Crabtree 4 keys: Key 1 Owners Compensation
Since the material in Greg Crabtree’s book “Simple Numbers, Straight Talk, Big Profits” has been so helpful to myself and our consulting clients, I want to share more from his book. In the coming four weeks, we’ll be taking his four recurring issues he’s seen in own consulting work as an accountant.
His book is written with a real world understanding of how to look at your business financials from an entrepreneurial perspective, not a lofty corporate structure.
In the forward iconic business coach Verne Harnish credits Crabtree with highlighting basic truths about running a business that are rarely articulated in a business book, “starting with the fatal mistake of thinking you’re making a great profit without accounting for a reasonable salary for yourself.”
Crabtree’s focus is squarely on mastering the basics, tailors his advice for the street-level entrepreneur, from startup to $5 million in revenue, and uses examples from businesses still in that early growth phase or beginning to ramp up.
There are lots of ways to think about your business, and it’s easy to get distracted by different ideas of growth. But growth doesn’t necessarily reflect that your business is healthy. There are plenty of businesses that have had great top-line growth — right up until they ended up closing the doors and going bankrupt.
Alternatively, if you think of your business like a cow, the goal is to keep that cow healthy so that it can provide for you now and in the future.
A healthy cow not only provides milk every day, but it’s also worth something down the road should you consider selling it. An unhealthy cow doesn’t provide milk, and if it gets bad enough, it will die — with no value to the owner.
“You can keep the cow healthy and milk it every day, or you can have one big barbeque dinner.”
— Greg Crabtree
The reason businesses don’t survive is because entrepreneurs fail to see the relationship among the most basic business metrics: cash flow, profit and productivity.
Crabtree explains how these three key financial indicators work, and how failing to understand them leads to four recurring problems that can kill your business. They are:
Confusing profits with salary: Crabtree says one of the most important things an entrepreneur should learn early on is this: “You get paid a salary for what you do, and you get a return on what you own.” When business owners don’t pay themselves a market-based wage, and include that expense in their financials their net income number is misleading.
Breaking even isn’t good enough: The goal of every business owner is to make a profit, but that should be on top of getting paid for the work they do. If you are just breaking even, after paying expenses, taxes and yourself, you’re not profitable enough to grow the business.
Productive means profitable: Nothing sustainable happens without labour productivity. And the best way to get control over your profits is to make sure you are getting the maximum productivity out of every labour dollar you spend. This does not mean working people harder, this means getting the right people in the right spot.
Know where the money goes: Many business owners get in a cycle of seeing money come in and go out of their business with no clear understanding of where, and why, it’s going. Crabtree urges owners to master the “four forces of cash flow” that suck money out of their business: paying taxes, repaying debt, building working capital and taking profit distributions.
This week we’ll dip our toes into Salary Caps, leaving further explanation in the third week, Labor Productivity. But today it serves our purpose to start the conversation around owners' pay. Believe it or not, you have a salary cap too, and it has nothing to do with your opinion.
What Is Your Salary Cap?
Like the NFL, we as business owners have salary caps. The NFL created a salary cap to max out what each team can spend on their players in an effort to create a fair shot amongst all the teams.
Now, you may have not thought that you have a salary cap. However, in reality, we cannot pay ourselves more than we generate in revenue, and we also shouldn’t pay out more than what would be a respectable profit margin. every business needs to strive for profit.
In general, a company with less than 5% profit margin is on life support. One that is greater than 10% is a good business, and a profit margin above 15% reflects a great business. More on this next week.
You need profit to pay your debt and to have cash flow to grow the business.
Let’s look at an example of how this works to determine what your salary cap would look like:
Revenue $ 1,000,000
Salaries $ XXX,XXX
Non-Salary Expenses $ YYY,YYY
Pre-Tax Profit $ 100,000 (10% of revenue, the percentage you want to have to be a good business)
Now you can determine your business’ salary cap. This includes your salary.
Start by adding up all your non-salary expenses and plug them into Y.
Then, subtract your pre-tax profit and the non salary expenses (Y) from your revenue, and the number you have left over is your salary cap (X). It should look like this:
Pre-Tax Profit ($100,000) - Non-Salary Expenses ($ YYY,YYY) = Salaries ($ XXX,XXX)
This is the number you don’t want to exceed in order to maintain the appropriate profit margin to increase your business.
Remember, breaking even is dying, and having less than a 5% profit margin means the business is on life support.
What do you do if your salary number is higher than what it should be to maintain an appropriate profit margin? Go back and look at the productivity of your people and determine who is getting it done and who is not.
We will discuss this in depth in week three, but in brief, as business owners, we need to make sure we have the right people performing in the right roles for optimal productivity.
When looking at your own salary, remember there’s a difference between a salary and a return on the business.
Are Your Net Profit Numbers Distorted?
Most entrepreneurs are not clear on the difference between their salary and the return on what they own.
Business owners often confuse the profits of their business with their salary. You get paid a salary for what you do, but you get a return on what you own.
When you are not paying yourself a salary at market levels, you are distorting your true net profit margins. When you are not looking at accurate numbers from this perspective, your financial data is worthless.
Making decisions from skewed financial data is like having a compass that is five degrees off in every direction.
If you don’t get real with the numbers, then you won’t get where you want to go.
Most entrepreneurs are underpaying themselves. This may be to show off our higher numbers to others or because they want their numbers to look good for potential investors.
The industry, your responsibilities and your salary cap all come into play when you are deciding your salary. Check out Economic Research Institute’s Salary Survey Assessor or go to www.salary.com to compare your salaries with the industry averages.