Why Profit First is not Suitable for Your Start Up.
Over the last week or so I have had a number of my clients call me up and say to me ‘Hey, I would like to implement Profit First principles’ within my business. I then go into my speech of why Profit First isn’t quite suitable for their business…
Whilst I completely get the problem that Profit First is trying to address, I wholly believe that it is only suitable for certain types of businesses and Start Ups that are either experiencing or aspiring to have significant growth are not one of these businesses.
What is Profit First?
Profit First Principles suggest that a certain percentage of an organisations revenue is allocated firstly to a bank account that is earmarked for profit, then a percentage to a bank account earmarked for taxes, and then a percentage to a bank account for salaries. The residual balance can then be used to pay for expenses therefore ensuring that the business owner takes their ‘Profits First’.
These principles are ideal for a business that generates steady income month in, month out as it challenges the owner to look at the expenses and really tighten up on what they are spending.
This is a great piece of advice, however due to the complexity of the Start Up world this isn’t always suitable…
Why Profit First is not suitable for your start up
Firstly, lets define what a Start Up by looking at Investopedia’s definition:
‘The term start up refers to a company in the first stages of operations. Start ups are founded by one or more entrepreneurs who want to develop a product or service for which they believe there is demand. These companies generally start with high costs and limited revenue, which is why they look for capital from a variety of sources such as venture capitalists.’
From this definition, there are a number of scenarios that I can immediately think of where Profit First principles would have a detrimental effect on a business:
- Not generating enough profit:
Let’s think of how Facebook started. When Mark Zuckerberg started Facebook, the primary goal of the site was to expand the user base. Revenue wasn’t considered at first as it was assumed that the monetisation side of things would be easier with large volumes of users.
Often the initial focus of a start up is to develop a product or service that could potentially generate future revenue and profits. It is rare that revenue is generated from Day 1, therefore there is often a period of significant loss making. Ocado is another prime example of this – they spent a long time perfecting their supply chain model and growing their customer base, which took a while to generate a profit.
Let’s look at the above chart of a fictitious tech company. The business has ongoing operating cost of £300k a year which which are a team of developers writing code for a new app that they are developing.
Let’s imagine if Profit First principles were applied. In 2021 there is nil revenue, therefore Profit First falls at its first hurdle. Lets now look at 2021 where £100k of revenue is made. 2% of this is set aside for profits and then 20% for tax — both pointless activities because the business hasn’t broken even yet, therefore has not made a profit and as such is not liable for any (profit based) taxes.
A strong focus on cost management, management of project deliverables (i.e. when will the developers finish their app to be able to generate revenue) and cash flow management are the mechanisms required here rather than Profit First principles.
2. Bank Reconciliations
Every sizeable business should be reconciling their bank balance with the cash balance on their balance sheet – factors such as payment processing delays can cause discrepancies between the two hence the need to understand the gap between the two.
If cash has been spread over multiple bank accounts this amplifies this job from being a small task to an enormous project. This creates unnecessary inefficiencies and confusion in your Finance function.
Furthermore, it creates uncertainty to certain stakeholder groups such as investors if they do not have a clear picture or reassurance of the cash position within the business.
3. Audit
In the UK, if a business reaches a certain threshold an audit is required. When a business reaches this size there are hundreds and thousands of transactions being posted into the general ledger and flowing through bank accounts.
The last thing an auditor wants to do is to be tracing items here, there and everywhere. This will firstly cause confusion which will not sit well with the auditor, and potentially increase your audit fees given that it will take twice as long to complete the audit.
4. Pricing
On occasions a business may reduce their margins significantly to gain market share or some other reason.
If a business has net margins of 1% it is inappropriate for the owner to takes 2% of revenue into their profit account. Similarly, next to no tax liability will be generated in this scenario.
5. Unavoidable/inconsistent expenses
Some costs are unavoidable — imagine a business owner taking out profits for their business before paying their staff. This would suggest that the owner puts personal wealth over his staff welfare which raises an ethical question.
Similarly, inconsistently billed expenses throw the Profit First theory off — imagine a supplier invoices you annually. You have implemented profit first and set aside money for profit, taxes and personal salaries. Profit First principles suggest that this expense should not be incurred and you choose not to. Then you realise that this expense is required to generate revenue, and your ability to generate revenue has been affected.
SOLUTION:
Accountants and Finance Professionals spend years at college, university and studying for their qualifications. Furthermore, they spend years perfecting their art whilst they gain experience.
As a Start Up Founder it is vital to have a good understanding of your margins, the strength of your balance sheet, cash flow challenges, however I strongly advise to leave the management of the Finance function to a professional who is trained in this field rather than trying to learn from a book.
Ensure you have a Finance savvy member of your team that understands the intricacies of cash flow management, working capital management and strategic financial management.
At McQuade Consulting we manage the entire Finance functions for start ups, with a major focus on cost optimisation and unit profitability of a business. Please feel free to drop us an email to discuss this further.
