The Role of Profit in a Creative Enterprise
Blair has some questions this week and David has answers. The topic is profit - what it is and the targets firms should be setting.
Transcript
BLAIR ENNS: Okay, David, we're going to do this a little bit differently.
DAVID C. BAKER: Big surprise. Big surprise.
BLAIR: Yeah. Usually you would say to me, "You're going to interview me, Blair, and I want to talk about this," and you'd send me an article.
DAVID: Right.
BLAIR: And maybe there's a couple minutes of preparation and vice versa. This time I'm choosing your topic because this is a topic where I have questions and I know you have answers, so we're not referencing something you've written here. The topic is profit.
DAVID: Oh, good. I thought it was hair growth or something. Hair Club for Men. I don't have answers there.
BLAIR: Yeah, no, no. It'll be completely in your comfort zone here.
DAVID: Yeah. So P-R-O-F-I-T, just to be clear.
BLAIR: Sure.
DAVID: Not P-H-E-T.
BLAIR: Yeah, yeah, yeah, yeah.
DAVID: Okay.
BLAIR: Yeah, so we're going to talk about profit. We've talked about making money and too much money ... Is there such a thing as too much money? We've talked a little bit about that. I specifically want to look at the need to make profit, what profit targets you should be setting for your firm, and how different types of firms maybe are free or even should explore different thresholds of profit. But first can we start with the definition? What is profit?
DAVID: Sure. Profit is what's left over after all normal expenses. And the expense that people mess up so much is how much they pay themselves, especially with the kind of firms that you and I work with which are typically small, closely held, entrepreneurial creative firms. So pretend that they have ... Let's just use percentage numbers to make it easier. Let's say they have 20% profit and their pretty comfortable with that. It feels good. Then when you probe a little bit they're underpaying themselves so in essence they are subsidizing the net. The term that most folks would use to fix that is that what they would need to do next is to normalize their compensation. Whether or not they actually pay themselves what they should pay themselves, they pretend ... What would the profit look like if they were paying themselves a normalized amount. And then that's the really normal profit.
It's what's left after you're paying yourself and all the other normal expenses. That's profit.
BLAIR: Let's talk about principal compensation for a minute and normalizing, because what's the context you would use to determine that a principal's compensation is normal or appropriate so that you can get an accurate reflection of the profit?
DAVID: We could build very complex spreadsheets that accounted for the geography and the nature of the creative firm and how long it's been in business and so on, but then it becomes so unusable that it's just not very helpful. So I just use a very simple standard that's tied to the number of people at the firm. If there's up to four people, I say at least $100,000, I'm talking U.S. dollars here, and then it goes up from there in different brackets and it goes all the way up to about $410,000. Then there of course would be a calculation to account for any multiple partners, because you can't expect, say if there's a 10 person firm and let's say that each partner is making $200,000, that's going to be reflected in less profit than normal because it's an overhead burden that wouldn't be typical. So there's a formula for that. But anywhere from $100,000 to $410,000, and then you would expect a certain level of profitability after paying yourself that normalized amount.
BLAIR: So you must, in the work that you do in your core offering at Total Business Review or any other financial review when you go in, you must encounter some situations where the principal is feeling pretty good about their profit level and then you normalize their income and say, "Well, you're actually significantly underperforming profit-wise."
DAVID: Shatter their hopes. They fall and they're crying on the conference room floor.
BLAIR: It doesn't change, at the end of the day, how much money is in their pocket.
DAVID: It doesn't.
BLAIR: The context has got to be really helpful.
DAVID: It is. I find that the principals who are paying themselves less than what would be considered a normalized amount, usually aren't feeling desperate about that. They actually derive quite a bit of comfort not just by how much money the business is paying them on a regular fixed basis, but they also feel like they're making a significant investment in the company. So their expectations are different. It doesn't have to come to them all right away, in fact it's not all that odd to find these companies where there are one or two or three other employees besides the principal who are making more money than the principal on a fixed regular basis.
BLAIR: You're saying that's okay?
DAVID: Well, it's okay to them. It's not okay to me but that's their perspective when I point out they're making less money than they should, that doesn't send them into that despair I was joking about because they feel like they're building something else. My feeling, I have really specific expectations about why a company should be profitable regardless of where it is on that path with a few exceptions. So I'm not content with that.
