John Lund 00:02
Hello everyone and welcome to Five Tips. I am super excited to have Greg Crabtree with me today. He's been one of the greatest people to know in EO and the Entrepreneurs Organization, [he] does amazing stuff when it comes to numbers around starting a business, running a business, and growing a business. So, welcome Greg to five tips. Do you want to share a little bit about yourself and then let's get right into your five tips.
Greg Crabtree 00:26
Yeah, thanks for having me. And I certainly appreciate our long service together as member leaders in EO in various capacities. So it's always great to catch up with you. I was an unknown accountant and somehow a client of mine got me into EO and it totally transformed my life and the trajectory of what my career path and my business did. [I] ended up getting to serve on the global board for three years, I’ve served on the standing finance committee for many years and I finally got released on my own recognizance a couple years ago. Fortunately, I still get to do executive ed programs with EO. So that's really kind of my passion is educating entrepreneurs. Really, it's kind of a feedback loop. I've learned from them by watching them, and then figuring a way to take what they know intuitively and then turn it back to the people who don't have that intuitive sense of finance, you know, for an entrepreneur. And trying to get unstuck out of the accounting things that make things more complex than what they should and so in my case, my practice really took off with my first book in 2010, Simple Numbers, Straight Talk, Big Profits. And then as you can see on the screen here, this is the soon to be released next book. It's at the printer, you know, trying to get all the specs done and getting ready to start the print run. So it should be out here really soon. But this is really the culmination of the last 10 years of our consulting practices, the things we figured out, things we've observed, and really taken the original concepts and taking them to the next level. And really, it's about this idea how to scale your business, but do it in a smart way. I want to improve your bets. I want to improve your odds of success. But there's still some tough work that goes in it. So I'm going to give you some excerpts from that book in the process.
So these are the five tips that I would say we're going to start off with the three simple rules for business success. The three business value plays, there's only three plays of value in business and you want people to overtly decide which one are you actively running. The new concept we develop is CPR: Cash Power Ratio. It's a way to understand when your business is positioned to grow cash flow free. Essentially, you got the power you got the cash and the profit aligned to where you don't have to go get outside money and those are the super healthy businesses, the ones that can make that happen. Then the one number that's been big for everybody in this COVID crisis is the cash needed to be fully capitalized. Our clients who follow this principle, have really fared super well during this time. And then the last one, I call it the magic pixie dust of business, launch capital is really this thing that we've discovered and put a name on for people to understand. This is really how most operators grow their business. And so we think it's a really cool concept. I got a case study to show people how that works.
So the first one is to get an entrepreneurs head around, it's really simple. If I'm doing an analysis of your business. One, figure out what the market needs. And it's not so much just the product or service of what your business does. Are you doing it in the way that the market wants it to be delivered? I learned in our practice that we sucked at doing what the market needed from an accounting firms perspective. The thing that the people wanted was help me run a more profitable business. Oh, by the way, then let's figure out the taxes. And then we want regular communication, and so we've designed our practice around this idea of making that happen. And fortunately for us, we we've grown to a point that we were getting more demand. And so one of the things that's happened to us is we merged with one of the top 25, accounting firms, Carr, Riggs & Ingram back in January. So now I've got much more resources and ability to say yes, as we launch the next book, and really take this thing to the next level. So I'm really jazzed you know about having much more in the in the tool bag in terms of capabilities.
