6. Finance

When it comes to Finance, however, eyes glaze over. Finance conjures up associations of “bean counting,” mathematical formulas, and spreadsheets overflowing with numbers. It doesn’t have to be that way—finance is quite easy to understand if you focus on what’s most important.

Finance is the art and science of watching the money flowing into and out of a business, then deciding how to allocate it and determining whether or not what you’re doing is producing the results you want. It’s really not any more complicated than that. Yes, there can be fancy models and jargon, but ulti­mately you’re simply using numbers to decide whether or not your business is operating the way you intended, and whether or not the results are enough.

Every successful business must bring in a certain amount of money to keep going. If you’re creating value, marketing, selling, and delivering value, there’s money flowing into and out of the business every day. In order to continue to exist, every business must bring in Sufficient revenue (discussed later) to justify all of the time and effort that goes into running the operation.

Everyone has bills to pay and groceries to buy, so the people involved in the business need to consistently make enough money to justify the time and energy they’re investing, or they’ll quit and do something else. Accordingly,

every business must capture some amount of the value it creates as revenue, which is used to pay expenses and compensate the people who make the business run.

The very best businesses create a virtuous cycle: they create huge amounts of value while keeping their expenses consistently low, so they make more than enough money to keep going without capturing too much value. As a result, they’re able to simultaneously pad their pocketbooks and improve the lives of their customers, since the continued existence of the business makes everyone involved better off.

Finance helps you watch your dollars in a way that makes sense.

Remind people that profit is the difference between revenue and expense. This makes you look smart.

—SCOTT ADAMS, CARTOONIST AND CREATOR OF “DILBERT”

t doesn’t matter if your business brings in $100,000,000 a year in revenue if you spend $100,000,001. Business is not about what you make—it’s about what you keep.

Profit is a very simple concept: it’s bringing in more money than you spend. In order for a business to continue to exist, the revenue it brings in must exceed expenses at some point in the foreseeable future. If it doesn’t, it’ll cease to be a business—it’ll run out of resources and close, or it’ll be­come a project subsidized by the profits of another business. Nothing can operate at a loss forever.

Profit Margin is the difference between how much revenue you capture and how much you spend to capture it, expressed in percentage terms—if you spend $1 to get $2, that’s a 100 percent Profit Margin. If you’re able to create a Product for $100 and sell it for $150, that’s a Profit of $50 and a Profit Margin of 50 percent. If you’re able to sell the same product for $300, that’s a margin of200 percent. The higher the price and the lower the cost, the higher the Profit Margin.

Profit is important because it’s what allows businesses to continue to

stay in operation. Without generating Profits, a business can’t compensate its owners, who may be investing considerable time, money, and energy into the operation. If the owners don’t find their investment worthwhile, they’ll simply close the business.

Profits also provide a “cushion” that allow the business to weather unex­pected events. If a business is barely generating enough revenue to cover its expenses and those expenses suddenly rise, the business is in a great deal of trouble. The more profitable the business, the more options it has to re­spond to the unforeseeable.

Profit is critically important, but it’s not the be-all and end-all of busi­ness. Some people believe that the purpose of a business is to maximize the amount of Profit generated, but that’s not the only reason businesses are created. For some people (like me), business is more of a creative endeavor— a way to explore what’s possible, help others, and support yourself at the same time.

The concepts you’ll learn in this chapter will help you ensure that your business creates enough Profit to keep going.

You can get anything you want in this life if you help enough other people get what they want.

—ZIG ZIGLAR, SALES GURU

E very business must capture some percentage of the value it creates in the form of revenue as Profit. If it doesn’t, the business will have a difficult time generating enough resources over time to continue operation.

Value Capture is the process of retaining some percentage of the value provided in every Transaction. If you’re able to offer another business some­thing that will allow them to bring in $1 million of additional revenue and you charge $100,000, you’re capturing 10 percent of the value created by the Transaction.

Value Capture is tricky. In order to be successful, you need to capture enough value to make your investment of time and energy worthwhile, but not so much that there’s no reason for your customers to do business with you. People buy because they believe they’re getting more value in the Transaction than they’re spending.

