In entrepreneurship, the excitement of forging your own journey is accompanied by unique challenges. Among these challenges is navigating how to handle an unpredictable income.
Unlike the predictability of a monthly salary, variable income can swing you from feast to famine, making financial planning feel impossible. But with informed strategies in place, it’s possible to maintain financial stability, even amidst these uncertainties.
Integrating “Profit First” Principles for Financial Stability
When I transitioned into entrepreneurship after a decade of a stable income, I was confident in handling my personal finances. But managing the finances of a business presented a whole new set of challenges.
That’s where the book Profit First made its entrance.
Written by Mike Michalowicz, Profit First inverts the traditional accounting formula. Instead of the typical “Sales – Expenses = Profit” calculation, Michalowicz proposes a better alternative: “Sales – Profit = Expenses.”
This shift in perspective is similar to the personal finance principle of paying yourself first.
However, the book primarily focuses on business finances, offering a structured approach to ensure businesses remain profitable.
While it’s a game-changer for many entrepreneurs, including myself, it doesn’t address the intricacies of intertwining personal and business finances.
In this guide, I’ve expanded upon the essence of Profit First to bridge this gap.
The goal is to provide a holistic framework that ensures your business thrives and guarantees your personal finances are in sync with your entrepreneurial journey.
Here’s an overview of the strategy, with detailed insights in the subsequent sections.
- Create a Basic Monthly Budget. This budget covers your everyday living expenses and needs, and will act as a basis for how much profit you should take out of the business.
- Establish a business contingency fund. This is a reserve intended to offset periods of low business income. This isn’t for unexpected personal expenses like car repairs; it’s a dedicated safety net for low-income months. You’ll use this account to cover the gap when your income doesn’t meet your basic monthly budget.
- Figure allocation percentages. Before distributing your income, determine specific percentages for personal compensation, profit, taxes and operating expenses. These percentages provide a systematic approach to managing your finances, ensuring every dollar has a purpose. Your personal compensation (or owner’s compensation) is designed to cover your basic living expenses. On the other hand, the profit allocation serves as your entrepreneurial reward, earmarked for your financial goals.
- Distribute profits. Periodically, distribute funds according to your set allocation percentages from the revenue that’s come into the business.
- Review and adjust. As your business evolves, so will its financial landscape. Regularly review your allocation percentages and adjust them based on current business needs, ensuring your financial strategy remains aligned with your business’s growth and changes.
Step #1: Create a Monthly Basic Budget
Your basic monthly budget — how much you spend each month on average in your personal life — will be the basis for your owner’s compensation. Keep in mind that this amount doesn’t include taxes or savings.
This is called a basic budget for a good reason: there shouldn’t be a lot of excesses here. It’s a step above a bare-bones budget, but not a giant step.
The goal is to choose a dollar amount that ensures your owner’s compensation allocation covers your personal essentials.
Consider using one of the many personal finance apps that accurately track past expenses to get a clear snapshot of your spending.
Step #2: Establish a Business Contingency Fund
Every business, regardless of its size or industry, faces unexpected downturns. For freelancers and entrepreneurs, these downturns can directly impact their personal finances.
That’s where a business contingency fund comes into play. Think of it as an emergency fund for your business, ensuring that your basic monthly budget remains untouched even in lean months.
This is separate from a personal emergency fund, in which you still need to cover unexpected car or home repairs.
The Profit First methodology recommends stashing away at least three months of operating expenses as a starting point. However, I use a slightly different approach.
Since my business has minimal operating costs, I focus on covering my basic living expenses for three months. This way, if there’s a significant dip in income, I can still maintain my standard of living.
If you do have high operational costs, it’s best to focus on covering operational costs instead of living costs.
While every business is unique, the objective remains the same: to create a safety net that ensures business fluctuations don’t disrupt your ability to pay yourself first in the form of owner’s compensation.
Step #3: Allocate Your Business Income
Central to the Profit First method is the target allocation percentages (TAPs) principle.
Think of TAPs as a refined approach to personal finance management. With TAPs, every dollar that comes in already has a designated purpose.
So, if a client sends you a check for $1,000, you’re not left wondering where to allocate those funds — you already have a clear plan.
According to the Profit First method, the four TAPs you should have are:
- Owner’s compensation. Your take-home pay ensures you’re compensated first and your basic monthly needs are met.
- Profit. This allocation is your reward for running your business, which you’ll distribute regularly to yourself and allocate towards pre-determined financial goals.
- Taxes. A proactive approach here ensures you’re never caught off guard during tax season.
- Operating expenses. The costs of running your business, like rent and utilities.
