Michael: Hello and welcome to HaBO Village Podcast. I'm Michael Redman.
Kathryn: And I'm Kathryn Redman.
Michael: And this is a podcast working with you small, medium-sized business leaders who want to build companies with more profit, purpose and legacy. We're talking about companies with a greater culture and more cash on the bottom line. What could be better than that?
Michael: Today, we have a phenomenal interview that we're going to do that's going to be really fun. Wait. Wait for it. It's going to be about finances. But don't hang up. Please, don't go away.
Kathryn: Even better, tax, taxes. We're talking to a CPA tax guy today.
Michael: But this is good because he's a nice guy. He actually speaks like a normal human being.
Kathryn: He's wearing a T shirt that says, "We'll give tax advice for tacos." He's clearly our people.
Michael: So, before we even introduce him, how good could he be then if he'll only be here for tacos? Okay. So, welcome to the podcast where you get insulted before it even starts. So introduce our guest, Kathryn, because it's quite a day.
Kathryn: I know. It is quite a day. So, we are super excited to introduce John Briggs. He's the founder of Incite Tax & Accounting. And he authored a book called Profit First for Microgyms.
Kathryn: So, John, part of the reason we get to just connect with John and why we're so excited is that he has a lot of experience growing and scaling his own successful fitness gym through proper management and an anti-burnout work ethic, which is when I think of gyms and gym owners, that's a big deal.
Kathryn: But he also works with multiple gym owners, as well as other small businesses around the country, maybe international, I don't know that to really deal with what does it look like to build a business that has really good money management but you're not killing yourself to achieve financial success.
Michael: Welcome to the podcast, John. And thank you for your grace in listening to that intro.
Kathryn: Oh my gosh.
John: Thanks for having me. I didn't know. Do you want me to use my robot voice because I'm an accountant? Or do you want me to like speak human?
Kathryn: Most of our people are sort of human ...
Michael: If you've mastered the human one, let's use that.
Kathryn: Let's use that.
John: Okay. I'll try my hardest.
Michael: So, one of the things we've had experience with is gym owners to some extent, and if people are thinking, "Well, gym owners, what does that have to do with me," small gyms, these guys work really hard. They care about health. They care about fitness.
Michael: The CrossFit ones, we've got exposure to several of those. They suck at managing their time and their business. It's a weak spot. They're working in their expertise in the business and haven't quite learned how to work on the business. And that happens with a lot of different type of companies. Does that sound common to you or am I off in left field?
John: Yeah. I think the way all business owners can relate to gym owners is that they started their business with the passion first. And then they realize, "Oh, crap, there's another part of this that I have to know in order to keep doing the things that I'm passionate about."
Michael: Yeah. That's great. And it is an old crap, huge ones sometimes. Like, "How do I stay in business? What am I going to do?"
John: Right. How do I pay for the bills? How am I going to put food on the table? I don't know. I'm going to go help someone get healthier. I can't think about the other stuff.
Kathryn: And how do I compete with the 150 other small gym owners in my town?
Michael: And one of the reasons that I think is interesting talk today. So we have one friend, Peter Lee, a CrossFit guy up in Canada who no longer has a CrossFit gym. They did very well. They brought in a lot of customers, everything else. He totally ignored the finances.
Michael: He did everything. His marketing was amazing. He's fit. He's fun. He's a great guy. He actually doesn't talk like a gym head. But he's the first one to admit, because they're no longer in business, that the finances overwhelmed them and killed them because they weren't managing them. Speak to that for me.
John: I think, again, this isn't a thing just specific to gym owners. What happens is you can go for a length of time pushing through. We're just going to buckle down and push through, and work hard. All the while, you are emotionally and psychologically defeating yourself. But a lot of times, it's subconsciously.
John: But there always comes a point when it's like, "Oh, because I've neglected to take care of the profit component of my business, now I realize I've been doing this for x amount of years. I have nothing to show for it." You'd go into this kind of depressive cycle. And once that starts happening, ownership to we're closing our doors happens super fast.
John: I mean, that's the burden out that we're trying to avoid because if you're not focusing on your profit, it's happening especially for companies that are losing money. Yeah, they love what they do. But at some point, the piper has to be paid which is keeping the doors open to all that good stuff that we have to do. And, yeah, they just get to this point where it clicks and they realized, "I can't sustain my life this way," which is super sad because it's not just gym owners. Whatever passion it is that we have as small business owners, when that happens, a candle has been put out, the passion that you have is no longer benefiting the world anymore.
John: And so, that's why our message is so focused on, "You can focus on your passion but please don't neglect the profit side." So, the Profit First methodology isn't saying there's other things that are more or less important. It's just it has to be a component of the systems in your business.
Kathryn: So, John, is this a revelation that you came to by just watching people fall apart doing this? Or is this something that perhaps you walked through and experienced yourself? Tell us how you came to this.
