Can You Build a Business for Both Cash Flow and a Big Exit?

Summary

Business Lunch Podcast Summary Episode Title: Can You Build a Business for Both Cash Flow and a Big Exit?
Host/Author: Roland Frasier
Release Date: October 11, 2024

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Introduction

In this insightful episode of Business Lunch, hosts Roland Fraser and Ryan Deiss delve into a pivotal question faced by many entrepreneurs: Can you build a business that generates substantial cash flow while also positioning itself for a significant exit? Through a comprehensive discussion, they explore the dynamics between bootstrapped ventures and those backed by venture capital, unraveling strategies to balance immediate financial benefits with long-term growth and exit potential.

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Defining the Core Concepts

Ryan Deiss initiates the conversation by framing the central question:

"Can you build a business that you intend to sell versus building a business for cash flow? Are the two mutually exclusive?"
[00:56]

He articulates the common perception that businesses often have to choose between reinvesting profits for growth (aiming for a big payday later) or distributing profits for immediate cash flow, suggesting these paths are traditionally seen as divergent.

Roland Fraser concurs with Ryan's premise, emphasizing the flexibility inherent in bootstrapped businesses compared to those reliant on external funding, particularly from venture capital (VC) investors.

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Bootstrapped vs. Funded Businesses

The hosts draw a clear line between bootstrapped businesses and those funded by investors:

• Bootstrapped Businesses:

  • Flexibility: Greater control over financial decisions without the pressure of investor expectations.
  • Lifestyle Focus: Some bootstrapped businesses opt to generate just enough cash flow to support the owner’s desired lifestyle, avoiding aggressive growth or scaling.
  • Dual Objectives: It's feasible to both distribute profits and enhance the company's value for a future exit.

• Funded Businesses:

  • Investor Expectations: VC-backed companies are often obligated to reinvest profits to scale rapidly, aiming for high returns for investors.
  • Exit Pressure: The path is typically one-way, focusing on scaling and eventual exit, with less flexibility to prioritize immediate cash distributions.

Ryan Deiss succinctly summarizes the divergence:

"If you raise money through venture capital, then everything's got to get reinvested and you basically better get it generated 10x return for your investors."
[02:01]

In contrast, bootstrapped businesses enjoy the liberty to distribute profits while also building substantial exit value.

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Balancing Cash Flow and Exit Strategy

Delving deeper, Roland Fraser challenges the notion that building for cash flow and a big exit are mutually exclusive. He highlights practical strategies to achieve both:

1. Tax Optimization:

   • Expense Deductions: Utilizing business expenses to minimize taxable profits, thereby increasing distributable cash.
   • Strategic Write-offs: Legitimate deductions like business trips, employee perks, and other necessary expenses can reduce profitability on paper, enhancing exit valuations.

2. Restated Financials:

   • Transparency for Buyers: Adjusting financial statements to reflect true operating profits by accounting for non-recurring or personal expenses.
   • Maximizing Valuation: Presenting a clearer picture of profitability to potential buyers, thereby increasing the company's exit value.

Roland emphasizes:

"If you're building a solid business that is a wealth asset, you can take the money out and fund the growth that you need and add back anything you need through restated financials."
[08:46]

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Effective Cash Flow Management Techniques

Ryan Deiss and Roland Fraser outline robust cash flow management practices essential for balancing immediate distributions with sustainable growth:

1. Cash Flow Waterfall:

   • Operating Reserves: Maintaining a specific amount in the operating account to cover monthly expenses.
   • Excess Cash Distribution: Sweeping surplus funds for distribution or reinvestment after ensuring operational needs are met.

   Ryan explains:

   "We create a cash flow waterfall so that the cash, when it goes through, it's going to flow through the excess cash. We're going to leave a certain amount in operating... Everything over and above that is going to get swept out."
   [09:30]

2. Emergency Funds:

   • Cash Reserves: Allocating funds for unexpected expenses or downturns to prevent disruptions in operations or distributions.
   • Refund Reserves: Especially crucial for businesses with significant return rates (e.g., e-commerce), ensuring funds are available for customer refunds without impacting distributions.

