Congratulations! Your startup moved out of the dorm room, shared work space or whatever other creative locale you’ve found inspirational. Online technologies are pushing new businesses to rising heights again (this time, hopefully, without the bursting bubble and subsequent crash.) So, where’s the money?
Experts agree that the failure rate for businesses in the first two years is significant and, for those that do make it, many more fall before hitting five.
For those that crossed their second birthdays, good work and be careful. The third through fifth years are when many companies move from the start-up phase to early growth. This is when sales really start increasing, profitability becomes expected and new hires are joining the ranks every week. While this seems like the time the cash flow will really start coming in, the reality is often the opposite.
Companies that find themselves successful on paper but still seemingly strapped for cash need to pay attention to what I call the “triple tax.” It’s a concept that includes three specific areas — actual taxes, working capital and investment – that require a lot of new cash to support a growing company.
Federal and State Taxes:
This is the most obvious and yet can really sneak up on a growing company. Profits are taxed at year end and can quickly add up to be large sums of money. Business owners need to be careful about the tax liability all year and plan for the large tax payments without impacting the business.
Working Capital Requirements:
Working capital is the money required to run the business. It can act as a bridge between paying bills and collecting revenue or cover off on expenses in slow times and unprofitable months. There is no one magic number, just the reality in growing companies, working capital requirements will always increase. This can become a very quick tax to growing companies with much of the profits from prior months needed just to pay the increasing bills and payroll.
Growing companies need to make continuous investments. Hiring for new roles, buying new software/ hardware, getting an agency to help with marketing, and looking at expansion are all examples of a growing company’s investment opportunities. Each of these items takes significant capital to get underway and will probably require months or years to see a return. While necessary and good for the company in the long term, investments represent a cash flow tax when incurred.
Understanding these three taxes on cash flow is an important part of managing a growing business. Simply identifying that each exist and quantifying the amount of money required to fund each item will go a long way, allowing a management team to assess how much money is needed and prioritize accordingly. Managing each separately, with unique forecasts and accounts, a leadership team can go further by isolating priorities against real available funding.
A simple example illustrates the point. A leadership team looking at $1 million in a business bank account could easily say, “Let’s build a new product.” But if that account represented $200,000 of tax liability and $600,000 for working capital, then the decision for new product development is limited to a $200,000 investment. This could lead to a very different discussion and decision for the company.
The quick, and common, fix for cash flow demands is raising capital through loans or additional investors. This can solve immediate cash flow issues but it also adds liabilities to the balance sheet or decreases owner equity. It is important to assess if the infusion will continue to support the business growth before going down that road.
Here’s another strategy: slow down.
I know, these are exciting times to be in business but don’t get carried away. Commit to slowing or stopping growth for six months and focus on optimizing the business.
While the income tax will still accrue, this should minimize the working capital and investment cash flow burdens and allow the company to build up cash reserves. Growth is important over time but stabilization is a big driver of future growth. Be aware of times that your growing company could use a breather and take advantage of that time to build a healthy balance sheet.
Working in a company that is growing fast is an amazing experience and one to be proud of. As business matures and the future actually starts looking like reality, it is imperative that cash flow becomes as much of a focus as profitability and business strategy.
By assessing cash flow as consistently as other business critical metrics and forecasting where future cash flows will be applied, all companies can successfully navigate around the triple tax and ensure they will be among the organizations seeing their fifth birthdays.