John: This particular observation of working for a passion and then realizing, "I don't have the money to keep doing this," has come through my experience working with gym owners. I have worked with businesses that they didn't take care of the finances. I mean, we can get into the story if you want of this company that did $30 million in revenue and declared bankruptcy the same year.
Michael: Yeah, we want to get into that story.
Kathryn: We definitely want to hear that story.
John: But that to me wasn't a passion project for anybody involved. They sold door-to-door like DIRECTTV or DISH stuff, but definitely an important component of profit. The passion part I've definitely seen with gym owners because, and it's not just gym owners, anyone who's doing a service that is affecting people physically, they just have this nature of charity in their body. It's just in their DNA.
John: And because of that, they usually don't want to say that I deserve to be profitable because they're helping people have a better life. But the reality is everybody deserves to be profitable. And I argue, you have to be profitable. In fact, your clients are begging for you to be profitable because if you're not, you're not going to be around to continue to bless their lives.
Michael: That's good. That's really good. Let's jump back to the $30 million for a moment. I mean, when you look at the stats, the stats we've seen are 80 to 90% business failure rate. Of the companies that survive, only 4% get to seven figures which is even a smaller percentage gets to eight figures. So, you're no schmo to get to $30 million. That's not an easy task at all.
Michael: How do smart people who had a $30 million company filed for bankruptcy?
John: Okay. So, quick side note and then I'll give you the dramatic story of how this went down. They were number 76 on the Inc. 500 list the same year they declared bankruptcy. So just as a side note, I have nothing against the people who created the Inc. 500 thing. It's a terrible metric to go off of people. You cannot just focus on top-line revenue, it means nothing. It's a dog and pony show.
Michael: [inaudible 00:07:56].
Kathryn: Yeah, totally, completely.
John: So, I'm sitting in my office and the weekend before, we had just had our End of Year celebration where we're giving out bonus checks to all the sales reps. And I mean these are college-age students, $10, $20, $30,000 checks to these guys. And the president of the company comes running and he's like, "John, you better lock the doors. Don't let anyone know that you're here." So, I am the controller which is a fancy way to say head accountant. And it's really an ironic title because the controller has zero control.
John: And so I'm like, "Okay. Well, typically, my day is pretty boring. It seems like you're being a bit dramatic. What the heck is going on?" "Well, all those checks we just sent out, you know that loan the business owner was working on, the million-dollar loan he was trying to get. He didn't get it. So those checks are bouncing. And they're all going to come in because I'm texting him saying, 'Oh, just go into John, he'll write your new check.' But you can't be here because when you write them checks, those are also going to bounce."
John: Because again, he didn't get a million-dollar loan, $30 million in revenue, still needed a million-dollar loan, checks bounce, sales reps weren't getting paid. And the sales reps in a sales organization for door-to-door sales company, kind of a big component, they all jump shift.
Michael: And getting a million-dollar loan, for those of you who have never even thought about getting a half-a-million-dollar loan or $100,000 loan for your business. A million-dollar loan for a healthy $30-million company should be an afternoon conversation with your banker and that's about it.
John: Yeah, but not with their financials.
John: So, the mindset of this organization and it really goes into Parkinson's Law which we're all subject to even if we're not aware what's going on with it. So, Parkinson's Law says the demand for something expands to match the supply. The way this relates to us, as business owners, is we're saying, "If you have, say, one business bank account, the demand to spend that money will continue to expand until you no longer have any cash to spend."
John: Because usually, we look at the bank account, we make a decision, "Oh, yeah, I have money in the account, I'll go and spend it." On these guys, I was the first one to introduce the idea of a budget to them. And this was pre-Profit First, this cash flow system that I love a lot. But the concepts are there. And they just didn't have this like they didn't get it. Like, "No, if we need more money, we'll just sell more."
John: Well, when you say that over and over and over and over again, you've soon extended your capacity to sell compared to the expenses that you're taking on. I'm sure you've seen this with your clients. As income increases without proper systems in place, expenses increase the same pace, if not faster, than the income is increasing. And this company, that exactly what happened to them. They never took thought that they couldn't outsell their expense problems.
John: I mean, they would get $800 for an install from DIRECTTV. The company kept $8 after paying out all the expenses of the things they put into place. Eight dollars, that's a terrible margin. So $30 million in revenue and you have $30,000 of profit. It's terrible.
Michael: Yeah, that's insane. So some people are saying, "Well, that's just ironic or moronic and I would never get into that situation," or, "That wouldn't be a problem." From what we've seen, there are small slivers of that in most businesses. I will admit that they exist in our business, too. And we're constantly trying to go, "Okay, how do we make sure that we're not letting them get out of control and we continue to learn and grow and be better?" You have to be diligent because it will just run off on itself.
Michael: But how does that happen? What does that look like? Why is that such a real problem?
John: It literally is this human psychology that we have with this Parkinson's Law. If we see the cash there to spend and we haven't thought to say, "Well, the reality is when a dollar hits my bank account, that whole dollar is not mine. I've made previous commitments whether it's to my landlord or my team." If the government, not that that's a voluntary commitment we make but it's there, it's a commitment we have to pay.
