Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine by Michalowicz, Mike

Chapter 1: YOUR BUSINESS IS AN OUT‑OF‑CONTROL CASH-EATING MONSTER

I learned that a nine-year-old girl had mastered the essence of financial security: save your money and block access to it so it doesn’t get stolen—by you.

Money problems occur when one of two things happen: Sales slow down. The problem here is obvious when you operate check-to-check and sales slow down: when your one big client goes out of business, or that big deal you were banking on falls through, you won’t have enough to cover expenses.

A great quarter can trick you into believing your business is on a permanent upswing, and you start spending like this is the new normal. But drought periods come quickly and unexpectedly, causing a major gap in cash flow. And cutting back on expenses is nearly impossible because our business(and personal) lifestyle is locked in at our new level. Exchanging the newly leased car for a rust bucket, laying off employees because we’re overstaffed, saying no to our partners—all of this is very hard to do because of the agreements and promises we made.

We steal from Peter to pay Paul, hoping for another big payout.

The owners did everything right—except that they grew too fast. After building their business slowly, they suddenly scaled from twenty to forty locations. Sales could not outpace their debt, and Fried’s beloved pizza chain was forced to close. The perfect size for your business? It will happen naturally, when you take your profit first. You will reverse engineer all the elements of your business, and as Fried says,“the right size will find you.”

Here’s the deal, my friend: Profit is not an event. Profit is not something that happens at year-end or at the end of your five-year plan or someday. Profit isn’t even something that waits until tomorrow. Profit must happen now and always. Profit must be baked into your business. Every day, every transaction, every moment. Profit is not an event. Profit is a habit.

“Revenue is vanity, profit is sanity, and cash is king”?

When you focus on profit first, you inevitably figure out how to make a profit consistently. Profitability. Stability. Sanity. Forevermore.

What do we do when instead of a decent bank balance, we see that there’s next to nothing there? We immediately panic. We hit“go” mode: need to sell fast! Need to make collection calls! Need to pretend the bills never arrived, or send out checks and“accidentally” forget to sign them. When we know our bank balance is super low(I’m talking limbo,“How low can you go?” low), we’ll do anything to buy the only thing we can afford: time.

Without an effective money management system that does not require massive mind-set change, we get stuck in trying to sell our way out of our struggles. Sell more. Sell faster. Get money any way you can. It is a trap—a dangerous trap that would even have Frankenstein’s monster poopin’ his panties. It’s the Survival Trap.

Each new“easy sale” took Ernie further from his lawn-raking business.

Instead of being the world’s best at one thing, mastering the process of delivering perfectly and super-efficiently, we end up doing a greater variety of things and becoming less and less efficient at each step while our businesses become harder to manage and costlier to run.

GAAP’s fundamental flaw is that it goes against human nature. No matter how much income we generate, we will always find a way to spend it—all of it. And we have good reasons for all our spending choices. Everything is justified.

“This is an accounting profit. You spent the money in some way already. It doesn’t mean there is any money actually there right now. In fact, in your case it’s already gone. This is just the accounting of what already happened.”

Accountants define profit differently than entrepreneurs. They point to a fictitious number at the bottom of an accounting report. Our definition of profit is simple: cash in the bank. Cold. Hard. Cash. For us.

Chapter 2: THE CORE PRINCIPLES OF PROFIT FIRST

In 1955, a modern philosopher named C. Northcote Parkinson came up with the counterintuitive Parkinson’s Law: that the demand for something expands to match its supply. In economics, this is called induced demand—it’s why expanding roads to reduce traffic congestion never works in the long term because more drivers always show up in their cars to fill those extra lanes.

Similarly, if your client gives you a week to turn around a project, you’d likely take the whole week—but if she gives you just a day, you’ll make it happen in a day. You see the more we have of something, the more of it we consume. This is true for anything: food, time, even toothpaste.

When you have less, you do two things. The first is obvious: you become frugal. When there is less toothpaste in the tube, you use less to brush your teeth. That is the obvious part. But something else, far more impactful happens: you become extremely innovative and find all sorts of ways to extract that last drop of toothpaste from the tube.

