How would you like to someday retire from your business? That is someday build a business that affords you the time and money to enjoy the people and things you like to do outside business? I often talk to entrepreneurs and even though this is something they want, they never take the time to plan for it. They somehow hope that someday they will wake up and have a business big enough they can retire from.
Well, hope is not a strategy!
We often take things for granted when things in our lives are going well. Just because your business is doing well today, does not mean it will always be that way. If you ever want to retire from your business, you will have to plan: What would happen if:
- You suddenly became ill.
- Or a new competitor got in the market and almost wipes you out
- Or you get too old to work as hard as you used to
- Or some type of regulation that has the potential to destroy your business gets passed
What will happen to you financially, if you could no longer work in your business for whatever reason? These are things you need to think about and plan for. But yet we often take this for granted.
What makes a business an asset that can fund your retirement?
Now that we know we have to think about out financial independence, the next question becomes how do I get started? The first thing you will need to do is build a solid business. A solid business is built as an asset: That is a collection of systems that generates revenue independent of the owner.
If you have just a product or service you will eventually hit the maturity and decline phase. However, a business that has systems in place has the potential to outlive its founder. If you want to build a business that endures, you need to understand systems and how to make the numbers work in your favor.
Systems can be classified into 3 broad categories:
- System 1 -A mapping system/overall strategy plan.
- System 2 -A financial system: Revenue generation/maximization, cost minimization, building and managing assets, balancing liabilities and equity.
- System 3 – Internal business process: complying with legal requirements, managing risks, partnerships and process improvement.
To retire from your business, you will need to create systems so you can walk away from your business and still earn income.
System 1: A mapping system
Have you ever travelled somewhere you have never been without a map or gps system? If you have ever done that, how did you know when you arrived? But yet, it is very amazing to me how many people build businesses without a map of where they want to go.
A mapping system is where you plan to go. If you want to build a business and not just a product or service that provides good revenue for a while, you will need to map out your goals. A way to accomplish this is the business plan. The business plan expands on what you will like to look like. It does not have to be anything fancy in the beginning. Just something that gives you a direction.
I have come across entrepreneurs who thought because they had the genius to come up with an idea they have the knowledge to run a business. After setting shop, they quickly discovered that running a business and pursuing an idea are two different concepts. However, these concepts do not run in isolation of each other. A good idea can become a good business if entrepreneurs learn to keep an eye on the business. However, not all good concepts become businesses.
To develop a good concept into an idea you need to have a plan with milestones. These milestones are also known as goals. There are 5 questions you need to ask yourself before you start developing your plan:
- Where are you going?
- What is required to get there?
- What you are willing to do to get there?
- What you have right now that could help you get there?
- What gaps need to be filled to get there?
Defining your goals help you set a clear path because our choices for today become our destination for tomorrow. I think one of the most important things you can do before you start any business is define what is important to you because as you become successful a lot of opportunities are going to come your way which might be in conflict with the goals you initially set for yourself.
We have a whole world out there telling you how to live your life and defining what success should look like for you. The truth is we are all different and my definition of success may not necessarily be yours. We have to be aware that there is a part of us that likes to impress others so it is easy to adopt other people’s philosophy because we think that is the way to impress the world.
The mapping system should be visited regularly as it sets the entire tone of your business.
System 2: A solid financial system
An entrepreneur starts out with an idea of a product or service. Couple of months later, he/she realizes that something is missing. Income is coming in but yet there is no real progress in the business. This is the point where most entrepreneurs realize they need a financial system if they are going to survive.
The journey from idea to financial independence is never an easy one. It is filled with lots of uncertainties, difficult decisions, impossible paths, etc. While having a financial system will not prevent adversities from affecting your business, it will give you a more solid anchor in handling the adverse events that come your way.
If you refuse to build a financial system, your business will surely but slowly dissipate. Businesses rarely crumble in a day but slowly and surely overtime, bad decisions eventually catch up: choosing to do nothing is one of the worst decisions you can choose to make. Learn to build systems around your ideas so you can become truly financial independent. Any business that is going to survive the long haul must have a financial system. A financial system affects every area of the business, and works hand in hand with the marketing and operational system.
A solid financial system should include:
Your revenue generation system:
Any business that is going to survive needs customers and needs a system to reach and maintain them. This is the life blood of your business. If you do not know how you make money in your business, you will not survive for very long. This must be the first financial system that must be developed in any business system. In other words, you must be able to describe your revenue generation system in numbers.