The more value you capture, the less attractive your offer becomes. Cap­ture too much, and your prospects won’t bother purchasing from you. Mov­ies are great, but would you pay $5,000 for two hours of entertainment?

There are two dominant philosophies behind Value Capture: maximiza­tion and minimization.

Maximization (the approach taught in most business schools) means that a business should attempt to capture as much value as possible. Ac­cordingly, the business should attempt to capture as much revenue in each Transaction as possible—capturing less than the maximum amount of value possible is unacceptable.

In the short run, it’s easy to see the appeal of maximization—more Profit is a good thing for the owners of a company. Unfortunately, the maximization approach tends to erode the reason customers purchase from a business in the first place.

Would you spend $999,999 in order to make a million? It may be rational (after all, you’d be $1 ahead), but most people won’t bother. Customers pur­chase from you because they’re receiving more value than they’re giving up in the purchase. The less they receive, the less they’ll want to buy from you.

The minimization approach means that businesses should capture as little value as possible, as long as the business remains Sufficient (discussed later). While this approach may not bring in as much short-term revenue as maximization, it preserves the value customers see in doing business with the company, which is necessary for the business’s long-term success.

When something is a “good deal,” customers tend to continue to patron­ize the business and spread the word to other potential customers. When a business tries to maximize revenue by “nickel-and-diming” their customers or trying to capture too much value, customers flee.

As long as you’re bringing in enough to keep doing what you’re doing, there’s no need to fight for every last penny. Create as much value as you possibly can, then capture enough of that value to make it worthwhile to keep operating.

Know contentment and you will suffer no disgrace; know when to stop and you will meet with no danger. You can then endure.

—LAO TZU, ANCIENT CHINESE PHILOSOPHER

nce, a powerful executive went on vacation—his first in fifteen years. As he was exploring a pier in a small coastal fishing village, a tuna fisherman docked his boat. As the Fisherman lashed his boat to the pier, the Execu­tive complimented him on the size and quality of his fish.

“How long did it take you to catch these fish?” the Executive asked.

“Only a little while,” the Fisherman replied.

“Why don’t you stay out longer and catch more?” the Executive asked.

“I have enough to support my family’s needs,” said the Fisherman.

“But,” asked the Executive, “what do you do with the rest of your time?”

The Fisherman replied, “I sleep late, fish a little, play with my children, take a siesta with my wife, and stroll into the village each evening, where I sip wine and play guitar with my friends. I have a full and busy life.”

The Executive was flabbergasted. “I’m a Harvard MBA, and I can help you. You should spend more time fishing.With the proceeds, you could buy a bigger boat. A bigger boat would help you catch more fish, which you could sell to buy several boats. Eventually, you’d own an entire fleet.

“Instead of selling your catch to a middleman you could sell directly to the consumers, which would improve your margins. Eventually, you could open your own factory, so you’d control the product, the processing, and the distribution. Of course, you’d have to leave this village and move to the city so you could run your expanding enterprise.”

The Fisherman was quiet for a moment, then asked, “How long would this take?”

“Fifteen, twenty years. Twenty-five, tops.”

“Then what?”

The Executive laughed. “That’s the best part. When the time is right, you’d take your company public and sell all of your stock. You’d make millions.”

“Millions? What would I do then?”

The Executive paused for a moment. “You could retire, sleep late, fish a

little, play with your children, take a siesta with your wife, and stroll into the village each evening to sip wine and play the guitar with your friends.”

Shaking his head, the Executive bade the Fisherman farewell. Im­mediately after returning from vacation, the Executive resigned from his position.

I’m not sure where this parable originated, but the message is useful: business is not necessarily about maximizing Profits, profits are important, but they’re a means to an end: creating value, paying expenses, compensating the people who run the business, and supporting yourself and your loved ones. Dollars aren’t an end in themselves: money is a tool, and the usefulness of that tool depends on what you intend to do with it.

Your business does not have to bring in millions or billions of dollars to be successful. If you have enough profit to do the things you need to do to keep the business running and make it worth your time, you’re successful, no matter how much revenue your business brings in.