   Roland adds:

   "If you know that you've got a 10% refund rate and you're doing a million dollars a month, then you know that roughly $100,000 a month of the money that you bring in is not going to stay in the company."
   [14:06]

3. Budgeting and Planning:

   • Predefined Allocation: Deciding in advance how excess cash will be utilized, whether for reinvestment, distribution, or reserves.
   • Financial Discipline: Ensuring that distributions do not compromise the company’s ability to invest in growth opportunities.

Ryan concurs:

"If you distribute money out to the stakeholders, that money can always be reinvested back in. So... it keeps everybody honest."
[10:45]

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Tax Considerations and Financial Structuring

A crucial aspect of balancing cash flow and exit potential involves strategic financial structuring to optimize tax liabilities and enhance profitability:

• Tax Deductions: Leveraging allowable business expenses to reduce taxable income, thereby increasing distributable cash.
• Salary Structuring: Paying reasonable salaries to owners to avoid excessive personal withdrawals that could negatively impact the company’s valuation.
• Restated Financials: Adjusting financial statements to present a more favorable profit picture to potential buyers by excluding non-essential or personal expenses.

Roland stresses:

"If you have a material refund rate... you got to put aside because otherwise it's either coming out of your reserve or it's coming out of your cash flow."
[14:06]

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Real-life Examples and Experiences

Ryan Deiss shares personal experiences to illustrate the effectiveness of balancing cash distribution with building business value:

• Comparative Success:

  • Retention vs. Exit: Entrepreneurs who continuously distribute profits over time can accumulate more wealth compared to those who hold out for a single large exit after many years.

  Ryan notes:

  "I had generated more in distributions over that same period of time from one of the companies than they made from that one exit."
  [16:19]

• Time Value of Money:

  • Annuity Effect: Regular distributions benefit from the time value of money, allowing reinvestment and compound growth, which a lump-sum exit cannot match.

Roland concurs:

"You had the time value of money right as an annuity. You had an annuity that was paying constantly as opposed to that end thing. So... it becomes pretty significant."
[16:43]

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Cautions and Considerations

While advocating for the simultaneous pursuit of cash flow and exit strategies, the hosts also highlight potential pitfalls:

1. Overdistribution:

   • Resource Depletion: Excessive cash withdrawals can hinder the company’s ability to invest in growth opportunities, potentially reducing exit valuations.
   • Debt Accumulation: Misallocated funds towards unproductive investments like unsuccessful acquisitions can lead to debt and diminished company value.

2. Dilution and Equity Stakes:

   • Investor Returns: In VC-backed scenarios, distributions can conflict with investor expectations, leading to strained relationships or reduced support.

3. Exit Realities:

   • Actual Returns: Not all exits deliver the anticipated financial rewards due to factors like dilution, debt, and secondary obligations (e.g., preferred stock).
   • Expertise in Exits: Success in exiting requires more than just business growth; it necessitates strategic negotiation, optimal financial structuring, and comprehensive preparation.

Roland emphasizes:

"Exits are not always what you anticipate them to be. They may not provide the full value you expect after accounting for dilution, creditors, and other factors."
[17:33]

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Conclusions and Final Thoughts

Ryan Deiss and Roland Fraser conclude that for bootstrapped businesses, generating substantial cash flow and building for a significant exit are not only compatible but also mutually reinforcing goals. They advocate for:

• Strategic Cash Management: Implementing systems like cash flow waterfalls and maintaining adequate reserves.
• Financial Discipline: Balancing distributions with reinvestments to sustain growth and enhance valuation.
• Informed Decision-Making: Understanding the nuances of financial structuring to maximize both current profits and future exit value.

