A fool-proof method to owner’s drawsJun 01, 2023
Most owners distribute/draw money from their business on a whim.
But, it doesn’t have to be that way.
Today, I provide a framework that will:
- Clarify the process
- Provide stability for the business
- Give you, the owner, flexibility
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A fool-proof method to owner’s draws/distributions
Over the last few weeks we’ve discussed:
Today, we wrap up the series as we put a bow on it and talk about owner’s distributions.
Now that we understand how to properly manage capital expenditures, we need to create a process better than “hey, I want $250,000 now.”
Being a CFO and talking to CFO friends, I’ve heard all sorts of horror stories.
Unfortunately, it seems it’s most common for owner’s distributions to be determined by the owner’s personal toys than an actual plan.
Today I’m hoping to break you of that habit.
By not having a plan, you put both your business and family in jeopardy.
Let me explain….
You’ve gained some weight and decided it’s time to go on a diet. Because you’ve failed so many times before you tell yourself “no dessert this time.”
But, this rule sabotages you from day one. The no dessert rule makes you crave more and more dessert. Every day you think about it, every day you come this close to failure.
Then, when you do break, your wife tells you “Good job babe, you lasted 2 weeks instead of 2 days this time” as you eat your third slice of cheesecake.
(you know this example isn’t me because I don’t eat cheesecake…………)
We do the same as owners. “I’m taking nothing out… no toys for me.”
Without the buffer, without the breathing room, the system breaks down quickly.
Too strict of guidelines leads to blowouts. Blowouts where you ask yourself why you’re working so hard if you can never even spend the money.
So today, I want to give you a little breathing room.
As the owner, you deserve some benefit. Let’s talk about what this looks like.
Determining Maintenance Cash Flow
So, the steps to determining your distributions look like this:
- Calculate Operating Cash Flow
- Calculate Maintenance Cash Flow
- Allocate MCF into 3 categories:
- Determine how to spend your set-aside
Operating Cash Flow tells you how much cash you generated from operations.
This is the number you should look at, instead of profit.
These are the things you buy that have a life longer than 1 year.
But not all capex is the same.
It can be split into 2 categories:
- Maintenance Capex
- Growth Capex
Maintenance is what you need to maintain current operations.
Growth is what you need to grow the business. This could be all sort of things:
- New facilities
- New equipment
- New technology
- Different markets
- Different business lines
- New businesses all together
- and anything else you can think of
When we split capital expenditure into these two categories, we’re able to get to “Maintenance Cash Flow”(my term).
This is the baseline we use for determining owner’s distributions, their tax planning, and what gets reinvested for growth.
Allocating excess cash
As an owner, once you’ve determined Maintenance Cash Flow, I then create 3 categories:
- State & Federal Taxes
- QOL distribution (QOLD)
Each of these has a set goal associated with them.
State & Federal Taxes
Tax planning shouldn’t be a once-a-year communication with your CPA that you need to write a $25,000 check by Tuesday.
Tax planning should be an ongoing conversation, which multiple check-ins each year.
Don’t just pay your minimum quarterly payments and hope you don’t owe a lot when taxes are due.
Make it a habit to each month or quarter set aside a percentage of your Operating Cash Flow (OCF) for that period.
Work with your CPA to determine that percentage and make sure you put a little cushion.
Then, put this money in an account or location where you can’t touch it until it’s time to pay.
A great way to do this is to create a separate bank account and treat it as if it’s not there.
Quality of life distributions (QOLDs) are the way the owner gets rewarded for their hard work.
When we go back to the diet example I used, QOLD’s are meant to stop owners from drastically changing their lifestyle while still getting benefits of ownership.
The irregularlity of cash flows of a business can result in owners leveling up their cost of living, then being in a bad spot when cash flow is slow. This not only puts stress on the person, but the business.
Businesses with healthy buffers and rules thrive, allowing them to provide more cash flow in the future. This is the crux of why the finance function is so important.
With QOLD’s, there is no restriction. Spend this money on whatever you want! It’s yours. Buy the toys, get that beach condo, or do the renovation.
When owners buy into this structure, it helps stabilize the business and family life.
Size of business, type of business, and owner’s desire are the biggest determining factors of what’s “right” when it comes to QOLDs.
Figure out what cash flow you want historically, then pick a percentage and stick to it.
I’d encourage you to make this a “small” percentage, as you can take more distributions out of the set-aside.
Once you’ve identified your QOLD’s and taxes, you’ll have a percentage left over.
Ideally, this is where the majority of your money sits.
This is the stuff that helps you get freedom and build wealth.
At this point, you make decisions that align with your values and goals.
I break this into 3 categories:
- Growth capex needs
- Desired personal comforts
- Investment ops outside the business
Every owner has different goals, so I can’t tell you how to allocate these funds.
The key is to allocate these funds and set them aside. A big mistake that businesses make is keeping these mingled with general or operational funds. Track them closely or physically separate them.
Now that they’re separated, it’s time to make intentional decisions with them.
Your goal could be to maximize growth of your business,
optimize for financial safety,
or maximize your personal wealth.
All 3 are great but create different decision trees.
If growth, growth, growth is the goal, then it makes sense to chase all the opportunities you can.
If financial safety is the goal, it makes sense to distribute risk.
If maximize personal wealth, it makes sense to chase the highest (and asymmetric) returns.
This is the part where I can’t answer the question for you.
Remember, I’m just your Newsletter CFO.
You, now, must look inside and make the decision for yourself.
Let’s say you’re services company that has very little equipment.
Say you have 30 employees and replace computers for those employees every 3 years, meaning approximately 10 computers per year are replaced.
At an average cost of $2,000 per computer, that’s $20,000 per year in new equipment.
Revenue is $2 million with $400,000 in profit.
Non-cash adjustment of $20,000 accounts for depreciation of 1/3 of computer expense.
Working Capital Change is left at $0 to keep it simple.
Say your CPA tells you to allocate 30% of OCF to taxes, which is $114,000.
With those variables known, and a 10% QOLD, we can determine our set-aside is $210,000.
You now get to choose how to allocate $210,000 based on your specific goal.
- Growth capex needs
- Desired personal comforts
- Investment ops outside the business
Say there are some business opportunities that would mean adding 15 new employees (15 x $2,000 per computer = minimum $30,000 investment) and $50,000 in manufacturing equipment.
That would mean that opportunity would cost you 38% of your set-aside. You can then ask: is this the best use of these funds?
This is an intentionally simple scenario, but hopefully it makes the point clear.
Understanding the long-term strategies and goals in both your business and personal life is the only way to make the proper decision.
This started with me trying to define a new metric and ended with me writing out a whole system for maintenance capex, growth capex, and distributions.
I’d love to hear your feedback, as this is something I’ve seen work in my situations, but I’m sure you’ve seen different things as well.
Reply to this email and let me know how you approach these decisions in your business!
💰 The personal finance tool of the future has arrived. I recently came across a cool financial tracking tool that integrates AI and custom dashboard called Fina. You can ask “How much money have I actually spent at Starbucks this year??” and it’ll answer! Sick!
💰 Goldman Sachs is preparing for more layoffs and has predicted 300 million jobs will be lost or degraded by AI . Staying on brand for this newsletter, we’re talking about AI again… but with those predictions, it’s something no one can ignore. Companies will be best served by being proactive and seeking out solutions to automate their processes. In the end, those on the leading edge will have a competitive advantage of being faster, leaner, and a lower cost structure.
💰 Anders Liu-Lindberg put together a Twitter thread about the CEO/CFO relationship which I thought was really good. The chart by itself makes it easy to digest.
Thank you for reading!
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See you next week,