Sufficiency is the point where a business is bringing in enough profit that the people who are running the business find it worthwhile to keep going for the foreseeable future. Paul Graham, venture capitalist and founder of Y Combinator (an early-stage venture capital firm), calls the point of suf­ficiency “ramen profitable”—being profitable enough to pay your rent, keep the utilities running, and buy inexpensive food like ramen noodles. You may not be raking in millions of dollars, but you have enough revenue to keep building your venture without going under.

You can’t create value if you can’t pay the bills. If you’re not bringing in sufficient revenue to cover the operating expenses, that’s a major issue. In order to keep going, you must be able to pay the employees and the owners for the time, effort, and attention they’re giving to the venture. If these people don’t find their investment sufficiently worthwhile, they’ll stop doing what they’re doing and start doing something else.

You can track financial sufficiency using a number called “target monthly revenue” (TMR). Since employees, contractors, and vendors are typically paid on a monthly basis, it’s relatively simple to calculate how much money you’ll need to pay out each month. Your target monthly revenue helps you determine whether or not you’ve reached the point of Suffi­ciency: as long as you bring in more than your TMR, you’re Sufficient. If not, you have work to do.

Sufficiency is subjective—how much is enough to continue what you’re doing is a personal decision. If your financial needs are meager, you don’t need that much revenue to keep going. If you’re spending millions of dol­lars on payroll, office space, and expensive systems, you’ll need much more revenue to maintain Sufficiency.

The more quickly you can reach the point of Sufficiency, the better the chance your business will survive and thrive. The more revenue you gener­ate and the less money you spend, the quicker you will reach the point of Sufficiency.

Once you reach the point of Sufficiency, you’re successful—no matter how much (or how little) money you make.

Four Methods to Increase Revenue

Money is plentiful for those who understand the simple laws which govern its acquisition.

—GEORGE CLAYSON, AUTHOR OF THE RICHEST MAN IN BABYLON

Believe it or not, there are only four ways to increase your business’s revenue:

• Increase the number of customers you serve.
• Increase the average size of each Transaction by selling more.
• Increase the frequency of transactions per customer.
• Raise your prices.

Imagine you’re operating a restaurant, and you want to increase the amount of revenue that your restaurant brings in. Here’s how to apply these strategies:

Increasing the number of customers means you’re trying to bring more people in the door. This strategy is relatively straightforward: more visitors to your restaurant will equal more tabs, which (assuming the average trans­action size stays the same) will bring in more money.

Increasing average transaction size means you’re trying to get each cus­tomer to purchase more. This is typically done through a process called

upselling. When a customer purchases an entrée, you offer them appetizers, drinks, and dessert. The more of these items the customer purchases, the more they spend, and the more revenue you collect.

Increasing the frequency of transactions per customer means encouraging people to purchase from you more often. If your average customer comes in once a month, convincing them to patronize your business once a week will increase your revenue. The more frequently they visit your establish­ment, the more revenue your restaurant will bring in, assuming the average transaction size stays the same.

Raising your prices means you’ll collect more revenue from every pur­chase a customer makes. Assuming your volume, average transaction size, and frequency stay the same, raising your prices will bring in more revenue for the same amount of effort.

Remember the lesson of Qualification: not every customer is a good cus­tomer. Some customers will sap your time, energy, and resources without providing the results that you’re looking for. If you’re spending a lot of en­ergy serving customers who don’t come in often, have a low average transac­tion size, don’t spread the word, and complain about the price, it doesn’t make sense to attract more of those customers.

Always focus the majority of your efforts on serving your ideal custom­ers. Your ideal customers buy early, buy often, spend the most, spread the word, and are willing to pay a premium for the value you provide.

The more ideal customers you can attract, the better your business.

The moment you make a mistake in pricing, you’re eating into your reputation or your profits.

—KATHARINE PAINE, FOUNDER OF THE DELAHAYE GROUP

magine doubling your current prices. If you’d lose less than half of your customers, it’s probably a good move.

Pricing Power is your ability to raise the prices you’re charging over time. The less value you’re capturing, the greater your pricing power. Serving

customers takes time, energy, and resources—the more you earn per cus­tomer served, the better your business. Changing your prices can help you maximize your results while minimizing your effort and investment.