Ryan encapsulates the episode's message:

"The businesses that we've had that exited for the most also just happen to be the businesses that kicked out the most cash. Because businesses are going to exit based on their profitability and profitability should at some point show up in the form of cash."
[15:41]

Roland adds a practical note:

"It's a lot more fun than waiting 20 years and hoping that you're going to get a payday at the end."
[16:15]

The hosts encourage entrepreneurs to adopt a balanced approach, leveraging cash flow as a tool for both immediate rewards and long-term success, thereby “eating their cake and having it too.”

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Key Takeaways

1. Flexibility in Bootstrapped Businesses: Without investor constraints, entrepreneurs can balance profit distributions with growth investments.
2. Strategic Financial Management: Implementing systems like cash flow waterfalls and maintaining reserves ensures sustainable business operations and supports both cash flow and exit strategies.
3. Tax Optimization: Leveraging legitimate business expenses can enhance cash flow while maintaining or increasing business valuation.
4. Real-world Insights: Regular distributions can outperform the financial gains from single, large exits due to the benefits of the time value of money.
5. Cautious Optimism in Exits: Understanding the complexities of exits ensures that entrepreneurs are prepared to maximize their returns post-sale.

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For more insights and discussions on building successful businesses, subscribe to the Business Lunch podcast on your preferred platform or visit our YouTube channel.

Transcript

[Roland Fraser]

Yeah, and I agree. And I think the first thing that you said is a really important distinction, that if, if you're bootstrapped, you have a lot more flexibility than if you're funded, particularly if you're funded by investors, as opposed to maybe friends and family and things like that. But in those bootstrapped businesses, there's some businesses are considered lifestyle businesses, which basically is, I just want the business to produce enough cash for me to live the way that I want to live now. Hey everybody. Welcome to another episode of Business Lunch with Ryan Deiss and me, Roland Fraser. We are happy to be here with you sharing fun things. We just finished an event and a couple people asked some really cool questions that we thought might be good podcast topics because we figured if they had them, then you might have them too. Brian, you want to kick us off?

[Ryan Deiss]

Yeah. So this particular question was posed and really came down to the difference between building a business that you intend to sell versus building a business for cash flow. Right. And are the two mutually exclusive? And if you're, if you're building a business and you're pulling a lot of money out of this business because, I mean, that seems to be, it's almost treated, at least out there in the media world, as two different things. Like there's one path where whether you raise money or not, right, you're putting all the money back, you're constantly investing money back into the business. You're investing for growth, investing for growth, investing for growth. And then you're going to make this big payday at the end. And then the other one is you're taking money out, you're taking money out and you're taking money out. And maybe you sell one day, maybe you don't, but you're basically optimizing for today instead of optimizing for tomorrow. And the question really is, can you do both? Is there a way to balance? What do you think? And so that's the question, Roland, can we have our cake and wait for it, eat it too?

[Roland Fraser]

I'd love to hear your thoughts on it.

[Ryan Deiss]

Well, I would, I think for, if you, it comes down to what is the path that you picked from an in, from an investor and fundraising perspective. Number one, if you went the VC route, you raised a bunch of money, then you are on a particular path. And that path, you, you just walk through a one way door. So if you raise money through venture capital, then it is kind of big eggs that are bust and creating a cash flow business is not going to be good for anybody. And so yeah, everything's got to get reinvested and you basically better get it generated 10x return for your investors. They're going to be miserable and that's at a bare minimum. So that's. If you took the VC check, if you didn't take the VC check and you're bootstrapped, then not only do I think you can both take money out and generate cash flow today and have a large exit value, I think you should. I mean, we have experienced this. But I think the ultimate sign of a healthy business is, you know, not just a high NPS score or even a really large revenue number. I think the ultimate sign of a healthy business is that businesses ability to kick out large amounts of distributable cash each and every month or quarter. So yes, I think if you do want to sell, then having an ability to make big distributions is not only something you can do. I think it's something that you should do now. Coming up with a balance so that you're not sending out so much money that there's not enough fuel for growth is definitely a balance that you need to keep in mind. But yes, I do think you can have both.

