Respectfully, many Professional Service Providers (PSPs) have not built and do not own a business; they own the job they do, or a practice perhaps, but not a real business. One of the key differences is how each level handles the cash flow through the business – not a matter of quantity, but organization.
A sole proprietorship, or a force of one type of organization tends to operate what I call a two-basket cash flow approach. Basket No. 1 is for general overhead – everything and everyone not counting the owner. In Basket No. 2 is what’s left, or wages + profits. Typically, this second basket of cash flow is reported by a PSP on his/her tax return using Schedule C, which means that wages + profits are taxed at ordinary income rates.
I suggest to those who want to build a valuable, investable and tax efficient business organize, or compartmentalize, this cash flow to more clearly illustrate the concept and benefits of profitability.
Start with the notion that all incoming revenue from all owners and PSPs flows into three different “baskets” in a tax-conduit entity structure (“Newco, LLC”). The first basket (picture a large, wicker laundry-sized basket if you will!) is set aside for general overhead expenses, the second basket is reserved for owners’ compensation, and the third basket is what is left over, or profits, literally the bottom-line of Newco’s rebuilt or reimagined P&L. The general idea is this—overhead is the cost of running the business and encompasses all expenses except for owner salaries. Basket No. 2 is for the owner(s) total annual base salary/salaries, or more accurately, wages for work performed. These two carefully organized baskets serve to acknowledge that everyone, including and especially the owner(s), must be paid for the work that they do. These two baskets also provide notice that not every dollar of revenue after overhead expenses have been paid is allocated to the owner’s salary as it would be in a sole proprietorship (the training grounds for most entrepreneurs).
In fact, there are often tax advantages to be gained by isolating and limiting the amount of money paid through basket no. 2, in deference to basket no. 3. In the end, it is basket no. 3, profits or profitability, which is the measure of success and the primary determinate of Business value. To a next gen PSP who wants to buy in to ownership, these isolated and often more tax efficient dollars (such as through an LLC electing S-Corporation tax treatment) provide the return on each owners’ investment and provide a stream of revenue to service the buy-in debt.
Every small business and Professional Service venue is unique but let’s start out with a rule of thumb of 25% profitability as a reasonable, near-term future goal and adjust from there, acknowledging that some Professional Services can only generate half that, and others, twice that. The profitability of a given Professional Services business varies widely depending on factors such as location, specialty, experience, and management ability. The strategy and the logic still apply regardless of what normal profitability is for your specific Professional Services model.
If Newco, for example, generates $1,000,000/year in gross revenue for services rendered, then after basket nos. 1 and 2 are satisfied, $250,000 flows to the bottom-line of Newco’s P&L and flows home, pro rata, to the owner(s) of this tax conduit or flow through entity structure. Basket no. 3, along with a paycheck for work performed from basket no. 2, is a large part of what creates and supports the concept of a business being investable for the successor team members (next gen PSPs). But to be clear, the only way to access the dollars in basket no. 3, often in a more tax efficient manner as compared to basket no. 2, is to take the risk of ownership and buy an equity interest.
One of the primary goals of using this three-basket cash flow system is to help newer, younger owners learn to think and act like an owner. Building a valuable business means everyone needs to keep an eye on the general overhead of the business. Given that the next generation owners who buy equity will need to use much of their future profit distribution checks from basket no. 3 to pay for their investment, growing the top-line of the business while limiting the amount of overhead and owners’ compensation, within reason, leads to greater value and a shorter debt service period. Effectively, the successor team members are motivated to use “smart and efficient growth” to build value and to address their debt service obligations.
For those Professional Service owners whose venue requires much higher overhead that, in turn, reduces profitability to the 10% to 15% range, don’t give up hope! Doctors, dentists, veterinarians, accountants, just to list a few such learned professionals, are expensive to hire and retain, but the lessons on how to balance cash flows more effectively and how to use equity to hold expenses and salaries down in favor of more tax efficient rewards (i.e., stock appreciation and profit distributions) are still very much worth considering. At the very least, bolstering profitability by even a couple percentage points over your competitors could change the value of your business significantly whether it is built for internal Succession or is to be sold to a third-party buyer, what I call an Exit Plan.
Anything and everything works in a cash flow system when there is just one owner; modeling for two or three owners is a revelation.
Thanks for reading,
David Sr.