John: So, we're saying in our system to avoid that like, "Let's separate those main things out first because without it, you are going to run through the risk." And here's a litmus test that everyone listening can do if you think, "That would never happen to me."
John: Pull up your statements, even for the last few months, say three months. If you can look at every single expense and you don't say these two phrases to yourself, then maybe it won't happen to you. But every time we've done this with our clients, these two phrases come up as we're looking at their expenses, "I don't know what that's for," and, "I thought I canceled that." Those two phrases every single time.
John: This is an absolute. A hundred percent of the time, I've sat down with a business owner and gone through their expenses, they've said one of those two things.
Michael: At least once, right?
John: At least once, yup. "I don't know what that is," hey, which by the way, if you don't know what that is, chances are you're not getting value from it. So, you're overspending money and you're falling into prey of Parkinson's Law. Or, "I thought I canceled that," you're not paying enough attention. And again, overspending money because if you thought you canceled it, obviously, you know you don't need it.
John: Look, we're all human. We all make mistakes. Even still I follow the system, I still make mistakes. But because of the way I monitor my expenses on an ongoing basis in little chunks of time so it's not overwhelming, I can at least identify those things like, "You know what, I did decide to spend that but I know I'm not getting the buy. I want out of it anymore." Let's just cut it off now instead of going two or three years down the road realizing, "Oh, I'm paying $50 a month for something that I'm never using."
Michael: Yeah. Okay. There's a couple of questions that I think are cropping up at the moment. One is, what system are we talking about? And two, there's that intrinsic question that people are asked like, "Well, crap, how do I even find the time to go through all that? And how do I even organize it in a way where it's not overwhelming?"
Michael: So there's three questions there. How do we organize our finances in a way that's not overwhelming? How do I find the time to do it? And what system are you talking about? That I assume helps answer the first two questions.
John: Yeah. In fact, I'll answer all of the questions with the system and explain to you the nuts and bolts of it. So we're talking about the Profit First system originally created by Mike Michalowicz. It's a great book. And now, there's some of these books like I've written Profit First for Microgyms. There's one for dentists. There's one for real estate investors that are niche specific to obviously those things. But Profit First is the cash flow system that we're talking about here.
John: And let me just lay out the nuts and bolts because it answers those questions. How do we do this in a way that doesn't kill me as a business owner because I don't feel like I have any time right now? We've talked about this. I have team members I have to pay. I'm going to owe taxes likely to some extent.
John: Some other things that owners overlook. I got to pay myself. Hey, you know what, I love my team and I try my best not to toot my own horn. But guess what, as the owner, you are the most important employee of your business. How do you treat your most important employee? You make sure they freaking get paid.
Kathryn: You know what, I love that you said that. I mean, we will talk over and over again about how many people come through our doors. And they're like, "We're doing great. I'm breaking even. I'm profitable." And we're like, "But are you paying yourself?" It is shocking.
Michael: We've talked to people that are making $6 million a year in revenue. And literally, they're not taking anything. They're barely covering maybe some health insurance for their family and that's it. I'm like, "How did you get here?" I remember talking to this one woman who had two business partners. And so for some reason, all three of them thought this was a good idea.
Michael: And they were like, "Well, if we can just get from $6 million to $10 million, the problem will be fixed." And literally that was theirs. I'm like, "Oh, please don't do this to yourself."
Kathryn: You're just going to have $4 million more of the bigger problem.
John: And more of a bigger headache, exactly.
Kathryn: Because you have a really bad mindset about how you're doing this.
John: I think that's why this system gives us the boundaries around that. I mean, so this system would change that $6 million client's life. Now, owner's pay is specifically identified for the owner who's working in the business. Sometimes you have owners who don't work in the business. And that's why there's a separate account called the profit account because all owners should receive a profit distribution, even those working in the business and those not working in the business.
John: Because guess what, you guys have taken on a risk that your other team hasn't. That risk deserves a reward. We call that return on investment or a profit distribution. So we call it profit account and it's pretty simple. We say create separate accounts for each of these things. The first one, income account. The purpose of the income account is to solely receive customer deposits. And it makes the rest of the system super easy. And it will make sense in a second when I tell you how we do the mechanics of it.
John: So there's an income account, an owner's pay account. There's a profit account and a tax account. And then, usually the account that everyone's already using right now, we keep that and call it operating expense or opex. So, five basic accounts that if you're looking for the nuts and bolts of the system, those are the things.
John: Money comes into the income account. Either once a week, no more than once a week, or twice a month, you're going to sit down. And I promise, it feels overwhelming now because I just said, "Oh, you should set up five bank accounts." And now, you're going to manage these five accounts. Most owners who aren't feeling like they're managing one account are being like, "No, it's actually taking the elephant into smaller bites and it works."
John: You're going to be able to get through.
Michael: So what I hear you saying is it sounds counterintuitive that it could work.