[Roland Fraser]

Yeah, and I agree. And I think the first thing that you said is a really important distinction that if, if you're bootstrapped, you have a lot more flexibility than if you're funded, particularly if you're funded by investors as opposed to maybe friends and family and things like that. But in those bootstrapped businesses, there's some businesses are considered lifestyle businesses, which basically is. I just want the business to produce enough cash for me to live the way that I want to live now. And I'm not really concerned about it building significant value or even growing because I'm happy with where I am and I don't. Which, which is, may sound a little animatic. Right. It's, it's, it's what you don't want to grow, you don't want to scale. Well, you, you advised somebody one time, a friend of ours on Facebook, I remember, long ago actually, and you said, I think they were talking about scaling the business to 10 million. And you said, well, before you do that, ask if you want what that brings because it brings a whole host of different things. But that's a different conversation. I think the answer is that you can do both. And the confusion arises out of the advice that you're given that you want to do things differently a couple years before you sell. And a lot of people believe that it's mutually exclusive. That you're either building a business to sell or you're building a business for cash flow and that you have to like flip that switch. But it's not completely true. There are things that you will do, typically as an entrepreneur who doesn't have to answer to other investors that will minimize your taxes. Like you'll write off everything that you possibly can. You'll take maybe trips that would not be tax deductible and you'll take all of your employees to some fun place that you would otherwise have a non tax deductible vacation. You'll maybe pay for cell phones or automobiles or other expenses that the business doesn't need, or maybe you'll lease properties or things like that that the business doesn't necessarily have to have, but they are tax deductible because they are ordinary and necessary or basically helpful to the business that reduces profitability. And because most businesses sell based as a function of profit, anything that takes the profit down is arguably something that will inhibit your ability to get a higher sales price. Now that's typically addressed through restated financials where we go through an exercise to say, hey, over the last couple of years, what are all the things that were one time expenses like masterminds or consults or training programs or all those family type experience expenses or other things like that that will not be ongoing required expenses of the business to achieve profit going forward in the hands of the new buyer, that can also include the excess salary. Maybe you're paying yourself a million dollars a year, but you could be replaced with somebody that only costs 200,000 a year. We'd add that 800 back. So I don't find it to be bad to take a lot of cash out of the business. And we've gone through recently in a couple of the businesses having this out with high level people that were C suite people that we brought in because their argument was, well, you're taking money out of the business, that's hurting my future potential exit value. And the answer to that is kind of a combination between, well, what do you think we need to put that money in to do? What would we be doing that would dramatically increase the value of the company? And in this case the answer was, well, acquisitions, you should put that money towards acquisitions. And our answer was we don't really need money for acquisitions. We have a line of credit for $10 million and we've got a process for identifying and absorbing acquisitions that don't require a lot of cash to start with in the first place. And if we were to go heavy into acquisitions, we know that more than 80% of those fail to realize their value. We could end up with a bunch of debt and a bunch of extra investors and no cash distributed and a bunch of losers. So if we have a process that's continuing to add value and we don't need that cash for the business, then I think we should probably take it out. And now you may get, as you start to bring in professionals and professionalized people that say, well, you need to have a reserve. And that's good, solid advice, because a lot of bootstrapped entrepreneurs will pay refunds and other expenses like, you know, equipment that's depreciating. They'll just pay it out of cash flow and they won't set money aside for it. So having some set aside makes sense. And other than that, I just, I think that they are not mutually exclusive and that if you're building a solid business that is a wealth asset, you can take the money out and fund the growth that you need and add back anything you need through restated financials, and you're not giving anything up in the exit. And you're getting to eat your cake and have it, too.

[Ryan Deiss]

Yeah. Funny enough, I've seen excess cash left in companies lead to bloat, which actually caused businesses to slow down, not grow, I would argue.

[Roland Fraser]

I remember personally a couple of those things that you and I have done.