If you first extract your profit and remove it from sight, you’ll be left with a nearly empty toothpaste tube to run your business. When less money is available to run your business, you will find ways to get the same or better results with less. By taking your profit first, you will be forced to think smarter and innovate more.

Primacy Effect. The principle is this: We place additional significance on whatever we encounter first. Here’s

Taking profit first will help you figure out which of the many things you do makes money, and which don’t. Then the direction is obvious—you do more of what is profitable, and you fix(or dump) what is not. You will focus on what makes profit for you, naturally, and you will get better and better at it. And when you get better at what your customers already want and like, they will like you more. All this translates into fast, healthy growth. Boom!

To grow the biggest and the fastest, you need to be the best at one thing you do. And to become the best at something, you need to first determine what you are best at and do it a whole lot better. To get there, you take your profit first and the answers to being the best at something will reveal themselves.

When money comes into your main INCOME account, it simply acts as a serving tray for the other accounts. You then periodically disperse all the money from the INCOME account into different accounts in predetermined percentages. Each of these accounts has a different objective: one is for profit, one for owner compensation, another for taxes, and another for operating expenses.

Always, always allocate money based upon the percentages to the accounts first. Never, ever, ever pay bills first. The money moves from the INCOME account to your PROFIT account, OWNER’S COMP, TAX, and OPEX(OPERATING EXPENSES). Then you pay bills only with what is available in the OPEX account. No exceptions.

And if there isn’t enough money left for expenses? This does not mean you need to pull from the other accounts. What it does mean is that your business is telling you that you can’t afford those expenses and need to get rid of them. Eliminating unnecessary expenses will bring more health to your business than you can ever imagine.

Move your PROFIT account and other“tempting” accounts out of arm’s reach. Make it really hard and painful to get to that money, thereby removing the temptation to“borrow”(i.e., steal) from yourself. Use an accountability mechanism to prevent access, except for the right reason.

Do your allocations and payables twice a month(specifically, on the tenth and twenty-fifth). Don’t pay only when there is money piled up in the account. Get into a rhythm of allocating your income, and paying bills twice a month so that you can see how cash accumulates and where the money really goes. This is controlled recurring and frequent cash flow management, not by-the-seat-of-your-pants cash management.

After setting up this new checking account at your bank, nickname the account PROFIT, and from this moment forward from any deposit you put into your normal checking account, transfer 1 percent of that deposit into your PROFIT account.

Chapter 3: SETTING UP PROFIT FIRST FOR YOUR BUSINESS

Here are the five checking accounts you need to set up: INCOME PROFIT OWNER’S COMP TAX OPEX

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.

Chapter 4: ASSESSING THE HEALTH OF YOUR BUSINESS

The real estate agency that does $ 5,000,000 in annual revenue and has a couple dozen agents(subcontractors) taking $ 4,000,000 in commissions is really a $ 1,000,000 business that manages real estate agents making $ 4,000,000, not a $ 5,000,000 business. The $ 3,000,000 a year staffing firm that bills out subcontractors to do work, and pays those subs $ 2,500,000, is really a $ 500,000 business. The architectural firm that bills out $ 2,000,000 in annual fees and has an in-house staff that does practically all the work has Real Revenue of $ 2,000,000 a year.

Real Revenue is your total revenue minus materials and subcontractors utilized to create and deliver the service or product.

Gross profit, on the other hand, is an accounting term calculated as total revenue minus materials, subcontractors, and any of your employees’ time utilized to create and deliver the service or product.

you will generally pay your employees for their time regardless of whether you have a bad sales day or good one. You will likely pay them the same if they fix a car transmission in four hours or five. So to simplify things, we categorize any employee that you have, full-or part-time, as a cost of the business operations, not as a cost of the goods sold.

If you think you have a profit, but it is not in the bank and was never distributed to you as a bonus, this means you don’t really have a profit.

When a company is doing less than $ 250,000 in revenue, it typically has one employee: you. You are the key employee and usually the only employee(with some contractors, part-timers, or possibly one full-timer). Many freelancers are at this stage, and if they elect to stay(just them and no employees), they should be able to increase the profit and pay percentages even more than what I have listed because they don’t have the expense of employees or the need to incur the expenses necessary to support multiple employees.

