Whether you started your own small business out of passion or necessity, it’s safe to assume that you didn’t start your own business because you love accounting and paperwork (unless that is your business of course). Collecting your first piece of revenue is a big step for most companies, but even if you’re already a self-made millionaire, the money has to be put to work. After all, revenue comes at a cost — the cost of revenue or cost of goods sold (COGS).
Depending (sometime dramatically) on your industry, somewhere between 9 (for heavily automated industries) and 50 (for many service-based industries) percent of your revenue will go to payroll. If there is anything more satisfying than getting your first payment from a customer, it’s depositing your first paycheck. While paying yourself for your hard work as an entrepreneur is very satisfying, managing cash flow in a way that allows you to pay yourself on a regular basis can be extraordinarily challenging for many.
The moment you start to pay others, the challenges (and the stresses) grow dramatically. Back in January — before COVID-19 was even on our radar — the “2020 Small Business Worry Index” survey reported that “nearly a quarter of respondents anticipate being unable to make payroll at least once, leaving as many as 1 million Americans at risk of missing a paycheck in 2020.”
As a small business owner myself, I struggled many months to make sure our AR were in order such that we could make payroll — sometimes at the (temporary) cost of paying our vendors. I was fortunate to have a business partner who was much more competent in business financials than myself. Nevertheless, we had a few close calls. Inevitably, the moment came when, after the loss of two major clients, we were faced with the extremely difficult decision of laying off one of our account managers. And this was in relatively good financial times.
With COVID-19 continuing to rear its ugly head, these difficult decisions are being made across the globe. There’s no perfect way to lay anyone off, and we’ll be back with specific advice on that task, but there are ways that you can minimize the chances of missing payroll, which carries enormous risks for your business.
Here are my five rules for making payroll every month:
- Prioritize your outlays.
- Learn to say “no”.
- Make it easy for you to invoice, easy for your customers to pay quickly, and painful not to.
- Identify your money leaks.
- Know your numbers.
RULE #1: Prioritize your outlays.
I don’t know about you, but I wasn’t the most disciplined of entrepreneurs for quite some time. My first consulting gig was for a technology training company in Detroit. I was 25 years old, working for a big public university, and pulling in $500 a day 2-4 times a month in a sweet side job as a trainer. It was “stupid money” to me, and I was stupid about spending it. I didn’t save anything for the Tax Man, and when the day of reckoning came, I was in trouble.
I vowed never to repeat this, and when the time came many years later to strike out on my own, my partner and I were much more careful with our taxes. But when revenue tightened, we struggled with how to handle the loss of income. My partner convinced me, rightly so, to metaphorically put our masks on first. We had to lay off one of our account managers, and it was at the time one of the hardest things I’d ever needed to do.
A 2019 survey of entrepreneurs found that “51 percent of small-business owners forego paying themselves for multiple months to control cash flow” in their company. 26 percent of respondents went two to six months without paying themselves and another 25 percent went more than six months without a salary. Now this is fine in the very early days of a venture. This is fine in the first year of operation. But the average respondent had 10.5 years of entrepreneurial experience (we didn’t dig to find out when in the course of their business they made this sacrifice). If you have to do this a few years into your enterprise, you’re definitely doing it wrong.
It’s okay for wealthy CEOs and other executives to take pay cuts during extraordinarily tough times, or even to give up their salaries entirely. But startup owners shouldn’t be sacrificing their own health and welfare for others.
“Pay yourself first” has been a mantra in the entrepreneurial and personal finance worlds for a long time, and for good reason. But it is (necessarily) overly simplistic, and for some people, it just doesn’t work. If you’re undisciplined, it’s difficult to put in place (changing to an “S-corp” forced us to be more disciplined). If you’re altruistic, it’s hard not to put others first.
So I argue that entrepreneurs need to find their priorities and stick to them. For me, the right order is Caesar, my team, me, then my suppliers. This is for two simple reasons. First, I know that if I don’t deliberately put taxes first, I’ll end up in that same spot again, 25 years later. Second, I am fortunate to have a spouse with a good paying job and nice benefits.
RULE #2: Learn to say “no”.
The first few years of any startup involve a lot of sacrifice and more than a little desperation. But there’s one sacrifice you should never make: exchanging your mental and emotional health for money. One of the most important skills an entrepreneur has to learn in order to be successful is when to say “no” — specifically, how to say “no” to a bad client (no matter how much money they have), and “no” to requests that can distract you from your goals.