[Ryan Deiss]

Yeah, yeah. Ones that we owned and one in particular that I ran. So, yeah, it is absolutely, I believe that we have this idea that money is fuel. And it can be. It absolutely can be, but it's not always fuel. I mean, a better way to think about it is sugar. Right. And so it's sugar, and it can be fuel for a little bit, directed in the right direction, but there can also be a sugar crash. So if money and cash in a business is directed, if there's a plan for it, then absolutely, positively, it makes sense. If it's just left there, though, it turns to fat, it turns to bloat, and it slows the business down. So what I would say is have a budget, decide ahead of time where this cash is going to go and decide ahead of time that at least some of it is going to show up in the form of profit and that those profits are going to be distributed. We make sure we create a cash flow waterfall so that the cash, when it goes through, it's going to flow through the excess cash. We're going to leave a certain amount in operating. Typically, it's one month is going to be in the operating account. However much one month, OPEX is going to stay in that operating account. Everything over and above that is going to get swept out at the end of every month. And it's just a really healthy way of saying, okay, like this, this business now has everything that needs to operate for the next month that is going to then stay in basically kind of that sweep account and out of there. We can then put it into different accounts perhaps for future investment and, or for distribution. The nice thing about it, if you distribute money out to the stakeholders, that money can always be reinvested back in. So if there's a significant enough investment opportunity, the investors can all decide at that time to buy back in and the ones who believe can do that. But I think it keeps everybody honest.

[Roland Fraser]

I think that's a good way to look at it too because really it comes down to who can get a higher return on the money. Are you like, number one, do you have all the money that you want to maintain your personal living style? If you do and don't need to take any more, then it's a pretty cut and dry decision to me. Can the company earn a higher rate of return on that money than I can earn on the things I'm going to put it in? And if, if the company can earn a higher rate of return, why wouldn't I, from a financial perspective, leave it in there? But if it can't and it's just accumulating the money. And I would argue this about Apple and, you know, and several of the other companies that probably shouldn't have, you know, billions or trillions of dollars in cash. They should probably distribute money out to the shareholders and let them decide what they want to do. Because if you've been holding that much cash for five years or more, you.

[Ryan Deiss]

Don'T have a plan for it.

[Roland Fraser]

Yeah, right.

[Ryan Deiss]

Yeah, you clearly don't have a plan for it.

[Roland Fraser]

Yeah.

[Ryan Deiss]

So I look at. Yeah. So I would say again to the person that asked this question, if you're VC backed, then they're not mutually exclusive. When you took the money, you picked your path. And that path is basically scale and exit or bust like that. That's kind of the only path you got. If you're bootstrapped, which is why we love bootstrap business. That's why we want to stay bootstrapped for as long as possible, then you do have options. But the option of are you going to have a business that kicks out a lot of cash or are you going to have A business that can exit for a lot of money, they're definitely, definitely not mutually exclusive. In fact, the businesses that we've had that exited for the most also just happen to be the businesses that kicked out the most cash. Because businesses are going to exit it based on their profitability and profitability should at some point show up in the form of cash. If you're worried about distributing out too much and not leaving enough in for reinvestment, just plan and budget for that. But what we do from a cashflow management perspective, leave one month operating expenses in an OPEX in the operating account. I believe we keep between three and six months in an emergency fund in cash so that it has that at the company level and then everything else is going to get either distributed out or it's going to get put in a specific directed savings fund that is going to be used for a specific directed savings purpose. And beyond that, yeah, get it the heck out of the business.

[Roland Fraser]

The only other thing that I would say is if you have a material either in terms of percentage or dollars refund rate that you know exists that you can kind of consider that part of the money not yours that you're taking in. So you may have a separate refund account as well, like a refund reserve. So if you know that you've got, you know, I'm going to use a high percentage just because you would want to look into this. But it's easy to do the math. If you had a 10% refund rate and you're doing significant money, let's say you're doing a million dollars a month, then you know that roughly $100,000 a month of the money that you bring in is not going to stay in the company. So you would be wise to, through whatever the cycle of refunds is, have that hundred thousand dollars a month times the number of months in the cycle to give as a refund. So, and that you got to put aside because otherwise it's either coming out of your reserve or it's coming out of your cash flow. Right? It's coming out. I mean your emergency thing that, but, but you shouldn't just have the refund thing. You should also have kind of an emergency refund excuse, not emergency fund like you talked about. That's the only thing I would add to that, that, that I think is, is nice just because then you're not, hey ryan, I took $50,000 out of your, your personal account this month to put back in the company to cover refunds. You know, not that we've ever had that happen.