At $ 250,000 to $ 500,000, you likely have employees. Basic systems will be necessary(like a shared CRM* for your team), equipment, etc., plus you will need to pay your people, so Operating Expenses increase. Owner’s Comp adjusts down(and will continue to) as you take your first step in being a little less employee and a little more shareholder, when other people start to do the work, and you get the benefit of the profits via your distributions.

(More taxes, as painful as they are to pay, are a sign of a healthy business—the more you make, the more you pay... until you make so much you lobby politicians and pay nothing. Don’t get me started.)

Chapter 5: ALLOCATION PERCENTAGES

no matter what the number is, if you work toward it and believe it’s a possibility, you will not only achieve it, you will blow past the“reasonable” numbers others have set.

For your company to join the fiscally elite, you will slowly, deliberately, and consistently move toward the TAPs. What you will do is move from 0 percent profit CAP to 1 percent. Then, next quarter, you will move your CAP to 3 percent, and then next quarter, 5 percent.

But a five million-dollar company that reports a million in profit is kicking butt and taking names. That li’l ole company spits at bad days.

If your sales were to stop completely, with not a single deposit coming in, here’s a good longevity rule of thumb: 5 percent profit allocation = 3 weeks of operating cash. 12 percent profit allocation = 2 months of operating cash. 24 percent profit allocation = 5 months of operating cash.

The bigger your profit allocation percentage, the more efficiently you are running your business, which means less in operating expenses. So not only do you have more saved up with a higher PF percentage, you spend less, which affords you even more time.

The only way to keep big margins is to milk them for all they’re worth when you have them and keep innovating to find new ways to bump up profitability.

I suspect you are familiar with the term owner operator, which means you own the business(have equity) and you operate the business(work as an employee for the company).

(Equity members of your company who do not work in the business just get a profit distribution.) Your salary should be on a par with the going rate for the work you do, in other words—the salary you would have to pay your replacement.

the job of CEO: vision planning, strategic negotiations, acquisitions, reporting to investors, addressing the media, etc.

Determine your salary based on what you are doing 80 percent of the time, and what you would reasonably pay employees to do those jobs.

Owner’s Comp should represent the work you do.

Working on your business is about building systems. Period.

The transition from working in the business to working on the business happens over time—slowly, deliberately, one small step followed by another small step.(Are you starting to see the theme here?) This is the reasoning behind the Owner’s Comp percentages in the Instant Assessment—larger percentages for owners when the company is tiny and smaller percentages as the company grows.

The other 10 percent of the time you spend recording everything you do so that you can systematize it for your other few employees or contractors to do the work without your input. Basically, you are a true entrepreneur(building systems) 10 percent of the time, and a hardworking, hard-selling employee of your own company 90 percent of the time.

my business serves me; I do not serve my business. Paying yourself next to nothing for hard work is servitude. Always start with CAPs—where you are now—and increase by 1 percent each quarter.*

As your annual revenue grows past $ 500,000, you will transition to spending more time building systems. Now you’re a systems developer 20 percent of the time, a manager 10 percent of the time, and an employee 70 percent of the time.(Note that the better you are at creating systems, the less management is required because the recipe for how to get things done is consistent.)

However, remember that it is likely you will always work in your business. Because even if you are a master of building systems and spend 80 percent of your time in that magic zone, you’ll still spend roughly 20 percent of your time handling the big sales. Almost every entrepreneur-to-CEO is in charge of the big sale. You bet your bottom dollar Jeff Bezos is in the room when Amazon is closing a hundred-million-dollar deal. And when your big deals are on the table, you will be right there, sitting at its head.

Profit First is not about accounting to the exact penny. That’s what your bookkeeper and accountant do. It is about handling your accounting quickly and easily with numbers that are as close to accurate as possible.

Chapter 6: PUTTING PROFIT FIRST INTO MOTION

Because if your business can’t afford to set aside two percent of your revenue, it’s probably not a business worth pursuing.”