Not only is it important to know how you make money but you have to know how to structure your cost so you maximize profits. You must be willing to test various financial models to see which one maximizes profits. However, most entrepreneurs I meet do not think too much of this area. They plunge into various opportunities without examining what the bottom line impact will be on their business. Cost management mainly involves managing your cost structure meaning: what percentage of fixed to variable cost is optimal. As you scale up, having a more fixed cost structure could be the optimal level at which profits is maximized. However, you will need to test your specific situation using financial modeling.
Balance sheet management
In building a business, an entrepreneur needs to acquire assets to make revenue production possible. Revenues come from assets: An asset is defined as the costs we have in our business that is used to produce future revenue. The main point of a business is not just to generate revenue but to build assets over time. A business that only generates revenue but retains no asset, is a business that can easily be blown away. A sustainable business is one with large enough assets that keep producing revenue with little interference from the founders. Assets don’t have to be tangible, they could also be intangible (for example systems of operation).
Balance sheet management consists of:
Cash management is the management of cash by controlling the collection, usage and investment of cash. To manage cash, you will need to effectively manage your working capital (https://www.youtube.com/watch?v=H_nZsOqDFXA); loan payments, investments and distributions from the business.
Capital structure optimization:
You have to understand your business is an asset. Just like any other asset, there should be some income gained from the asset. Most entrepreneurs who think of their business as an asset understand it as something that appreciates and yields capital gain. While this is true, this should not be the only way you gain from your business.
Your business should also generate investment income like dividends. I am not talking about salary you get from working in your business. As a business owner you should rewarded for the 2 hats you wear in your business. 1) As an investor 2) As an employee. Dividends are your rewards as an investor and wages are your rewards as your employee.
However, to maintain a healthy balance sheet, you must be systematic about the way you pay dividends as this affects many areas in your business. If you blindly take money out of your business without a system, then you might be depleting resources that could have gained you higher returns. You need to know how your dividends payout is related to your capital structure, cost of capital and your business value. That is what percentage of liabilities: equity puts the most money in your pocket without losing future value. I go into more details on how to do this in Retire from my business videos with exercises: Module 2.
Capital purchase planning:
Planning for capital purchases is a very essential function in your business. How will this new asset affect your business? To find out you must know the return on investment on the asset. If your existing solution has higher returns, then you are better off not buying the asset. You also must have a minimum rate of return which is tied to knowing your cost of capital. New assets should be in line with the key ratios you watch in your business. The assets in your business should be producing more than you can make from saving your income in a CD or savings account.
Manage your key ratios
I often hear businesses tout how much revenue they make. Honestly, I think total revenue is the least important measure on how well a business is doing. If you gross $1,000,000 in your business this year, should that be considered good or bad? Well, we don’t know until we hold it against relevant financial ratios. Financial ratios are factors that help us understand our business performance. If the 1 billion in asset was used to produce 1 million in net profits, then we have a problem. However, if 500,000 in assets were used to produce 1 million in net profits then we are doing quite well.
The efficiency of the assets you accumulate is measured by the return on your asset. Return on asset is measured by net income divided by total assets. So, if you made 10,000 last year and your total assets were 5,000, your return on assets will be 10,000/5,000 = 200%. This means that you were able to double the amount you started out with. Your assets are being put into good use.
Knowing and managing your key financial ratios is a great way to keep your financial structure in synch. Your ratios tie the income statement to the balance sheet statement for better analysis of what is going on in your business. I go into more details on how to do this in Module 2 Retire from my business videos with exercises.
An accounting information system:
To manage your revenue, cost and assets, you must invest in a good accounting information system. Knowing your business starts with having good records. As a business owner, you must:
- Generate regular financial reports
- Understand basic accounting principles: I have written more about learning accounting principles on my blog on accounting basics.
- Understand your financial statements
One system that needs to be challenged that most business owners hardly think about is the system of recording financial information. The goal of recording financial events is to generate financial records.
Your data collection system must be optimized to capture relevant data. If your system is not optimized to capture relevant data, then the reports you generate will also be irrelevant. As your data increases, your need for automation might also increase. Regardless, the system needs to go under the microscope from time to time to examine if the data collected is a true representation of what is going on in the business. If your data collection process is faulty, then every other effort in your business will be faulty. As simple as book/ record keeping may sound, it is a very vital function in your business as it affects everything else you do.
Design your budget
Once you understand what cost and capital structure will maximize profits and returns respectively, the next step is to design a budget to help you stay in line with these numbers. A budget is you telling your business where it is going; rather than the other way around. You must also compare actual results to budget and investigate every significant deviation. If not, a budget becomes worthless.