What we focus on first is this consulting piece of helping you figure out what the market needs and then from there, what's that market price? I’ve talked about an easy, good way to not make money is take all your costs, add them up and add 10% to it. That's a great way to lose money because your costs always are going to be more than what you thought. And really, I'm a big believer of you figure out what the market price of anything is, and then I make my cost fit and really just strive for efficiency, efficiency, efficiency, that is sustainable in that process. That's really once you figure out what the market needs, that's that figuring out a way to do it profitably. I mean, and that to me is the easiest step. I mean, once you know what you can do it's really a fairly straightforward exercise of what's the labor that you need. One of my finite operating costs that are the necessaries of it. And if I can't be profitable, then I got to go back to the drawing board and figure out okay, let's do something different because growing, when you're not profitable is not a good decision. It almost never is. But if you can show that you're profitable, this is the big aha that I've learned. And really, this came to me from being able to be the EO member chair for the executive ed program at Wharton that EO does. David Wessel who is one of our lead professors turned me on to this concept of return on invested capital. Now, David, you know, he looks as a professor, he's got public company data. I got all the private company data. So I got to take that concept, apply it to all of our base of clients. And what we've really settled on is, if you can't make a 50% return on invested capital is our number. If you can't be a 50% return in a US economy, international economies you got to look at things a little differently, but US if you're not 50% or better, you're not going to be sustainable. And, what I'm trying to get an entrepreneur to understand is you got an investment in your business, that you want to keep fading as long as it keeps growing. Because tell me what else you're going to get a 50% or better return on investment year after year after year. And oh, by the way, that's the minimum number.
The average of the well-run businesses are generally between 75 and 100% return. So why wouldn't you keep fading it? Now there's a point that the market says and no more I, you know, I've got it. The next level jump is I got to go to a geography I'm not comfortable with, I got to add more people than I care to manage. Those are all choices that you get to make. But until you know that business finishes its run, this idea that investment advisors always tell entrepreneurs to take money off the table. Well, why would you take money off the table, if someone's producing 100% return and I can give it some more money and it keeps giving me 100% return? I mean, that's kind of the dumbest idea I think I've ever heard. And that's because they want your money and give you 8% return on. I don't think that works, you know, in that process. Now, there's a point that you don't leave excess money in. And this is, this is a freebie. I don’t have this in the slides. So once a business gets fully capitalized, I will tell you this, you can actually deploy 100% of your profit back into the business effectively. I mean, what we say we call it the 40/30/30 principle. So 40% goes out for taxes, 30% gets retained for growth, and 30% of your cash is about the most you can deploy effectively from what we see. And 30% can be distributed. And so we have most of our clients on this 40/30/30 strategy, understanding that you can harvest 30% of your profits and take those out as after tax distributions of the business. Just don't get in the habit of having to have them because once you do that, you're putting stress back on the business. The business it's not going to always be profitable given the conditions in the marketplace. But as you distribute those, those are your external wealth building things that you can build money external to the business. So realistically, you can have both you can grow your business to the extent that it can grow and you can harvest that some of that wealth and build it externally to the business.
So anyway, Alright, so next thing. So let's talk about the three business value plays known as business value. So there's only three plays in business, you either run to harvest, that's the most common small entrepreneur, hey, it's a business, it's never going to get a premium. It's hard to run, but it's profitable, it'll produce cash. And it's usually gonna cap out at some size, it could be a million, it could be 5 million, it could be 20 million, you know, but there's a natural point that it hits its cap. But it's messy in general, those characteristics of the messy businesses that, you got to carry some receivables or inventory, you got a lot of labor. You know, most investors who pay premiums, they don't like businesses that require a lot of labor, because labor is hard to manage, guess what you know, but you can be profitable doing it. But these are great businesses that you have to deploy that 40/30/30 principle and then once you're fully capitalized, you can actually get to where your 40% out for taxes and you can distribute really 60% of the profits to build wealth, but you have to have a mindset and not consume all of the wealth. That all the profit that comes out of the business, you got to take your market base wage out of the business, and use that profit to build investments, buy real estate, put money in stock market, whatever you want to do with it. That's, you know, talk to an investment advisor about that, but you will have a significant income stream. And to be quite honest, that's probably where 60 70% of the entrepreneurs run that play. That's, that's the play that's mostly run.
The second one is the one I love the most. And when you can pull this off, it's what we call a harvest to premium sales. So I get the best of both worlds. I got a business [that] is producing profit, I got a business that somebody's going to pay me a nice premium for. Typically, I would call a premium, something in the seven plus times EBITDA range but closer to 10 is usually where I like to see it. And there's tons of those where if you got recurring revenue, you're in a situation where you get paid in advance, you're a customer funded business, you're real sticky with your customers, you get some long term contracts that can be repeated, you know those type of things. Those are the characteristics and there's some people that try to take the run the harvest businesses and try to throw some window dressing on them to make them premium, you know, type businesses and they get disappointed because they start to realize that the people buying the businesses aren't that stupid, they know,
they know how to evaluate it.