Michael: But it is counterintuitive, it does work.
John: It does. Because you're going to end up taking 15 to 30 minutes, that's all it takes, whether you're doing that once a week or twice a month. So on these days, the money that's been sitting in your income account, you are now going to transfer percentages into these other four accounts. You do have to do a cash flow analysis.
John: And if you read the book, there's a table. If you go to our website, you can find the table of the recommended percentages. You're likely not going to take the recommended percentages, but that's where Profit First professionals can help guide them.
John: But let's just say for sake of I would say the typical client we bring on who's never done this before. We're just popping like 2% of their income into the profit account. Nothing big that they feel like, "Now, I'm strapped for cash." But we want them in the habit. So, 2% percent into profit. Unless your adjusted gross income on your tax return is more than a million dollars, if you're under that ... and I'm talking about your personal tax return because most businesses flow to the personal tax return.
Michael: Right. Like for instance, S corporations especially will do that, right?
Michael: And a lot of small companies are under an S corporation.
John: Right. So the S corp doesn't pay taxes. As the shareholder, you pay tax on your portion of the income. Our average is 7%, 7% of gross income into your tax account will cover your tax bill. Now, people are like, "Well, my tax rate is 40%." Yeah, but you have deductions. So that's why we go off of your real revenue. Seven percent for most of our clients is more than sufficient.
John: Two percent into profit, 7% into tax. Owner's pay, you're going to want to play with. You're obviously going to want to pick an amount that you can live your lifestyle off of. But we do have to have conversations with clients sometimes because they are paying themselves more than their business can afford at the moment.
John: Usually, though, that's not the case. They're usually starving themselves. And so, we get it up to like, "Well, how do we pay ourselves an amount so that you're not going to die or reach burnout."
Michael: So, is there a recommendation on that because the only percentage numbers I've ever heard are on the higher end of a large corporation where there's recommendations on what the CEO should be paying. But in a small company, I've never heard that before.
John: Yeah. So we go off of... there's a table, so Mike Michalowicz looked at a whole bunch of different companies across different industries at various revenue sizes. And he has percentages for each thing. Obviously, the larger the company, the smaller the owner pay percentages because it's a percentage of your revenue.
John: I personally do 22% for me. Gym owners, we generally have about 15%. But again, we want to make sure that the actual dollar amount they take home is enough for them to keep the lights on, put food on the table, and at least get to and from their house to work. We laugh at that but there are so many owners who don't even pay themselves that much.
Kathryn: Yeah, totally. Okay. So we're going to come back because I have a question about that from just how you handle it kind of perspective, but keep going.
John: Okay. And then, the remainder percentage is your operating expenses. So, again, we're talking about what am I doing when I sit down either once a week or twice a month? You're taking money from your income account, popping them into those percentages. And then from that point, when you sit down, we also recommend you look at the last seven to 15 days, depending on how frequently you're looking.
John: If I'm doing it every Friday, then I'm going to look at my past seven days of expenses. Right after I do my allocations to these different accounts, I'm just going to look at the last seven days of expenses. That's it. That's why it doesn't take a lot of time, but it gives me very timely information so that I can see that vendor pop-up.
John: And then when I say I thought I canceled that, I only went one-month pass instead of 12 or 16 months or I don't know what this is for, I can look into it right away. I'm not looking at 12 months, just seven days. That's what you do when you sit down. And because you're just looking at a small portion of time, it only takes 15 to 30 minutes.
Kathryn: So you're really looking at your opex account for those expenses. And you're just basically looking at that one account and going, "Okay, what did we spend money on these last two weeks? And was that appropriate?"
Kathryn: Interesting. So let me ask you this. If you're like ... I'm taking us as an example, we have a staff of about nine. Michael and I as owners, we do a W-2 but we also do a draw. How do you handle that one? I mean, are you actually moving all of my W-2 wages into this other account and taking me off the normal payroll? How would you recommend doing that? I'm a little confused.
John: Yes. So, we are talking about two separate hats here. One is managing our cash flow. And the owner's pay percentage is the cash amount we want the owners to pay themselves. Then we put on the tax hat and say, "How do we minimize our tax burden on how we get this cash that we know we deserve to pay ourselves?" And that's what you're talking about.
John: So within S corp, you have to pay yourself a W-2 if you're working in the business. It's a legal requirement the IRS forces on us. But you can certainly make that as low as reasonably possible. And so that's typically what we do. We try to get that down as low as possible. The difference then becomes a distribution. But you're still always comparing it to the dollar amount that the Profit First system told you, "This is the amount you should be paying yourself this month."
John: We take it a step further and add a third component in there with a strategy we call corporate rent, also known as the Augusta Rule by some.
Michael: So, explain that. I know what you're talking about, but explain that for our listeners.
John: Yeah. So, the simplest way to think about it is there's a, I don't want to say loophole because the tax code is nothing but loopholes.
Michael: But it's a line item in the tax code that allows for deduction.