But many principals don't feel this awesome pressure to make more money, especially if they compare it to their career before they started a firm. They're actually okay making less money as long as they don't have a boss. You and I have joked about that. You're willing to pay so much money to not have a boss which shows up as the difference between what you were making before you were working for yourself and what you're making now which is less as you're working for yourself.
BLAIR: You said you have some very specific expectations, I think was the word, around profit for your clients or ideas of what they should be hitting. What are they?
DAVID: Here I'll just mention in advance if it isn't going to be very obvious that these are really just my perspectives on it. I can't support this scientifically, but here's how I think about it. Starting a corporation, a company, a separate entity, is like having a baby. You don't just have a baby and just then ignore it. You have to feed it, there's certain expectations of care. Creating a corporation brings similar expectations in my mind and if you're not going to consistently, with a few exceptions, if you're not going to consistently generate a healthy profit then why even have a corporation? There are some good reasons to have one from a legal liability standpoint and so on, but it feels to me like you have an obligation to make more money because of what needs the corporation has. It should be a part of your planning to pay yourself a regular amount and then run the business regularly, with a few exceptions, where it's also throwing off money which is what a corporation should do. That's a philosophical belief I have. It's hard for me to defend that, honestly.
BLAIR: Yeah, and if I have one philosophical belief around profit, it's that profit, above the normal salary that the principal would generate for herself, the profit would be ... It's proof of concept. It's proof of sustainability. It's validation that the world needs what you do. When it's not there, that's a sign that maybe it's not all that valuable to the world and you should think about making a slight change or maybe doing something entirely different.
DAVID: I agree with that completely. You're sharing the same philosophical belief and you expressed it differently, that resonates with me. And again, you probably can't ... It's more a belief, it's a philosophical belief you have, and I share that. Frankly, it's like if somebody probes that and says, "Well, talk more," it's hard for me to even talk more about that because it's just a belief I have, it's not something that I can really demonstrate scientifically.
BLAIR: You made the point a little while ago that there are instances when the principal is taking less profit because they're building something, they're investing. That really gets to the heart of what I've been thinking about on the subject and why I wanted to talk to you about it.
A few years ago I read William Thorndike's book called The Outsiders where he profiled what he saw as the eight best CEOs in America, CEOs of publicly traded corporations. I was saying to somebody the other day, "I think it's the book that Jim Collins would've liked to have written when he wrote Good to Great," which was a good book. But the research behind this book was more substantial.
DAVID: Right.
BLAIR: The conclusions that he came to ... Warren Buffet's in there and then a bunch of people I forget, some of them go back quite a few decades. But these are principals of publicly traded corporations that have shown decades of continued growth. He found out who these people were empirically and then he looked for what they had in common and one of the things that they had in common was they saw their primary job as the allocation of capital.
DAVID: Mm-hmm (affirmative).
BLAIR: Basically six or eight core decisions around investing. So it's the idea of the CEO as investor. You can imagine why Warren Buffet, Chairman of Berkshire Hathaway, would be in that list or at the top of the list. Another is the strong COO, or sorry, not just COO, but operations people, really hands off operationally.
Anyway, so I read the book and there were other factors and I thought, "This is really interesting," and then I started looking for well, who's the modern equivalent? Who meets this bill? And it's Jeff Bezos from Amazon.
DAVID: Yeah.
BLAIR: What's really interesting about Amazon, and at the time we're recording this, Amazon's stock has increased 40% over the last year, and I remember reading this book about three years ago, looking at Amazon, looking at ... And thinking about some of the things Jeff Bezos said when Amazon went public. He said, "If you're going to buy our stock, you need to know there's no expectation of profit for at least the first 20 years."
DAVID: And people, the advisors behind him are just like, oh dying, "Don't say that, Jeff."
BLAIR: Yeah, and to this day, 20 years later, every quarterly earnings report, some young Wall Street MBA gets on CNN or some platform and hammers or downgrades the stock because of the expectations of profit.
DAVID: They hammer him because he's doing what he said he would do 20 years ago.
BLAIR: Yeah.
DAVID: Right.
BLAIR: For a few hours a couple of weeks ago he was the richest person on the planet, he will be probably by next week and he'll probably maintain that position and never give it up. I remember looking at Amazon three years ago, I think it was valued at around $300 billion, and I thought Amazon is going to be the world's first trillion dollar corporation.