All your business revenue initially lands in a single “income account.” From there, you distribute the money into target allocation percentage accounts (TAPs), based on the predetermined percentages you’ve set for profit, taxes, operating expenses and owner’s pay. This ensures that every dollar has a specific job and is allocated purposefully.
The Profit First system recommends creating separate bank accounts for each category. This approach ensures clear segregation of funds and minimizes the temptation to dip into other accounts. Ideally, your bank allows you to create sub-savings accounts so that you’re not transferring money between banks every time money comes in.
Personally, I have a separate bank for my taxes and profits but use automatic payroll deductions for owners’ compensation and calendar reminders for tax distributions. After paying my quarterly estimated taxes, I take distributions from the profit account to my primary personal checking account.
Of course, understanding your business’s financials is the cornerstone of setting these percentages. They’re not one-size-fits-all.
The Profit First percentages are guidelines that can be adjusted based on your business’s unique needs. Some general TAPs, based on the book, are:
| Account Type | Typical Allocation Range |
|---|---|
| Profit account | Typically 5-10% of revenue. |
| Tax account | Around 10-25% of revenue. |
| Operating expense account | Depending on your business model, this can range from 50-80% of revenue. |
| Owner’s pay account | The remainder after other allocations. |
In your “profit” account, the funds should be directed towards a mix of short-term and long-term financial goals. This ensures that you’re living for today and planning for your future. The allocation within the profit account can be broken down further to meet various objectives.
For example, your profit distributions could be:
| Financial Goal | Percentage of Profit |
|---|---|
| Solo 401(k) distribution | 50% |
| Down payment on a home | 25% |
| Travel | 15% |
| Discretionary spending | 10% |
By setting TAPs for your personal finances, you can ensure your profit gets funneled toward what’s important to you.
Step #4: Distribute Profits
The final step in implementing the Profit First method is setting up a system to distribute your profits and other allocations. The key here is automation and routine.
By setting calendar reminders or using financial software that allows for automated transfers, you can ensure that you’re consistently following your allocation percentages.
On a monthly basis, you’ll want to:
- Pay yourself your owner’s compensation, which should cover your basic monthly budget. If for any reason you can’t meet your owner’s compensation in a given month, this is when you would tap into your business contingency fund to cover the gap.
- Make distributions based on your target allocation percentages (TAPs) within your profit account.
On a quarterly basis, consider:
- Paying your taxes from the designated tax account.
- Distributing 50% of the accumulated profits in your profit account
At the end of the year:
- Take a lump sum from the remaining profits, which can be a rewarding culmination of your year’s hard work.
Following the book’s recommendation of taking only 50% of your quarterly profits, you can set yourself up for a substantial year-end bonus.
Step #5: Review and Adjust Quarterly
Your business is a living entity, and your financial landscape will change as it grows or faces challenges.
It’s important to review your allocation percentages regularly — ideally every quarter — to ensure they still meet your business’s current needs.
For example:
- If operational costs have increased due to scaling or unexpected expenses, you might need to adjust your operating expenses allocation for the next quarter.
- If you’re planning a significant business investment — like purchasing new equipment or launching new marketing campaigns — you may need to temporarily reduce your profit allocation to fund these initiatives.
- If you’ve had a particularly profitable quarter, consider revisiting your owner’s compensation and profit allocations. You might decide to reward yourself with a higher percentage in profit, or to invest more into the business.
- Tax laws and rates can change, affecting your tax allocation. Stay updated and adjust your percentages accordingly to avoid surprises during tax season.
This proactive approach empowers you to make well-informed decisions about scaling, investing or saving, ensuring that your business and personal finances are always in sync.
Final Thoughts
“The first rule of compounding: Never interrupt it unnecessarily.”
This advice from Charlie Munger serves as a cornerstone for any successful financial strategy, and it’s especially pertinent for entrepreneurs.
A lack of clear financial management often leads business owners to disrupt the compounding process, thus forfeiting one of the most powerful and easiest ways to build wealth.
The Profit First methodology offers a structured way to avoid this pitfall.
It’s not just about making your business profitable; it’s about ensuring that profitability translates into personal financial security and long-term wealth.
By setting aside specific percentages for owner’s compensation, profit, taxes and operating expenses, you’re not just managing your business finances; you’re also setting the stage for your money to grow exponentially over time, thanks to the power of compounding.
This system allows you to take advantage of dollar-cost averaging, a strategy that can mitigate market volatility and enhance investment returns over the long term.
It’s a disciplined approach that aligns your business operations with your personal financial goals, ensuring that you’re building a successful business and a secure financial future.