Now, before you dismiss this piece of advice as far too general for a list of rules for making payroll, consider two things:
- What’s the cost of a high-maintenance, never-satisfied customer on your (and your employees’) morale?
- What’s the impact on cash flow when (not if) your never-satisfied customer decides to delay or withhold payment?
The fact is, learning how to “no” will help your personal productivity skyrocket. More importantly, however, it will actually improve your cash flow as you bring on board the right customers. You’ll see shorter DSOs, which means money in the bank more quickly. In fact, there are plenty of arguments that can be made that saying “no” can actually increase your revenues, and that you should say “no” to almost everyone at least once during the sale. “Negative reverse selling” is a tried and true selling approach taught by the Sandler Sales Methodology, among others.
RULE #3: Make it easy for you to invoice, easy for your customers to pay quickly, and painful not to.
It starts with sending invoices out immediately. I hated invoicing at first. I found it horribly tedious. But if you find the right invoicing and payments system, it can be about as painless as possible. And getting your invoices out on time — I mean right on time — can be very rewarding when you see the revenue start to come in more quickly. Once you’ve found something that works for you, make sure it works for your customers. A good payment system will give you quite a few different leverage points that you can work with to manage cash flow:
- The more payment options you offer, the faster you get paid.
- Automating recurring monthly payments is the best mechanism for ensuring consistent cash flow and low DSOs.
- It’s easier to negotiate net payment terms up than down. Start with net zero if you can.
- Offer a carrot: Consider extending small discounts for setting up automated payments, and even larger discounts for pre-payment.
- Don’t be afraid of the stick: Extract penalties for late payments, and enforce service interruptions for non-payment.
RULE #4: Identify your money leaks.
Before you set down the path of layoffs and firings, look at these six common “money leak” areas, as defined by American Express:
- Employee salaries. Maybe you have the right employees, but they’re in the wrong positions. Perhaps you are outsourcing some tasks that could be handled by an hourly employee instead (at a lower cost to you). It may seem counterintuitive, but maybe you’re not hiring enough people to get the work done, thus having to pay overtime or deal with more turnover or absenteeism due to stress or overwork. And maybe you’re micromanaging your employees rather than training them to do their jobs themselves. All of these are possibilities.
- Rent. COVID-19 has shed a whole new light on rent, and remote work. This is an obvious place where significant costs can be realized, especially thanks to the slew of remote work and productivity tools now available.
- Small Stuff. COVID-19 has also dramatically cut back on office kitchen expenses, not to mention many of the other small stuff that are simply no longer necessary.
- Internet and phone service. Still paying for that office line and the high-speed internet? It might be time to cut the cable, or to renegotiate.
- Financial fees. Ditto on your bank. I haven’t paid bank fees in years for my business checking accounts. And there are still some high(er)-interest accounts you can find.
- The not-so-obvious. This was a broad, catch-all category with a series of important questions you should ask yourself. Read the article for more details here.
RULE #5: Know your numbers.
Entrepreneur Magazine offers up six numbers that every entrepreneur needs to know by heart. They are your setup costs, your COGS/cost of revenue, your breakeven point, your gross profit, your industry’s average gross profits, and your payback period. These numbers are indeed important, especially as you strike out looking for funding. But they’re not the numbers you need to warn you of an impending cash crunch. I recommend you keep close tabs on the following warning signs:
- Increasing customer concentration. Every customer you have that represents 8 percent or more of your total gross revenue represents a potential cash flow risk to your company. You should also look at your industry mix: specializing in a specific vertical has its advantages, but also represents a concentration risk. How are these numbers trending?
- Increasing DSO. How quickly are you collecting payables on average? Is that number — “days sales outstanding” — increasing or decreasing? If it’s going up, you may have a problem on your hands.
- Increasing fixed costs or increasing variable cost ratio. Increases in costs can indicate many things — from market pressures to a loss of discount pricing due to delays in your company’s AP cycles — but none of them are good for cash flow. If these numbers are increasing unexpectedly, quickly determine the root cause.
- Decreasing interest coverage ratio. If you divide your operating income by your interest expense, you should get a result above 3. Lower numbers, or a trend downward in this ratio, indicate potential difficulties in servicing your debt.
- Decreasing quick ratio. If you need liquidity fast, the quick ratio is a good way to know that you’re covered. Typically you calculate this by adding up your cash and cash equivalents, your marketable securities, and your accounts receivable, and dividing this by your current liabilities (due within one year). Ideally you want a 1 or higher.