John: Yeah. So, if you have a property and you rent it for less than 14 days, the tax code says, "You do not have to claim that as rental income," anywhere on your tax return. So we just say, "Well, a business owner can definitely do this themselves. Let's have the business rent from the owner their living space one day per month." So that's 12 times, we're under the 14-day rule.
John: Because guess what, it's good practice to have a board meeting and an annual or like a monthly review. And you're just going to have it in your house instead of going to a hotel or something.
Michael: And the benefit of this is.
John: When the business pays you as a person, that's a rent expense on your business. But because of the tax code, you don't pick up that as rental income. So all you've done is reduced your taxable income even though you've shifted money from your business into your personal pocket.
Michael: So, okay, let me make sure I'm following this. We start with in the Profit First model, we start with taking those percentages of what we're going to get. And part of it is pay in profit, our owner pay. That's what it's called, right?
John: Owner's pay, yup.
Michael: Okay. And then that percentage, once we have that figured out that percentage and what dollar amount that means for that week or that month or that pay period, then we go back and we look at putting our tax hat on and we go, "Okay, I'm going to take a percentage of that. If I have an S corp and a W-2, I'm going to take a percentage of that in owner's draw. And if I can do this Augusta Rule, I'll do that as part of it for the month, too."
Michael: So now, I've got three pockets to minimize taxes but those three together equal the percentage or the dollar amount for the owner's pay.
John: You got it.
Michael: Okay. Now, that seems like it's a little complicated even though it's only three things. I'm assuming based on just experience that once you just put all that down on paper once or twice, it becomes elementary and fairly quick to do. Is that true?
John: I would say most business owners after once it's set up, because your W-2 is going to be on your normal pay cycle. You [inaudible 00:27:13]. Usually, we have business owners set that up as monthly automated transaction from your business account, your personal account. So then the other thing that you have to do manually every month is transfer your distribution to yourself. The other two are automatic. So, yup.
Kathryn: And it sounds like if I'm understanding right, essentially every week or two weeks, you're emptying your income account.
John: The income account becomes zero every time you sit down.
Kathryn: Yeah, distributing it. Okay.
Michael: All right. So, let me ask this.
Michael: Because I can overcomplicate everything and somebody out there is overcomplicating.
John: It's a gift.
Kathryn: I am blessed to live with that. I'm really grateful.
Michael: Yeah, thank you so much. That said, okay, so I'm thinking I get 22%. So let's say our gross revenue is a million dollars. That means my owner's pay is $220,000. Let's just do simple math. And I've got my three ways I'm going to divvy that up. Am I worrying about taxes at that point at all? Or am I just literally ... do I need to do any fancy math and think about the taxes? Or do I just put it into a W-2 and lets the W-2 tax engine do its thing and then not worry about the rest?
Michael: And I'm going to say this because I think maybe I'm answering my question, because you have 7% of money that you put in a tax account that will handle the slush of whatever ways out later. Is that correct?
John: Yeah. I'm so glad you brought that up because really, I joke with Mike about this, the guy who wrote the first book. I said, "I think a more accurate title of the book would have been Cash for the Benefit of the Owner First, but it just wasn't as sexy as Profit First." So, we tease him about that.
John: Because owner's pay benefits the owner. The profit distribution benefits the owner. And this tax account benefits the owner. Because before running the system, they would have to do what you initially described. I have my W-2 income. I'm making $220. Out of that $220, I have to pull out my tax amount. So I'm not actually able to live off of $220.
John: With the tax account, you live off the $220 because the business generates the tax burden. It's saving the tax dollars. So you live off of the $220, the 7% going into tax, that then just gets distributed to you when you owe tax and you use it to pay your taxes.
Kathryn: And from a tax perspective, it's the minimize the W-2, maximize the draw. Is that the philosophy?
John: Yes, that's right.
Michael: Because it the key term there, if you're experienced, you know this. The key term there is reasonable pay. It's a judgment call that we all have to make. And some people who are more conservative are going to want that to be higher because they think reasonable needs to be more. And some people who are less conservative are going to say 10 bucks is enough.
John: Yeah. Let me address that though just in case we have anyone listening who is on the conservative side. The tax code does not define the phrase reasonable compensation. So, it is legit a judgment call. There have been court cases. So, if the IRS ever really wanted to poke at this for a business owner, they're going to look at the way like these factors that the courts have decided they're using to determine reasonableness.
John: The bigger your company is, the more team members you have, the less you could pay yourself. And at the end of the day, what we're doing is we're saying, "What's the replaceable value?" Look, we all know that you're the best and you're super expensive. But I could replace someone to do the tasks on paper for probably $12 or $15 if that becomes the new minimum wage or whatever the task is.
John: So, for example, my only job is to go and go to team meetings. I could pay someone $20 an hour to emcee a team meeting. And so that's what you argue with the IRS. Like, "Look, here's some reasonable compensation for similar tasks that other companies pay people for." And that's how we get it lower and lower.