When making a budget, the 3 major concerns are:
- Maximizing revenue.
- Full recovery of cash investments.
- Absorbing both current and future costs increase.
Before you start the budgeting process, you will need to understand your sources of capital, income and costs. To make good business decisions, proper classification of costs as assets or expenses is important.
The steps described above are not a onetime effort. The status quo must be frequently challenged. Key ratios might need to change due to external or internal factors.
System 3: Develop your internal business processes:
This is the system that governs the day to day running of the business. It is the vehicle through which the system carries out its purpose. Internal business systems are mostly driven by external forces and as a business owner your choices are to comply, improve or die. As an entrepreneur you face the pressures of meeting consumers’ needs, changes in the economic and legal environment, etc. These external changes force entrepreneurs to continuously improve (Lifestyle Entrepreneurship, A CPA’s Perspective).
Internal Business Processes Improvement
To develop systems that mitigate external risks, a system for improving our processes has to be adopted. One of the best models I have seen in assessing business processes was developed by Watts Humphrey in the late 1980s. Humphrey broke his model into 5 parts:
Level 1- Chaotic: this is the beginning phase where anything goes. The business is just starting out and has very unstable processes.
Level 2- Repeatable: The business realizes it needs to get its act together if it is going to survive. After lots of planning, some repeatable processes are defined and implemented.
Level – Defined: In level 3, the repeatable processes are taken up one more level. The repeatable processes go from just being processes but become a part of the organization’s framework. In this phase procedure manuals are developed, processes are further broken down and more clearly defined. The organization as a whole learns to embrace these processes as part of their growth strategy rather than something that is done as an afterthought when something goes wrong.
Level 4- Managed: In this level, processes are measured. Metrics are designed to report the effectiveness of the processes. Processes that do not measure up are re-defined.
Level 5- Optimized: The organization would have adopted an attitude of excellence at this stage and will continuously watch its metrics to make sure the processes are meeting the goals they were designed for. A metric does not have to be something complicated but could be something as simple as meeting with a CPA once a month. This is something that is very easy to measure and if it’s not been accomplished, you as the business owner will have to figure out why and how to improve your processes to accomplish this goal. There is a mindset of continuously improving the processes in businesses that aim to be the best in their field.
It should be every business goal to optimize its processes. Like I mentioned earlier, you have a choice to grow or die. “There is no such thing as a stagnant business; a business that is not growing is dying.”
When your system is optimized then you could effectively partner with others with a shared mission and vision. This allows you, the entrepreneur to walk away and still earn income. There are couple of things that need to take place for a successful exit:
- One your business must be able to run without you. Building the systems described above, will help you build a business that runs without you.
- You should have a diversification plan.
Building a business that runs without you
Once your business can run without you (by building the systems described above), there are multiple ways you can retire from your business:
- You can choose to sell your business – cash out.
- Pass it on to another family member.
- You can also choose to be 100% or less shareholder of your own corporation. If this is your strategy, you will need to partner at a much more significant level (the CEO Level). You could choose to also recruit a board of directors in charge of hiring top executives like a CEO, CFO, COO. The CEO will be responsible for hiring other employees: Partnering at the CEO level is the level you become truly financially independent if you choose not to sell. you can literally walk away from your business and other people are working to keep accumulating income producing assets for you. You get paid dividends as a shareholder. You don’t actively have to worry about what goes on in the business daily.
You should have a diversification plan.
No one knows what the future will bring. Your industry might become extinct tomorrow: It might be due to technology or legislative changes. Whatever the change, you need to plan for the what ifs. I know this is sometimes hard to think about, but having investments outside your business is a great way to diversify your risk. Rather than spending your dividends, use it to generate more revenue producing assets. That way if your business asset class collapsed, you will still be okay.
Also within your business, you should have a retirement plan package as part of your compensation. This not only saves you taxes, but provides another way to fund your financial independence at retirement.
Time and not money is the most precious resource you have. Time once spent can never be repossessed. On the other hand, money spent can always be regained. If you use your time in a way that never invest in your future i.e. in a way that ensures you will never be able to retire from your business, then do not expect something different in return. You reap what you sow. Being too busy in your business to profit from it in the long run makes no sense. Once time passes, you cannot go back and get the gains from all the investments you did not make.
Even if you plan to work forever, (maybe you have no other goals in life), they will come a time where you will be too weak to keep working at the rate you currently do, what will you do then?