beginning of the business. They also had reserves in case they hit unexpected obstacles.

That’s another
key to success. Successfully Going from $1 Million to $5 Million During this $1 million to $5 million phase
—and this goes back to what you learned in chapter 1—you need to pay yourself a market-based wage
and get a return on your investment. Your goal is to still be profitable when you go from $1 million to $5
million, even though you’re not going to be as profitable as you were. You need to reinvest in your
business during the $1 million to $5 million phase, but that doesn’t mean you shouldn’t make a profit
during this time. It simply means you leave the profits in your business to fund the growth rather than
relying on debt or investors. That’s the whole strategy behind pand Q behind ying yourself a market-
based wage. You need to live off your wage instead of living off the profits from your business. If you
can’t do that, just stay in Kansas City. Don’t take the wagon train to California. You will not make it
through the Badlands. If you don’t have the provisions you need (a capital safety net) and you’ve already
started the hiring process, you might find that you have to downsize to fix your business model and get
profitable and healthy again. After that, you can try again to make it through the Badlands and reach
California. $5 MILLION AND BEYOND Once you get past $5 million in revenue, these same principles
apply, just with larger numbers. Hopefully, you have developed a team of people to support you in the
process. Entrepreneurs who get past $5 million and continue to survive do so because they have great
instincts. Some of my clients have phenomenal instincts, and I think one of the reasons they like working
with me is that I help them verbalize what they already instinctively know. They just need someone to
observe what they’ve done and connect the dots. When it comes to profitability, you have to balance
these ideas. But if you don’t get the owner compensation right, your profit number will be distorted.
That distortion decreases as you approach $20 million or $30 million in revenue. But when owners are at
$5 million or less in revenue and play games with their compensation, they’re messing up the data that
could tell them how healthy their business is. For example, if everything you buy at Sam’s Club goes into
a business account even though it’s groceries, your books don’t really mean anything. Chapter 2 Keys 1.
EBITDA is earnings before interest, taxes, depreciation, and amortization. However, as a smal -business
owner, you should always include interest, depreciation, and amortization as part of your pretax costs.
2. Focus on pretax profit instead of EBITDA. 3. Ignore revenue and focus on gross profit. 4. Your
breakeven point is 10 percent: 1. 5 percent or less of pretax profit means your business is on life
support. 2. 10 percent of pretax profit means you have a good business. 3. 15 percent or more of pretax
profit means you have a great business. 5. As a business grows from $1 mil ion to $5 mil ion in revenue,
it wil pass through the black hole. To survive, the business owner must have adequate resources to hire
additional staff to take responsibility for key functional areas. 6. Learn how to hire the right people, then
take time to train them. 7. To get through the black hole, you wil need a capital safety net. Prepare a
cash flow forecast by month for the time period of the expansion to determine your capital needs. 8.
Raise your capital safetys p Qtal safe net either by reserving profits or by seeking funds from investors.
9. Make a plan to live off your market-based wage and leave every dime of profit in your business as you
grow from $1 mil ion to $5 mil ion in revenue. CHAPTER 3 LABOR PRODUCTIVITY: YOUR KEY TO
SURVIVING THE BLACK HOLE The teams that win are the teams that get the most productivity for every
dollar of labor. When businesses go through tough times, everybody thinks first about cutting costs. My
experience always leads me back to one key factor: labor productivity. Nothing of value happens
without labor productivity. Even something like overspending on kitchen supplies can be traced back to
a lack of productivity by the person responsible for that task. When you are below $1 million in revenue,
you are a lot closer to what is happening, so you can monitor labor productivity more closely. Once you
go past $1 million, your biggest challenge is getting the required productivity for every dollar you spend
on labor. I refer to labor dollars instead of full-time equivalent (FTE) employees, because counting heads
does not give you the proper understanding of your true profit model. Focus on your gross profit per
labor dollar as your key indicator for labor productivity. First this chapter will give you a close-up view of
how two companies navigated their way through the black hole, and you’ll gain an understanding of
how labor productivity and the black hole are connected. Then we’ll take a look at some strategies to
manage your profits by controlling labor costs. SURVIVING THE BLACK HOLE: COMPANY A In exhibit 3.1,
you can see that Company A, in the first year, was slightly under $2 million in revenue (solid line). You
also can see that they didn’t have a lot of equity built up. Equity is your assets (what you own) minus