So if you can create but there's more and more businesses that have moved into the premium marketplace because of this one thing. There's more money in the private equity world today than ever. People don't go public with their businesses. You know, if you're going to exit you're going to sell to maybe a public company or a bigger company, but you might sell to a private equity group and there's private equity guys running up the prices even today. Even if it's COVID, we've got several, we've had probably three clients that have done transactions during this this environment. So there's plenty of money in the marketplace. The trick here is when you have a harvest until premium sale business, the trick here is understanding when do you say yes? And so we have in the new book, I talked about this idea of a replacement return decision tree, where, you know, when somebody presents me an offer to sell, I look at my after tax proceeds, and then say, [what] is the profit that I'm currently making as a percentage to my after tax proceeds? If that that number is 15% or less, it's probably a green light to go ahead and sell. But if that replacement return has to be higher than 15% of what my net proceeds after tax are. You know, I need to keep going. Because guess what I mean, I've had this number of times happen. I’ve had clients say no. And guess what, they came back to the table and offered him more money, because when you have profitability, you can afford to say no. And that's the key, you know that I believe.
Now the third one you always hear about the tech world, but even there's some other industries. Build to sale is where you're throwing everything you can at the business, you're not, clued into profitability. And you're just really trying to get big, and most of these build to sales that are successful in the entrepreneur world are more so what I call strip sales. And so essentially, you're building it up and in, you know, we've had clients that weren't profitable, but sold for a lot of money because they generated a margin creation business that could be bolted on to somebody else's business. So that's how you create value in that realm. But it's really dangerous because it's like having one fuse to light your rocket. If you fail to achieve escape velocity, you crash and burn, and there's not a good outcome. And so you just kind of understand one, it's a low percentage chance of success. And two, it has a lot of risk of you go, you go, you go, and then all of a sudden, it just implodes. And unfortunately, you know, we worked with some successful ones, and we worked with some people who weren't successful. And they got sucked into the volume game. And you know, you're just getting bigger for no apparent reason, and that that just didn't work on that process.
This is one of my favorite new charts is we call it CPR: Cash Power Ratio. Now, I'll show you what I mean here in a second, but just take it for face value for this. So think of working capital current assets minus current liabilities. That's what we were taught in college is accounted so it's an important number. Guess what? It's a flawed calculation. I’m telling you. So working capital is a dumb calculation because it contains two numbers that shouldn't be there. Cash and debt. So if I take cash out of working capital, take debt out of working capital, what I have left over is what I call trade capital. It's everything else that turns over. Simply, it's accounts receivable plus inventory plus work in progress. Minus accounts payable, minus accrued expenses, minus deferred revenue. It's the net of those numbers. Any one of those numbers individually is just an individual action. It's how those numbers work off of each other as a net number. As accountants, we screwed things up by putting half of the stuff on the asset side and half of the stuff on the liability side.
The reality is they should be looked at as one that number because when that number is a positive number, that's a capital component that you got to find in your business unless you figure out a way to be better than the rest in the industry and get your customers or your vendors to support it to where the net number is zero. And so now, once you know what that trade capital number is, you're going to look at it as a percentage of revenue, annual revenue just like you look at profit as a percentage to annual revenue. And when my profit percentage is higher than my trade capital percentage, I don't need any external cash to grow. I'm going to create my own with every new dollar that I sell, I'm cashflow positive. Anytime that my trade capital percentage is higher than my profit percentage, I'm going to burn some cash. So if my trade capital percentage is 15%, and my profit percentages is 10%, every hundred thousand dollars of new sales that I get, I gotta fund $5,000 of that with my own money. I'm negative cash flow with growth. Now, once we've shown our clients, this relationship, what has happened is they grow more backbone to push profit up and get better terms and pull trade capital down. And all of a sudden, what they thought was not possible, becomes possible. And they become a cash flow free business and they don't have to go to the bank and beg for lines of credit increases, they don't have to go and beg investors for investment money. They can grow as fast as they can execute. And when we get growth to an execution only decision, that's when we're at our best as entrepreneurs, you know, in that regard.