My business partner and my compensation will immediately go from $ 40,000 annually to $ 50,000, we would have $ 10,000 of profit at the end of a full year, and we would also have $ 10,000 reserved in taxes to help cover our personal tax bills. And we are now forced by my company to run the business off $ 930,000 a year, instead of $ 960,000.

Your business is serving you now. You are going to take a profit distribution check every quarter. Every ninety days, profit will be shared to you.

Don’t confuse the profit distribution with Owner’s Comp, which is pay for working in the business. Profit is a reward for owning the business. Just as you get a profit distribution when you own shares in a public company, for which you didn’t do squat workwise, so you get a piece of the profit from your own company. Profit is a reward for equity owners, and Owner’s Comp is the pay for people who are owner operators in the business.

Quarter 1—January 1 to March 31 Quarter 2—April 1 to June 30 Quarter 3—July 1 to September 30 Quarter 4—October 1 to December 31

Remember, the PROFIT account serves a few purposes: Monetary reward for the equity owners of the business. A metric to measure growth. Cash reserve for emergencies.

take 50 percent of the money as profit. The other 50 percent remains in the account, as a reserve. To be clear, you will take 50 percent of all the accumulated money in the PROFIT HOLD account, not just 50 percent of the quarterly allocations.

let’s say you have saved $ 5,000 in your PROFIT account during the first quarter of implementing Profit First. On the first day of the new quarter, you will take $ 2,500 as a distribution to the equity owners and leave the other 50 percent intact.

if you own 60 percent of the company, another partner owns 35 percent, and an angel investor owns 5 percent, the distribution would be $ 1,500(for you, the 60 percent owner), $ 875(for the 35 percent person) and $ 125(for the investor).

The key is this: the profit distribution can never go back to the company. You can’t use fancy terms like reinvest, plowback, or profit retention.

Profit is intended to be your reward for having the guts to invest in your own business.

the goal is to never take a step back. I would much rather you take a small step closer to your target profit percentage than take a big leap toward it only to step it back a month later.

I mentioned the ideal three-month cash reserve for your business, the place where you have enough cash saved to operate your business unscathed for three months if all sales came to a screeching halt and not another penny came into the business? Well, the PROFIT account is where this reserve accumulates, just for that circumstance. If you see that the money in it is in excess of a three-month reserve, you know this is a good opportunity to put money back into the business, to make some appropriate capital investments that will bring a lot more growth and a lot more profit, or to fund the VAULT account(that’s a little teaser for what you will be learning in a little bit).

Chapter 7: DESTROY YOUR DEBT

This is the ultimate survival moment. If you focus all of your energy on paying down debt, that is all you will ever achieve. You’ll still be caught in the trap of top line thinking, which will likely result in more debt.

Even when you and your business are in debt up to your eyeballs, you must establish a habit of putting your profit first. You must still(and always) pay yourself first. When you get into the habit of fiscal health based on this system, you will fix the problem permanently. Financial crises will be a thing of the past, because if someone calls your line, you’ll have the cash to cover it.

tweak is, when you distribute profits, 99 percent of the money goes to paying down debt. The remaining 1 percent goes toward rewarding yourself. This way, the debt gets hit just as aggressively, but you still strengthen your Profit First habit.

Give yourself more joy when your bottom line grows(not just the top line).

The trap we fall into is believing our most recent best month is our new normal. Then we start running the business according to that“normal.” When the next month, or the month after, we come up short, things drop and we are caught off guard.

When comparing figures, compare your current month to the same month in the prior year. Comparisons and rolling averages will give you a much clearer picture of where you truly stand.

Until your best month becomes your average month, it’s not the norm; it’s the exception.

Cash is a fact.

If you have more money in the account than you take in salary, the difference in money stays, and accumulates. This way, when(notice I didn’t say if) a slow month happens, money has accumulated in your OWNER’S COMP account and your salary stays consistent.

you have to realize that switching from working in the business to on the business is not like flipping a light switch. It is gradual.

I also want you to know that no matter how devastating this is, laying off people is necessary. Trying to keep a few employees your company cannot afford will only put it under, thereby ensuring that all the employees lose their jobs.

Small, repetitive, continuous actions, chained together, build momentous momentum(say that one ten times fast).