Michael: So, what I hear you saying then is you're talking about what are the physical tasks? And that's all you'd have to argue versus, "Wait a minute, I have 30 years' experience. I have a lot of wisdom. I understand the market. I have a highest emotional intelligence. I'm a fantastic leader. You can't get all that for $12, $15 bucks an hour? Is the issue really the actual tasks I'm doing and not the skill level at which I'm accomplishing the management?"
John: Yeah. That's the argument you make to the IRS to justify the lower amount.
Michael: And is that been handled in court?
John: Well, there's nothing in the tax code that says, "You're disallowed deductions because you made a bad business decision."
John: Right. So it's like, "Look, I didn't want to do these tasks. So, I could replace myself and have this person do it? Would they do as good of a job as me? You know they wouldn't." But they're physically doing the same tasks you would be doing.
John: And the IRS can't argue with that. I mean, they may come back and push. But the reality is the companies who get in trouble are the ones who pay themselves zero. They're the ones who are getting flagged. If you're paying yourself a W-2, we've never had it come up as an audit issue. If there's any level of W-2 coming from the S corp.
Michael: Okay. All right, that's interesting because there is something that happens psychologically with some people that we've seen, just in general in life. But in business, it catches them even more where there's an assumption. Sometimes there are people who are really good with this. You told me this is what the rules are. They're really good at understanding the rules. But they don't think outside of the box much.
Michael: It's not a flaw because they are really good at certain things that those of us that think outside the box are not good at it. But they get stuck in this place of going, "Well, wait a minute, that's not what the intent is. And the rule is the intent." And they don't know how to separate those two out. So somebody may be listening today and going, "Wait a minute, you're violating the rules."
Michael: And what is probably really important to know he's an accountant. I'm not a lawyer. I'm not an accountant. But you need to know that when these things go to court, when these things are issues, what you're doing with is at some point, it's the letter of the law that's important to pay attention to especially with taxes.
Michael: Find somebody who understands that and trust your advisor because even if you do get audited, you want a good advisor that's going to be there with you when you get audited to processes. You don't want to be on your own. Is that fair to say?
John: Yeah. That's well said. Yup.
Kathryn: Does setting up five accounts and doing all this movement and stuff make reading things like income statements and balance sheets, and those really important reports more difficult, less difficult, same? How does that flash out?
Kathryn: Irrelevant? What does that look like? They've never going to be irrelevant.
John: Yeah. Look, I am an accountant. So, my initial reaction is irrelevant. But I get it. We deal with it all the time so we're very comfortable with financial statements. It does not change your income statement whatsoever because these bank accounts trip on your balance sheet. You are going to have a larger section on your current assets which is the top of your balance sheet because now instead of one account, you have five.
John: Other than that, your total balance and bank account is still going to be the same as the way you would have looked at it prior. And to go one step further because sometimes we're like, "Oh," people will hear this and they're like, "I don't want to go to my accountant. They're going to charge me way more money now because I've added four accounts."
John: These other Profit First accounts, you're talking about two to five transactions a month. And they're transfers from the other accounts. It does not add that much extra work just to account for the other accounts. So, it's not a big deal. And I also always throw this into when I talk about it, if you're a business owner, you should have a relationship with a banker. It doesn't matter what size you are, banks literally have positions that are specifically set up to be the customer point of contact for business owners.
John: And when a scenario like this happens, I love this, I email my banker and I say, "I need to set up another account. This is what I need. Put it under this business." And even now after COVID, this is one of the positive things. I don't even have to physically go into the office anymore. They're just sending me DocuSign stuff. So I don't have to waste two hours.
Michael: It's pretty cool.
John: This is super cool. I don't have to waste two hours going in and watching them typing up all the information. I let them do it on the back end. I get a DocuSign, bada boom, bada bing, it didn't waste any time of my life.
Kathryn: I mean, Gary. Gary and I are going to have a chat. He's my banker.
Michael: No, I like it. So, as we walk through this process, let's go back to something we were talking about earlier, cash flow. We talked about the fact that if you got the book, there's a chart and a few things. But let's talk about cash flow for a moment because I think cash flow really, for some reason, it is this elusive ... it's like smoke. Business owners try to grab an understanding of it and it just disappears through their fingers. Can you help us?
John: Yeah. This is definitely one of those scenarios where we've overcomplicated things. Cash flow is as simple as your customers pay you money, money comes into the business. You then pay vendors or yourself or you buy equipment and cash flows out.
John: What we're interested in is your free cash flow, like a healthy business has money left over after all that said and done during a normal cycle. So if you think about a month as a cycle, over the course of the month with customers paying me and then I have to give cash to other people for different commitments I made, the number left over, that's what we are very interested in, in determining the health of our business.
Michael: I've never heard anybody refer to it as free cash or free cash flow. Because obviously, when you look at the charts and you read the books and all that stuff, it's like, "Wait a minute, how does buying a piece of inventory and machinery all of a sudden still be cash flow because it's not cash, it's a thermos or a box of hay." We have a pet food business.