So here's an example. So, there's only three things that happen in business, you either make stuff, you sell stuff, or you do stuff. You might be a combination of the three but you have a dominant theme that you do. So in this manufacturing business, they’re at 13.3% profit to revenue they’re at 12.3% net trade capital because in their case, they're King AR but their vendors in this case they were able to get their vendors to essentially effectively give them consignment. So they only they had an agreement with their vendors where they only had to pay their vendors as they sold inventory. And so it wasn't literal consignment, but it was an economic consignment. And so in their case, they only had 542. Now, if this if the vendors didn't give them terms, this this wasn't gonna work, this number would be higher and that company would burn cash if they grew. They'd have to grow, pause, get cash, catch up, grow, pause. Well, those are hard knobs to turn. And this one they've got infrastructure capital, which is the second component of capital which is fixed net book value fixed assets minus debt, say about 250,000. And then this buffer capital is the cash, the two months of cash number that I talked about. And so this business needs $1.1 million of capital to be fully capitalized. And if they keep this 585 of net income, they meet the 50% return standard. They’re at 53% return. They're probably at optimize profitability and tweak even some of this trade capital, get some better days and receivables and get this trade capital down to seven or 8%. Guess what, this return on invested capital shoots up to about 75% of return. So that's why it matters.
In the sales business this is a great example. They only have 3.1% net profit to revenue, they do about 40 million in revenue. But in this case, this was a business that grew rapidly because the owner went to his vendors and he said, you know what, if you'll give me 75 day terms instead of 30 day terms, I can sell 10 times as much and he proved that he could and because you can see the accounts payable here 4.2 million covers not only inventory, but some of the accounts receivable and so they only have 767,000 in net trade capital. If this guy was carrying 4 million in trade capital against that, I mean okay, so you're profitable. Guess what, that's just not worth it.
We see this in the distribution world quite often, especially in third world economies, that people get drug into these big, high revenue businesses with 5% margin and it just chews cash. It never produces any cash and they feel like oh, I'm a big man. Yeah, I got 100 million dollar business. Oh, big whoop dee doo you ain’t making any money and return on investment sucks, you know so. So it really is. And as I've given this talk internationally, I will tell you the number one difference between a third world economy and a first world economy is the speed of cash through the system. If the third world economy could shorten the days and give terms like we do in the US, they would have a power, it's not that economic things don't go on in those countries. There's tons of demand, tons of need. It's just they don't have trust in the flow of money. Oh by the way, the governments who are promoting entrepreneurism in those countries, they're the worst payers of all. They're the ones that take 90 days to pay. And if they would be the leaders instead of the laggers, you'd see tremendous change in economic outcomes of those countries in their entrepreneurial endeavors in that process.
The service business, you can see why service businesses can be the most stable, but it does not have exceptional trade capital potential unless you get this deferred revenue number. So this company, this company would actually have negative trade cap or they would actually [have] their trade capital be higher than a profit percentage if they didn't get billings up front. And so if you're a service business and you're not getting paid up front, it's not good enough to just bill up front, you got to get paid up front. For some portion of your service, you got to stay ahead of the process. And I know sometimes that's a challenge, but if you don't ask you're never going to get it. And that's really kind of the key. But all of these produce a 50% or better return on investment, you know, and that's really kind of the key.
So we talked about the cash thing. I mean, I will say, the biggest thing for people that we've worked with through COVID is the ones who bought into our two months of operating expenses, including direct labor and cash, have nothing drawn on the line of credit. And then have your current taxes set aside that's not part of that cash and make sure that you're just not holding on the IRS money is part of that two months. Those are the companies that have just done so well through this. We’ve got one client that's been shut down through this, that they're not going to open till August. And they fared just fine, because they follow this principle. And so I can't, you know, push it strong enough. Now, when you have more than two months, that's idle cash, that's excess capitalization. You got to either figure out what to do with it or take it out of the business and at least you know, keep it on the sidelines in that process.