Use 99 percent of your profit allocation toward wiping out your debt. With that remaining 1 percent, you still need to celebrate. I know it doesn’t amount to much, but you can still reward yourself. Even if you are strapped with debt you are eradicating, you still need to celebrate during the process, and a cash profit distribution to you, however small, helps you do that.

Start the Debt Snowball. Pay off your smallest outstanding debt first. As you wipe out each bill with recurring payments, use the freed-up payments to tackle the next smallest debt.

Chapter 8: FIND MONEY WITHIN YOUR BUSINESS

So the method is simple: achieve greater efficiency first, then sell more, then improve efficiencies even more and then sell even more. Over time, speed up the back and forth between efficiency and selling until the two happen simultaneously.

How do you get two times the results with half the effort?

For example, if you own a snowplowing company and currently plow one parking lot per hour, I would ask you to figure out how to plow two parking lots(two times the results) in thirty minutes(half the time).

Most entrepreneurs focus only on tiny improvements—“ How do I do this a couple of minutes faster?” Small questions yield only small answers. You want both the incremental improvements and the landslide discoveries, and you’ll find both of those with big questions.

“How can I cut costs by one third and still service the same amount of customers?” Split the truck. Split the truck. Split the truck.

In the end, the profits generated from the top clients are used, in part, to pay for the losses accrued in serving the bottom clients.

All revenue is not the same. If you remove your worst unprofitable clients and the now-unnecessary costs associated with them, you will see a jump in profitability and a reduction in stress, often within a few weeks.

Ernie lost money on me, but he grew his sales by a lot. Tomorrow he intends to use his new equipment and tools to take care of other clients and will, in theory, earn his money back and then some. The problem is, that rarely happens. As the bills mount, the pressure grows to sell more and more; and you end up working on projects in which you have limited experience and sometimes little interest.

getting more of the same things done with better and better results, using fewer and fewer resources.

Chapter 9: PROFIT FIRST—ADVANCED TECHNIQUES

Every business should have a three-month reserve, meaning that, if not a single sale came in, all costs could still be covered for three months(a quarter).

For example, document that on the tenth and twenty-fifth of the month, all the money in your INCOME account is distributed to the PROFIT, OWNER’S COMP, TAX, and OPEX accounts based on the respective percentages. Then the specific dollar amounts—$ 75 for PETTY CASH and $ 1,500 for EMPLOYEE PAYROLL—are transferred from the OPEX account into the respective accounts. Finally, the total money in Bank 1’ s PROFIT and TAX accounts are transferred to Bank 2.

For each full-time employee, your company should generate Real Revenue of $ 150,000 to $ 250,000(ideally more, but this is the minimum). So if you want a million-dollar company, you know that you can afford four to six employees(including yourself). This is just a ballpark number; every business is unique.

For example, let’s say you’re a manufacturer with $ 6,000,000 in Real Revenue. If you hire cheap labor, such as assembly line personnel, you will divide $ 6,000,000 by four to get $ 1,500,000. This means that your total labor cost(the people on the floor and the folks in the office) should not exceed $ 1,500,000. And if you are a manufacturer with $ 6,000,000 in Real Revenue but use expensive labor, such as scientists and engineers, divide the $ 6,000,000 in Real Revenue by two and a half to get a total labor cost of $ 2,400,000.

Chapter 10: THE PROFIT FIRST LIFE

Financial freedom means that you have reached a point where the money you’ve saved yields enough interest to support your lifestyle and continues to grow.

So, for example, if you’re taking home $ 100,000(post-tax, paid by your business) and your Profit First lifestyle means you’re setting aside $ 20,000 every year and living on $ 80,000; this is where you will start your Wedge. Half of every income bump over and above $ 100,000 will go directly into the Vault. The Vault starts piling up cash, and changes from a“Holy crap, I have no money” fund to a“Holy cow, that’s a lot of money” fund.

Chapter 11: HOW TO KEEP IT FROM FALLING APART

Money is made by efficiency—invest in it. If a purchase will bring up your bottom line and create significant efficiency, find ways to cut costs elsewhere, and consider different or discounted equipment(or resources, or services) rather than sacrifice efficiency for what you think are savings.

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