your liabilities (what you owe). Don’t try to make it any more complex than that. Not only that,
Company A’s pretax profit was close to zero. Exhibit 3.1: Company A Like most entrepreneurs, they think
the solution to the problem of their lack of pretax profit is to grow. They make it all the way up to $4
million in revenue in the next two years. But look at their pretax profit. It didn’t go up along with the
revenue. See where the revenue flattens out in Years 3 and 4? This is where I started working with the
clients. I told them we had to fix their profitability before we could fix their lack of cash and their excess
debt. They made the classic mistake of adding labor to support their growth, but they failed to get
enough of an increase in gross profit to drive toward profitability. They had to go back, fix the functional
areas that weren’t working, and look at the business anew. They had inefficient field labor that was
taking t"0eabor thtoo long on simple tasks, people on payroll who were not billable, and sales people
who were constantly close to, but never above, the sales goal because they were wasting time by
chasing the wrong customers. Company A set out to improve their profitability so the profit curve would
mirror the income curve. In addition, they focused on making the slope of the equity curve equal to the
slope of the revenue curve. To accomplish this, they drove the revenue back down to $3 million and
then started working their way back up. They examined unprofitable customers and stopped taking on
customers that produced low gross profit. Since their revenue declined, it gave them an opportunity to
trim the staff and retain the core employees they felt were keepers. Notice in the graph that their equity
went up at the same rate as their pretax profit. Even though their revenue increased, they kept their
pretax profit in the business and turned it into equity by reinvesting it in the business. You’ll see why
that’s critical in chapter 4, “Business Physics: The Four Forces of Cash Flow.” SURVIVING THE BLACK
HOLE: COMPANY B Company B took the best approach. Take a look at exhibit 3.2. Exhibit 3.2: Company
B They started off below $2 million in revenue, and they were profitable right out of the gate. You can
see that they built equity at a nice pace by being profitable and, unlike Company A, they maintained
profitability as their revenue went up. Their pretax profit slowed a little bit, but other than minimal
amounts they had to pay in taxes, they kept that profit in the business in the first three years. Notice
that there is a flat year from Year 2 to Year 3. When businesses have early success, they sometimes think
they have reached a pinnacle and believe they’re as big as they’re ever going to get, so they just put
their head down and stop thinking about growth. Notice that Company B’s pretax profit goes down
between Year 2 and Year 3. This is because they hired more people to relieve some of the pressure
created by the growth of the business. The company stayed within the target of 10 percent to 15
percent pretax profit. In Year 2 they were closer to 15 percent, and in Year 3 they dropped back to about
12 percent. This isn’t a bad profit, but it’s allowing what I call cost creep. And a significant component of
cost creep is labor creep, which is the biggest profit sucker out there. You’re doing all those little jobs
and you start thinking, “Gee, I really don’t like doing that. Let’s hire somebody else to do that.” We all
have details we don’t want to take care of. I have four kids and I changed a lot of diapers, but after I got
through the first couple, I kind of got over it. Realistically, to have proper labor efficiency you have to
make sure that the annoying tasks are distributed to everybody in the company. Labor creep is one of
the most common ailments I see. It causes a lot of black hole struggles. Look at the Distributions line on
exhibit 3.2. Notice that Comparly athat Comny A doesn’t have a distributions line on their graph because
they had no distributions. Their profitability is below 5 percent, which is really close to zero. In Company
B, the distributions in the first three years reflect only tax distributions because they listened to what I
told them. They’re building the business, and until they reached their target equity levels, they left that
money in the business. Between Year 4 and Year 5 there is a jump in the distribution level. That’s a
serious change because I identified that the equity level at the beginning of Year 4 was the base equity
they needed to maintain. They didn’t need to hold the profits in the company any longer, so they
distributed them between Year 4 and Year 5. By the way, the owners of Company B were being paid a
market-based wage, so these are real profit numbers over and above market-based wages. See the
difference between Company A and Company B? Company A took the typical route of not being
profitable before they tried to grow to $5 million. They did not get the necessary productivity of labor to
have profit along the way. Company B followed my advice of staying above 10 percent pretax profit at
every step along the way and took distributions only to cover taxes until they had nothing drawn on