So this is what that looks like. And so it and you know, you can't get terms from direct labor, so you got to count all your labor. And so you can see that's why the service business has the highest core capital target of the two months is because it's all of this labor that they got to carry, that makes their number that much higher. But you just take these operating expenses, these are annual numbers, you take those divided by 12 take the labor numbers divided by 12 and that gives you how much cash you should have on hand. And so we try to teach like this manufacturing business, you know, we will tell them until you have $300,000 in cash, you don't have any cash. So just don't even think about it. Get accustomed to this idea of having $300,000 in cash and everything above that is what you can work with. What we've seen with the ppp money is I will say that this is probably the best looking balance sheets that our clients have seen. Even the ones that follow our principles, they're still sitting there holding on to the most ppp money. And so they're getting this feeling. It's amazing the feeling you have when you're looking at a very nice cash balance, even though the business might be a little bit under as normal profit run. And so from that standpoint, it really just helps you run the business in a much more effective way. And it is a hard number it you know. I think one of the things, how much cash is enough, we have a very defined formula. And every call, we go through the client, we're telling them this is what it is, are you above it or are you below it? And they know it.
So launch capital is another thing we learned in the last 10 years is this idea. So I talked about back here I talked about the four types [of capital]. There's four names for capital, which is trade capital, infrastructure capital and, buffer capital, which is the two month cash. Well, I said there's four, three of these reside on the balance sheet. So trade capital, infrastructure, and buffer is every account on your balance sheet that is active in the business. And you may have some balance sheet accounts of your interactions with the business that are not related to the business. And that's the trashed up that shouldn't count. But these are the three requirements of the things that are in your business that builds your capital base that the sum of those three is your invested capital in the business, but there's a fourth capital component and it's called launch capital. And it resides on your P&L.
Now, they don't teach this in college. But this is what entrepreneurs have taught me. Entrepreneurs, you've done this and throughout your business life, John, you spend money and diminish current profitability, on things that had no impact of what I'm currently doing. But the impact is where you want to get to with your business. And so any span that you make presently in your business of a discretionary case that I did not need to spend to take care of my current customers needs of what I'm currently doing, that's a launch capital spend. Generally launch capital comes in three major components. Marketing is generally the number one. Labor is number two. Facilities or infrastructures is number three. I would say 90 plus percent of the launch capitalist fans that we monitor is either marketing or labor. And so you got to have a way of looking at that and saying that is the catalyst expense. Now there's other costs that are going to change because I've spent those, I just really want to isolate the things that were the pure choices that started the chain reaction. That's what I want to focus on.
And so if I'm going to start a new activity, I'm going to focus on how much am I spending until the impact of that activity is now breaking even with what I have spent. So if I want launch a new location. How much am I spending to get that location open? What are my operating losses until it breaks even? The sum of those things, there's investment capital, or that's my launch capital. And that's what I'm going to base my return on. And so then I'm going to establish an expectation in the future if I launched that location, or a new line of business, or you're just trying to go win new customers, how much am I going to lose? And then what is what is my potential gain? And once again, it comes back to this 50% return. If I invest $200,000, in a new activity, I need to see $100,000 ongoing profit return to achieve 50% return on invested capital. So I get my money back and make a 50% return, you know, within a 12 to 24 month period. And we see this happen. I mean, it may sound too far fetched for anybody to achieve, but I mean it. I mean we monitor this all the time and when people get locked in It really changes their decision of what's a good spend versus what's Hey, let's just try this and see and it's perfectly fine to just try something. But you still got to have that evaluation loop to come back and look at it at some later point and say, Did it work? Or did it produce enough? And let's read, let's learn from that and say, either let's do more of it, or let's try something different. And so here's the example.
