, or reinvest the money into the business. Attempting to grow or take draws when there is not sufficient working capital can stress the business and the owners.
While not the only indicator of business value, the balance sheet is a financial statement or scorecard of the health of the business. Solvency ratios show whether a company has enough cash or assets relative to their debt to ensure they don’t run into trouble (quick and current ratio). Debt to equity ratios show if a business has been growing due to debt or funding its own growth through profits - the higher the ratios the higher the debt, and, therefore, the more cash required to cover the debt service and ultimately retire the debt. A business that carries a lot of debt may not be in a position to pay out larger owner salaries. Choosing to pay down the debt is possibly a better long-term decision.
Keeping track of the value of your business is important, particularly if you intend to sell it. Often, business owners overvalue their business, particularly when they factor in all the sweat equity. Unfortunately, someone who is interested in buying your business isn’t going to value your sweat equity. Most likely, the best value your business has to offer you is when it’s operating and generating a cash flow, which allows you to draw income that can be saved or invested into a more diversified portfolio of assets. Assuming someone is willing to pay for your client contracts or relationships, the only other value the business holds is the liquidated value of its assets. Used equipment doesn’t generally sell at a premium, perhaps slightly better than auction value if you’re patient and a little lucky.
Business owners who plan to cash in on their years of hard work by selling their business when they retire may be surprised at what their business is actually worth. If you’re banking on the sale of your business to make retirement possible you may want to estimate more conservatively. It may be well worth the expense to have professional counsel that can help you value your business, allowing you to track it over time so you can learn what is reasonable to expect or so you can best time your exit.
Build your machine
Someone once told me that a business is a like a machine that you build over time. It doesn’t happen overnight, and for some it may take five, 10 or even 20 years. But once the machine is built and operating properly it has the ability to produce handsome returns. This is really a lesson of delayed gratification along with building and intelligently investing in your business. If you leave enough money in the business to ensure you can replace and add assets as needed and you can fund growth with limited debt, you will be able to take sizable draws, particularly after more profitable seasons.
- Owners should seek objective outside counsel to determine the true value of their business.
- Good financial tracking and patience can help determine when an owner can remove money from the business.
- Business reinvestment goals should be strategically planned, like any other investment.
Douglas Freer, CSP, owns Blue Moose Snow Co. in Cleveland. Contact him at email@example.com.