their line of credit and two months of operating expenses in cash. How did Company B remain profitable
every year? They did not add labor until the last possible moment, and the owners, along with their
management responsibilities, were still productive in the business. HIRE SMART TO INCREASE
PROFITABILITY As we discussed in the previous chapter, as your business grows, it is important that you
hire enough people to take responsibility for functional areas that you can no longer manage. A key
talent is to know what tasks to reassign to new hires and what tasks to assign to your current
employees. We have seen that you need to maximize your labor productivity to increase your gross
profit, so don’t hire an employee for a function that you can do. Depending on the type of business you
are in, you might be able to outsource IT, marketing, or accounting, but there are two things that are
really hard to outsource: the CEO position and the sales function. I’m not a big fan of outsourcing the
CEO function because somebody has to be there every day and be the boss. It’s really hard to outsource
the sales function because you’re stuck relying on an outsider for a very critical component of your
business. You won’t own the contacts, and that’s a really dangerous thing. Unless you have a fear of
sales, don’t outsource the sales function. One thing that happens at $5 million in revenue and beyond is
that you continue to refine the management team and the people you’ve brought in to run operations,
finance, sales, marketing, and so on. You may find that they hit their ceiling at some point, and you have
to continually watch for that. You have to fill all of the business roles as efficiently as you can. WHAT
YOUR BUSINESS HAS IN COMMON WITH THE NFL As I started studying labor, it dawned on me that
every business is like an NFL team. Each team in the NFL operates under a salary cap. For the past
sixteen years or so, every NFL team has spent exactly the same amount on fit aamount olabor. This was
supposed to create equality among teams, but the New England Patriots won Super Bowls a
disproportionate number of times from 2001 to 2009. Most people say that the Patriots’ head coach
during this time, Bill Belichick, has the ability to get the most productivity in relation to the dollars spent
on players’ salaries. A coach has a set amount of money to spend. He can have a great quarterback, but
if he doesn’t also spend money on a really good left tackle, that quarterback is going to be dead by the
third or fourth game of the season. So he has to spend enough money on that left tackle. But wait—
now he has to find somebody for his great quarterback to throw to. And he needs a running back to
hand the ball to. What about the defense? It has to play well enough to stop the other team. See how
interconnected these decisions are? While looking at some news reports on the Patriots, I found a really
interesting example that highlights my point. Back in 2003, the Patriots had Lawyer Milloy, a free safety
who was holding out for a new contract. Milloy had a great career with the Patriots. His agent was
asking for a contract worth about $4 million, which at the time was the market value of someone with
Malloy’s skill set. Instead of extending his contract, the Patriots decided to cut him. Milloy’s market
value wasn’t disputed in the marketplace. He got picked up by the Buffalo Bills at that price. That year
the Patriots drafted a rookie, Eugene Wilson, and paid him the league minimum: $400,000 for four
years. Essentially, the Patriots swapped a known commodity (Milloy, who was a Pro Bowl safety) for a
rookie they thought they could develop into an effective player. Wilson didn’t start the first game, but
he did play during the first game. After that, Wilson started every game for the next four years. The first
year that Wilson was the Patriots’ free safety, they won the Super Bowl. At the end of Wilson’s contract,
he was a free agent and the Patriots didn’t re-sign him. The Patriots pride themselves on their ability to
maximize output for every dollar they spend on labor. Their success is based on knowing when to hire
veteran talent and when to develop new talent. They have been effective at both. I stress the story of
developing talent here because most entrepreneurs want quick success and resist training as a viable
option for growth. I know this may sound harsh, but even though you love your employees and you
want them to help you win at the game of business, at the end of the day you have a salary cap that you
have to live with. Every business has a salary cap. Even an NFL team. DETERMINING YOUR SALARY CAP
Determining your salary cap is the best way to achieve your required labor productivity. Imagine you’ve
got a million-dollar revenue business. You want the business to have at least a 10 percent pretax profit.
If you’re not at 10 percent already, you have to try to get there. If you’re already above 10 percent, you
don’t want to go backward. Take a look at exhibit 3.3 and to see how to start calculating your salary cap.
At 10 percent, the pretax profit on $1 million in revenue is $100,000. Simple math, right?cce ath, righ
You can see in exhibit 3.4 that I have $900,000 to allot to two types of expenses: salaries and nonsalary
cost