So what Jeff Bezos is doing is he's investing all of the operating profits into growing Amazon.
DAVID: Right.
BLAIR: But he can do this ... If I am the principal of a creative firm, does it make sense for me to continually reinvest in the business and grow the business because, for Bezos, the payoff is in the valuation of the stock. In a closely held company, the equivalent would be the payoff is the exit at the end. Is that fair?
DAVID: Yeah. Or the profit that's thrown off regularly over the 20 years you run it even if it doesn't sell. But either one.
BLAIR: In Amazon's example, there's no profit that's being thrown off regularly.
DAVID: Right.
BLAIR: They're constantly reinvesting. I've heard you say to principals many times, "Listen, you shouldn't be building and running this business with the expectation that you're going to cash out at the end.
DAVID: Right.
BLAIR: Therefore, you need to be taking so much profit as you go. Correct?
DAVID: Mm-hmm (affirmative). Right.
BLAIR: You want to say anything about that?
DAVID: Yeah, because I think that's such a great example because what I think is different, because I can hear somebody hearing our discussion right now and thinking, "I'm doing the same thing Jeff is," I shouldn't say Jeff, I don't know Jeff, but I don't know how to pronounce his last name very well so I just say Jeff. But they're thinking, "Yeah, I'm as smart as Jeff because I don't take profits either. I'm reinvesting in my company."
Okay, but here are the two differences between Amazon and your smaller, creative entrepreneurial enterprise. One is that Jeff could flip a switch at any point and make a lot of money. The other difference is that he can point to the allocation of capital to build IP. Most of the principals of the firms that I work with can't do that. The truth is that they're taking that money that would've gone to profit and they're spending it on employee salaries who are the same kinds of employees that they've had forever. They're not using it to develop a black box or some sort of research algorithm or launch out in a very specific way from a positioning standpoint into an area that might yield a lot of profit rather than just chasing the next thing. They're not doing either of those two things. So I think that it's quite different. It's a great example, but the difference are those two.
This is helpful to me when I'm trying to sort out a financial situation as I'm working with a client. I try to help them think through that they would normally think of themselves as getting compensated for three things that they do. One of them is they should be compensated for what they do, and that's the normal fixed salary that's paid to them, just like any other employee, and it doesn't matter what state or country or province, it doesn't matter what the corporate form is, whether it's an S corp, an LLC, a C corp, it doesn't matter, there should be a regular fixed paycheck. That's you get paid for what you do.
Second, you get paid for the risk that you take. Now, the risk that folks are taking running these firms is less and less these days. Because they're not borrowing money as much, they more frequently own their own building so there's very little risk to the enterprise. The line of credit, which they don't use as often as they used to, is still personally guaranteed, and so on. There's not a lot of risk. But if they load the business money then they should get some sort of an overriding interest rate. That's getting paid for the risk that you take.
The third thing is getting paid for something that you own, which is completely separate from either of those two things. Picture a non-participating principal who doesn't work in the business and doesn't take a risk. That person should get money for what they own. That's the distribution based on ... Let's say they own 20% of the stock, then they get 20% of the profits at the end of the year.
Separating the money flow into those three categories really helps. And if we're saying that you shouldn't ever get money for what you own, then we're misunderstanding. We're throwing away one of those critical three categories, in my mind. That's just how I think about it.
BLAIR: Isn't ownership itself a significant form of risk, though? Because you own essentially a falsifiable experiment, something that could fail.
DAVID: Yes, but let's say somebody gives you part of a company and you haven't paid anything for it. Then there isn't any risk really associated with that. That's what I'm talking about.
BLAIR: Right.
DAVID: Now if you put money into the company, then that would be getting paid for the risk that you're taking, the capital infusion. But just for owning something, especially if it's a passive investment, that should be viewed separately.
BLAIR: So we've got these two extremes where, on one end, Amazon is reinvesting essentially all of the profits in an effort to build a behemoth and doing very well at it, by almost any measure. On the other end of the spectrum ... So there's an end game, it's the valuation of the stock and if it's a privately held company the end game is an exit. On the other end of the spectrum you're saying, "Well, as the owner of a closely held or independent creative firm, you shouldn't be banking on an exit." We could do another podcast on just the subject of exits, that's probably worthwhile. But you shouldn't be banking on an exit. You should be taking meaningful profit along the way because that is your future. That is your retirement.