Michael: But it is. The free cash is a great way of putting it because it's cash that you can actually use and use to spend on something.
John: That's right. We like free cash flow because let's say I have $1,000 that came in but I had to spend $500 of it on the inventory itself. Automatically, that $500 is not free cash flow but it is cash flow like the cash had to leave in order to get the $1000. And then maybe have some expenses on top of that.
John: And after doing that, there's $200 leftover. It's the $200 that we would say is the free cash flow because now you can choose what you want to do with it. The other $800, you already chose what you were going to do with it prior to getting the cash.
Michael: That's where a budget comes in, right?
John: Yeah. I like Profit First better than the budget just because people have totally destroyed that concept. And the way they end up doing it is not healthy. Usually, if someone's going to budget, they look at what did I do last year, what are my averages, and that now somehow became my budget for the current year.
John: It's like, well, if your average was bad spending, though, you've just budgeted bad numbers versus looking at it from the standpoint of percentages, how much percentage of my income do I want to spend on operating? Now, that's a budget because I'm going to make decisions to stay within that boundary?
Michael: Yeah. No, I would say it this way that setting a budget needs to be based on a reference point that's healthy. Your last year shouldn't be your reference point because it may be healthy or not. And that's completely blind at some level. You've got to go back to a different reference point.
Michael: And if you're overspending here or underspending there, that's got to be where you set it. So I like that. I like that idea at the Profit First. It sounds good. Does this model affect the way you do accounting whether it's accrual or cash?
John: No, it doesn't. Obviously, when you sit down and you're looking at the dollar amounts in your income account, it's cash basis. You're only able to allocate what's in the account. But if you have to use accrual accounting or you are using accrual accounting for sake of KPI metrics, you can still do that. This is just sitting down and actually managing the real dollars that are in the accounts.
Michael: Yeah. Well, I think that's good to say.
Kathryn: So, if somebody were to come to you and say, "John, this sounds amazing. Right now, I have a 2% profit margin." So I guess the first thing I should be asking is expenses. What can I cut out? But do you have a suggested like building into this like a starting place where people ... first thing you do is set up the accounts and then just start doing something.
Kathryn: I mean, how would you recommend people get started if they're really freaking out about their profit margin at the minute?
Michael: They already jumped out of the airplane and they're halfway to the ground? What do they do now?
John: Like, "Crap, where's my parachute?"
Kathryn: Exactly. Throw me a rope.
John: First step is the cash flow analysis because you want to know where you were last year. Give yourself the before picture. And if you use the right tools, it will automatically give you the after picture. So, I'll just say this. If you go to our website, incitetax.com/fivedays, the number five days kind of one word, we've broken up the cash flow analysis into five digestible chunks that a business owner can do over five days, with maybe 10 to 15 minutes of work.
John: And the end product when they're done using the Excel file, it's part of that, they have a cash flow analysis.
Michael: Give us that URL one more time.
Michael: And we'll have that on the show notes page for you all.
Kathryn: That's great. Thank you.
John: So that's the first step. And that usually can help them see what percentage they should start with. Second step is setting up the accounts. And notice, I'm avoiding the fear that most lenders are going to have which is, "I don't know if I can do this because I have 2% margin right now." I'm saying trust the process.
John: We've personally worked with hundreds of owners on this. And over the course of the Profit First organization, we're talking tens of thousands of owners like this model works. Take one step at a time so that we don't focus on that fear because the fear is real. And I get it. I'm just asking you to turn that fear into courage because courage really is fear. You're just taking action on your fear.
John: So just have a little courage. Do what I'm saying. Cash flow analysis. Set up the accounts. Then let's look at the last three months of your statements and analyze the expenses. We're not analyzing in the form of, "Oh, is this variable? Is this fixed?" But that can have its place depending on what you're looking at. But for the sake of free cash flow and the financial health of my business, I'm interested in, is it productive or is it not productive? Does it help me make money? Does it support the way I currently make money? Does it help me with retention?
John: If it doesn't do any of those things, it probably can cut the expense especially if I have a 2% margin and I do the cash flow analysis, probably I'm going to identify I'm bleeding cash on my operating expenses and I need to find some stuff to cut.
Michael: I like that three because a lot of times when I've talked to people who just want to get at the brass tacks of all these things. It either makes money or doesn't make money. And the fact that you added those other two was really I like that. The fact that it's going to help with retention or it helps sustain the way I do business, the positive way I do business, because I may be doing some stupid things.
Michael: And then those three pallets together then you've got ... because it's not as simple as does it make money or not? Because sometimes you're like, "Well, I do this for retention and I send them flowers for when they have a big event in their life, and I'm not making any money." And then you get your head wrapped around an axle and walk away.
John: Yeah. An example we do in our firm, we've tried all these things. How do we incentivize client referrals? For accounting firms, for most traditional firms, it's like 95% of their growth comes from client referrals. We luckily don't have ... we're not handcuffed to that. But we do like client referrals.