[Ryan Deiss]

Yeah. And that's especially if you're, if you're in retail or you do any type of E commerce. Especially if you do sizing, somebody's going to order a medium and a large and send back the one that didn't fit. It's pretty, it's pretty typical and common, but yes. So keeping that in mind, I think the greater, the greater theme here is that if you're bootstrapped, the two are definitely not mutually exclusive. We encourage all of the businesses that we own, including the ones where we are investors in, we encourage them to take out lots of money. It's the ultimate sign of a healthy, successful business. So do it.

[Roland Fraser]

It's also a lot more fun than waiting 20 years and hoping that you're going to get a payday at the end.

[Ryan Deiss]

God, it is. You and I. You and I have friends who sold businesses after owning them and running them for 10, you know, 10 years and they had a really big payday at the end of it. But I remember doing the math, had one buddy doing the math and realizing that I had generated more in distributions over that same period of time from one of the companies than they made from that one exit. And we still own that one business.

[Roland Fraser]

Yeah. And you got the time value of money right as an annuity. You had an annuity that was paying constantly as opposed to that end thing. So if you think about, you put in a compound, you know, interest rate on that, it becomes pretty significant.

[Ryan Deiss]

Yep.

[Roland Fraser]

And I would also, I would also argue that exits are not always to kind of supplement what you said about your friend. They're not always what you anticipate them to be. And so when you hear somebody had a 60 million, 100 million, $300 million exit, they may have gotten very little out of that because they were constantly reinvesting. But also they were getting investors and they were getting diluted and creditors had warrants and things like that. And after all of those things happen, they didn't really end up with that much money. I know that they had a pref.

[Ryan Deiss]

Stack six levels deep like everybody else got their thing that happened to the.

[Roland Fraser]

Guy that founded ugg. I remember listening to him and talking with him about it. And Rand Fishkin wrote a book, I think about it. Do you remember what the title was?

[Ryan Deiss]

Lost and Founder.

[Roland Fraser]

Yeah, Lost and Founder, where he talks about that whole thing. So it's like when you hear that somebody had an ex. It's also when you're thinking about who to take advice from just because somebody had a big exit doesn't mean that they're an expert in exiting. Right? They like, they had a big exit. Maybe they got lucky. If they've done it two or three times, it's less luck. They're good founders and they build good companies. But did they actually get the full value that they could have gotten? You don't know that, right? You don't know if they know all the things that you can do to make companies more valuable or if they're just basically flipping a wholesale, like a wholesale real estate person. Buy and mark it up and then let somebody else take it. Let the private equity company take the lion's share of the profits. That happens a lot too. And it's funny when we're talking to people, when we're helping people with exits and they're like, yeah, so and so did this, this and this, and we're like, do you know what they got for it? You know, who helped them negotiate the deal? You know, let's, let's dive into it because there's a lot of points, you know, there's 62 profit points, there's 50 exit, you know, valuation amplifiers, there's 196 sales accelerators. Right. Are they aware of all those things? And then did they tax structure properly? So it's, it's a lot to think about as you, as you get into that world. Yeah, that's my rant. I'll let you close it out.

[Ryan Deiss]

Well, no, I mean, I think, I think we can, I think we can leave it there.

[Roland Fraser]

Awesome. Well, hope you guys enjoyed this. If you found it valuable, please share it with a friend. We love. We love having the business lunch podcast expand. And if you have got thoughts, questions, feelings or emotions about any of this stuff, then we'd love for you to share them with either us individually or on the business launch channels. We're on YouTube and all of your normal podcast places. So thanks guys and we'll see you next time.