DAVID: Right.
BLAIR: But those are the two ends of the spectrum but if you're constantly taking profit ... If there's a threshold in your mind as the principal, and let's say it's 20%, we can talk about whether that's a meaningful number or not, but that's the number that I use and you use it in some contexts as well.
DAVID: Right.
BLAIR: So you're doing everything you can to hit 20% but, at some level, every profit dollar that you take is a profit dollar that you will not reinvest in the business. You talk about developing IP, but maybe investing in the business I know a lot of ... I've encountered a lot of principals over the years who would invest in their business, not in IP but in growth. They feel like if you get to a certain size then we're saleable, so I'm willing to forego profit to grow so that I can sell. So that's the exit thing.
But let's put exit aside. In my business, we're constantly, I'd say, reinvesting in the business. Spending on things that you weren't anticipating spending on a year ago because an opportunity to grow comes up. And opportunity to move into a new space or to develop some new capabilities, to hire some talent that you didn't previously have on board to take your business into a new direction.
DAVID: Right.
BLAIR: I'm just saying there's this balance between the two things, and I guess the question is, how do you balance profit taking and growth?
DAVID: Right. Yeah, it's such a good question. I feel like when I hear that people are investing in growth it's hard for me to know exactly what that means because some of them clearly are, and as you dig deeper, you can see that they think really carefully about those decisions. It's not that they don't take risks, they do take risks but they think about it. They're not lying to themselves.
Then there's others who are always investing in the company. They can never switch that ... Or folks who feel like nirvana is just around the corner, all I need is this additional opportunity or I need these employees or I need this sales person to take me in this direction. To me, the kind of ... When you were describing in your business investing in growth, to me that's more about knowing exactly where you want to head, being open to additional opportunities along that same path but you're accelerating a very clear vision as opposed to getting distracted off of a clear vision and then investing in growth.
Talking specifically to where we should be in the middle of that spectrum, I agree, it doesn't make any sense to totally invest all the time, which the reverse of that is to never take any money out, that's really what that means. Then the opposite is to rip everything out of the business. Some rules of thumb that I usually follow is that you would normally want, after paying yourself a normal salary and then generating 20, that would be the minimum threshold unless the firm is in big trouble for a temporary period of time, 20% to 30%. Generally, a third of that you take out, a third of that you reinvest in the company, a third of that you reinvest in the employees in some way.
But if you were on a high growth path, then you will not be able to take out as much yourself. That third will probably be lower and you may live with that and feel like you're going to invest in yourself and you feel good about that. I really endorse that, I think that's fantastic. I just want people to have a plan and not just say to themselves, "Well, I'm investing in the business," and really what it means is that I haven't figured out this business and I haven't been able to take money out. As long as those choices are very intentional I think that's fantastic. But something to show for it at some point.
Normally, you have to fix the profitability problems you have at the current size and then you grow. You don't typically grow out of unprofitability. That is certainly true in the public markets, in the P and E, the private equity funded world where they're just looking for scale, but that's not the world we're playing in. We need to be generally profitable from day one, varying a little bit from zero to 30%, an there are times when we're investing in growth, there are times when we've stumbled and we live with no profit at all, or maybe even lowering our salary. But in general, we need to be profitable at every size.
BLAIR: That's a great rule of thumb, and the idea that if you're investing in your employees or in growing the business, you should be able to, if you wanted to or needed to, flick that switch and take that as profit instead.
DAVID: Right.
BLAIR: The decision you make around that is yours. It's entirely personal.
DAVID: Right, right. Investment isn't another word for sloppiness.
BLAIR: Yeah.
DAVID: Investment is a specific choice.
BLAIR: You mentioned right near the beginning that principals are taking less risk and one of the things you cited is that more and more own their own office buildings. You're seeing that as an increasing trend?
DAVID: Yes, for sure. It's been a part of this world for decades, about three decades, but it's certainly becoming more prevalent out there. It makes so much sense if a few things are true. Like if the size of your firm has stabilized. In other words, you can move into a building and you're not going to have to move again, if you can afford it, if you're in a market where making such an investment makes sense from a real estate standpoint and so on. If all of those things are ... And usually when you can afford it that usually means at least 15%, 20%, sometimes 30% down on a commercial loan.