John: We've tried incentives like, "Hey, we'll give you x amount of money." The people who refer are going to refer and the people who don't aren't going to refer. So what we do is we send a gift to our top referrers. And you know what happens? Within a few months, they've referred someone else to us.
John: And so we've tracked that. Does that custom suit generate revenue for the business? Well, on one hand, if you're looking at just from that standpoint, no. But if I'm looking from the standpoint, does it help me with retention, does it support the way I do business, I can absolutely track new revenue to that expense.
Michael: Yeah. And a custom suit, I mean, come on.
Kathryn: I'll refer you if you can send my husband a custom suit.
Michael: I don't think he was referring to giving away custom suits, were you?
John: Yeah. We pay for them. We give them like a gift certificate like, "Hey, thank you for referring to us. Here's a custom suit on us."
Michael: Oh my goodness.
Kathryn: What do you give people who bear your podcast? This is kind of a referral, isn't it, just in general? I'm kidding. I'm totally kidding.
Kathryn: Okay. So this is probably in some ways obvious. But just to make sure it's said out loud, how does doing all of this help prevent burnout which is the other thing that you're passionate about which is helping people make a profit and not burnout. So just tie those things together for me?
John: Well, if you think about the way we've been running, if you think about it prior to this system and these boundaries you place, people are going from one fire to the next. And they're looking at the money in their bank account. And usually, they're making decisions not in the best state of mind because they're strapped for cash. And then that leads to, "I can't put food on the table this month," or, "I hope there's something leftover after I take care of all this other stuff."
John: With the Profit First system, we put the owner first. Pay yourself first and trust that you'll find a way to make whatever's left over to run your business. Now, look, I'm not arguing there is going to be a transition period. If you're bleeding cash right now to where you're going to be, there's baby steps you got to take.
John: But by doing that, now, the owners paying themselves and there's zero risk for them to reach a point of saying, "I don't know if I have anything to show for this." They have something to show for it now. And therefore, they can focus on their passion which ultimately makes their business more profitable anyways.
Kathryn: Good. Okay. One other quick thing that I'm thinking about, nowhere in your system did you mention a savings account? Is there a savings account? We should have three months of reserves expenses sitting in a savings account? Is that something you recommend, too?
John: So, the profit account kind of becomes that because we only distribute half the balance every quarter. The other half stays in there kind of as your savings account rainy day funds.
Michael: So, that's a rainy day fund for the business?
John: Yes, for business.
Michael: So, if everything goes crazy like in COVID and we're trying to hold on to a couple of employees but we don't have the revenue coming in, that's where we would pull that money from?
John: That's right.
Michael: Okay. That's good because we were just talking about this last week about the idea of, okay, we've got profit. And we've got our net margins specifically on rabbit hole, "Hey," thinking about it going, "Okay." I was really thinking about what do we do when we're saying we're profitable but we've continued to invest the money back in the company? We've done that in both of our companies at some level.
Michael: And being able to say, "Well, where's that line?" Because sometimes, depending on where you ... I don't know how you would do this. This is my non-accounting brain trying to think through it. I'm either holding off all the money to the end of the year and saying, "Okay, there's these three initiatives we want to pay for so we don't do it," or, "I take a few thousands every month and invest it and get going on the project, and do the same thing."
Michael: And at the end of the year, now that floated into expenses as opposed to it was profit. And then I took the profit and put it back in the company. Do you understand the place I get stuck in?
John: Yeah. So, we definitely do not want people plundering or putting their profits back into the business. The purpose of the profit distribution is to reward the owner. However you want to do that, if that's investments or savings or retirement, great, but not back in the business. The reinvesting in the business needs to come out of the operating expense percentage.
John: So sometimes we actually have clients who will set up another account and call it investment and maybe carve out some of the percentage from operating expenses so they can see how much money they have. Because as you start writing this, you realize, "I can run a lot leaner than I'm running. And therefore, I can take some of that extra operating expense cash that I've said I'm going to spend this on my business and I can invest it into those opportunities."
Michael: Okay. So, if anybody's a gym owner or wants to contact you, what's the best way to contact you, John?
John: Incitetax.com is really the best way. Another URL if you want, the incitetax.com/wealth. We do have some free resources on there. One of those is the nine questions we ask to analyze expenses. So, if you're interested in analyzing your expenses, there's a free resource there as well.
Kathryn: You have been most gracious with the late start and we kept you late. So we appreciate you, John. Thanks so much. This was really educational.
Michael: This was really good.
Kathryn: Very, very good.
John: Thank you.
Kathryn: And we just said, if you are looking for help in your taxes and your structuring, definitely look John up. He's amazing and he works for tacos.
Michael: And he works for tacos. I'm Michael Redman.
Kathryn: And I'm Kathryn Redman.
Michael: This is the HaBO Village Podcast. Thanks for visiting. And we hope this was helpful today. I think you're going to get a lot out of it. Bye-bye.