So this is a client. This is a case study that's in the new book. This this client went from $700,000 in revenue to 10 million in five years. So I mean, this incredible story, but their number one catalyst was this marketing spending freeze that was every year they sat down and said, How much are we going to increase our marketing spend? So this first year they increase marketing spend 121,000, they got a profit increase of 55. So they got a 45% return on that marketing span, so not quite 50, but it's like okay, that's a good start. So let's try it again. So they increase it again by 103,000. Last year, they got a 493% return, I mean, just took off. Now granted, some of this profit in that second year was late and, you know, affected the things that happened in that first year I get it. But you know, you can interpret that once you see it, you just got to have the rules of how you're watching it, you know that process.
So, as entrepreneurs go, they say, we'll have a little bit good, a lot better, let's just have a lot on the fire. Let's put 394 [thousand] in it and the third year and you see that they got their head handed to you. At least they recovered their costs, but they didn't make anything new. And this is really where you start to learn how to find the edge of the universe. You don't leap to find the edge of the universe, you take one step at a time, and they overstepped the demand and the need of the market. And they overplayed techniques that have natural life cycles to them. And so they were still committed to the idea they just recrafted their strategy still added more money to it in the fourth year, and got back to a 91% return. And then same thing in the fifth year, you know, spend another 154 [thousand]. I mean, so the marketing spend goes from 75,000 a year to a million a year. They're getting continual results in their business model. And they're continuing to build their direct labor team, they're building their management team, they're building their infrastructure, you know, they're that process, but they made money every step along the way, because they stuck to this return philosophy in that process.
And so, you know, and this is really where, like I said, we've got clients that, you know, they figured out different ways to fund new locations, instead of maybe putting their own money in for leasehold improvements, they either are able to finance it and turn that financing cost into a kind of an operational cost, in essence, or get the landlord to fund it. You know, those kind of things and so where you can, when you can lower the capital cost of an expansion, then you really juice the return on investment return of what that new expansion is. And you lower the bar of, you know, I don't have to reach way up here to be successful, I can have a high return with a much more realistic outcome that growth in that process?
Yeah. That’s really interesting.
Cool. So, that's my five
John Lund 31:24
Those are incredible. I mean, just, I learn a lot every time I listen to you, and you share some interesting things. One question I have for you is, sometimes it’s early on, but sometimes we you know, three, four or five years into a business where either the owner themselves is not taking out you know, much in salary, or maybe even some key employees are getting paid below market, way below market. How do you ask people to account for those kind of situations, so they're, they're understanding the real cost of running their business.
Now, I've always been an advocate of you book, the full market wage whether you can pay it or not, you know, starting off. The idea is [to] make sure your accountant who does your taxes knows that you've done that because, you know, they need to account for it differently when they file your return. But, you know, I book the offset of that in the equity section. So I'm going to book the expense for the salary that I didn't take, I'm gonna put the other in sweat equity. And then I probably even call it sweat equity and put it in the equity section of the balance sheet. And basically, you know, keep it going until you achieve your minimum executive profitability. Because the thing I drive for is until you you're achieving a market wage and you're hitting your 50% or better return on invested capital, you got an underperforming business. I want you to not slow down because I want you to see the real brackets around you know the loss of the business and don't let yourself off. The amazing psychological thing over the years is we started harping on this idea of the market based wage, the sooner you can pay a market based wage to yourself, you will actually make more profit. I will guarantee it. I've never, never not seen it work. And there's just something psychological about you will work harder to keep your paycheck and not miss a paycheck, then you will then you'll protect profitability.
John Lund 33:22
Interesting, that is that is great. I mean, this is an amazing, man some great tips. I think a lot entrepreneurs will take away. I really appreciate you coming on MYB2BCOACH’s Five Tips. I appreciate everything you've done for the EO organization and me personally. So thank you very much, Greg. I appreciate I've
I appreciate it. I’ve benefited greatly from being around people like you. So we'll look forward to many more years of helping businesses together.
John Lund 33:46
That'd be great. Thank you.