But if all those things make sense, here's why it's brilliant. Or a couple reasons. One is that you would always own that building in a separate legal entity to protect everybody. Then you would pay rent from one corporation to the other and in certain tax environments there are real tax advantaged ways to pay rent to yourself because it's not subject to certain other like in the U.S. market it would be FICA, it's called other things in other markets.
But the main reason is that you ... There is this huge pool of buyers who would at any point buy your building, which is not true for your business. Most of the people who would buy your building, so there's a big market pool which means an efficient market. So all these people who could buy your building, most of them have nothing to do with your industry. Which means there's this larger pool of building which means it's easier for you to get out of that investment when it comes time to. So far ... I don't have the exact number but I do know that many more principals are making money investing and building equity in their building and then selling it at some point than are making money from selling their businesses themselves.
BLAIR: So that seems to be one of the master plans of agency entrepreneurship if you own an independent creative firm and that's you're taking profit and part of the investment is you are buying and paying for the building that's easier to sell.
DAVID: Yeah, and in many cases it costs even less than it would've cost if you were paying a commercial mortgage to somebody else. So it's almost a no brainer. There are about maybe a third of the circumstances where it doesn't make sense to own your own building in really large, expensive markets it typically doesn't make sense. But for many firms it really does make a lot of sense. That's an example of any investor would expect some return on an investment and buying a building. Why don't we expect the same thing with the business? Unless it's just, I guess, a lifestyle business which I'm uncomfortable with that idea, I guess.
BLAIR: Yeah, I used to have a lifestyle business and then one day I woke up and realized it was ruling my life.
DAVID: A life stealing business.
BLAIR: Yeah, that's more appropriate. Before we wrap up here, you have so much data on having worked with so many different firms and you have these benchmarks and ratios and ... Can you give the folks who are listening here, can you give them a sense of how well they're doing on the profit front? You said what the targets are, seemingly 20% to 30%.
DAVID: Mm-hmm (affirmative).
BLAIR: What do you see as the average? How many firms get to that target?
DAVID: Certainly not the average. The average would be somewhere in the 16%, 17% after you normalize principal compensation. So, the average firm is not hitting that 20% mark. And then some firms who are well run and have different expectations of themselves they would hear me say 20% and they would just snicker, it's like, "Really? Ah, it's got to be more than that. More like 30%." So it just varies. It doesn't have anything to do with the size of the firm or where you are in the country and so on. It's just universal. Most firms are in the 15%, 16%. My minimum threshold is 20%, I really would like 30%.
BLAIR: What's the ... I want to ask you, what's the highest one you've ever seen? That's probably not a fair question because there's so many different ways to get to a high profit margin over a short time period.
DAVID: I've seen some 40s.
BLAIR: Yeah?
DAVID: Yeah. I've seen some 40s. Yeah, for sure. Yeah. I wish I could say those 40% net profit firms are doing great work and the culture is amazing. It really isn't necessarily true. In some cases, it is. In some cases, it's run more like a factory with employees who aren't necessarily happy and they're just, they're tracking all their time to the minute. Other times, the firm is just really well positioned, their pricing is thought of very differently. It's more in line with how you think about pricing and it's not tied to effort, it's tied more to impact and so on, and they're just doing really well and they have a great culture. I love seeing that. In fact, I always feel like, "Why do you need me here?" This is pretty good. This is great.
BLAIR: Yeah. It's so wonderful when you see a well-run firm with good culture. Everybody's being paid well and the profit margins are high. I've made my own observation that when you see a lot of firms that are squeezing out really high profits, I've seen there's a correlation ... And when it's a function of billable efficiency, really just working everybody hard, usually the principal is the hardest working person. I don't know what the threshold is, but when your billable efficiency crosses a certain line, and maybe it's you're capturing and billing 75% of all of the available time. Or maybe it's 80%, maybe it's 85%, but at some point you get over a threshold where there's an inverse correlation between the billable efficiency of the firm and the lifespan of the principal.
DAVID: We need a chart that measures that out and then we can talk to a principal and say, "Oh. You might want to wrap a few things up. You've got about 47 months left, bud." Yeah.
BLAIR: On your life. Alright, this has been really helpful. Thank you so much for bearing with me and answering the questions that I have on profit. Yeah, of course I knew you would have all the answers and you did so that was great. Thanks.
DAVID: Thank you, Blair.