Pricing Power is related to a concept economists call “price elasticity.” If customers are very sensitive to the price of your offer, you’ll lose many cus­tomers with even a slight increase in price, meaning demand is “elastic.” Es­tablished semicommodity markets like toothpaste are good examples: unless you’re able to create something new and unique that customers badly want, dramatically increasing your prices is a good way to ensure that everyone stops buying your product and starts buying from your competitor.

If your customers aren’t price sensitive, you could quadruple the price with little change in sales. Take luxury goods, for example—customers pur­chase them because they’re expensive Social Signals (discussed later) that are exclusive because they’re costly. Increasing the price of designer handbags, clothing, and watches is likely to make those items more desirable, not less.

Economists like to spend time graphing and calculating price elasticity, but it’s not necessary—unless you already have accurate Norms, you can’t really know how much Pricing Power you have until you actually change your prices and watch what happens. Fortunately, unless you’re an estab­lished player in a large and active market (in which case you’ll have Norms to work with), changing your prices very rarely has permanent effects un­less your prices are broadly publicized and scrutinized; you can Experiment to find what works.

Pricing Power is important because raising your prices allows you to over­come the adverse effects of inflation and increased costs. Historically, cur­rency issued by any government tends to decrease in value over time—there are many strong incentives for officials to increase the supply of currency, which debases that currency’s purchasing power.

As a result, it takes more currency to purchase the same products and services necessary to stay in business, increasing your business’s Sufficiency needs. Without adequate Pricing Power, your business may not be able to remain Sufficient in the face of higher expenses.

The higher the prices you can command, the more reliably you’ll be able to maintain profit Sufficiency. If you have a choice, choose a market in which you’ll have Pricing Power—it’ll be much easier to maintain Suffi­ciency over time.

Lifetime Value

The purpose of a customer isn’t to get a sale. The purpose of a sale is to get a customer.

—BILL GLAZER, ADVERTISING EXPERT

magine operating a lemonade stand on the sidewalk of a popular tourist destination. Each cup of lemonade costs $1. You may be busy serving cus­tomers, but each customer you serve is just passing by—you’ll probably never see them again.

Contrast that with the insurance business. Assume the average cus­tomer pays a premium of $200 per month for car insurance—that’s $2,400 in premiums per year. If the average customer remains with the same insur­ance agency for ten years, each client is worth $24,000 in premium pay­ments over the lifetime of their relationship with the company. That’s a big difference.

Lifetime Value is the total value of a customer’s business over the lifetime of their relationship with your company. The more a customer purchases from you and the longer they stay with you, the more valuable that cus­tomer is to your business.

One of the reasons Subscriptions are so profitable is that they naturally maximize Lifetime Value. Instead of making a single sale to a customer, Subscription businesses focus on providing value—and collecting revenue— for as long as possible. The longer a customer remains Subscribed and the higher the price they pay, the higher the Lifetime Value of that customer.

The higher your average customer’s Lifetime Value, the better your busi­ness. By understanding how much your average customer purchases and how long they tend to buy from you, you can place a tangible value on each new customer, which helps you make good decisions. Losing a single lem­onade stand customer isn’t a huge deal—losing an insurance client is.

All told, it’s much better to operate in markets where customers have a high Lifetime Value. The higher the Lifetime Value of your customer, the more you can do to keep them happy, and the more you can focus on serv­ing customers well. Maintain a long-term relationship with profitable cus­tomers, and you win.

Allowable Acquisition Cost (AAC)

Any business can buy incremental unit sales at a negative profit margin, but it’s simpler to stand on the corner handing out $20 bills until you go broke.

—MORRIS ROSENTHAL, AUTHOR OF PRINT-ON-DEMAND BOOK PUBLISHING AND BLOGGER AT FONERBOOKS.COM

Think back to the lemonade stand: how much could you spend to attract a single paying customer? Not much—you’re only earning $1 per cup of lemonade, so you can’t afford to spend much on marketing to individuals.

Contrast that with the insurance agency: if the Lifetime Value of a cus­tomer is $24,000, how much could you spend to attract a new customer? Much more.

Getting people’s attention and acquiring new prospects typically costs time and resources. Once you understand the Lifetime Value of a prospect, you can calculate the maximum amount of time and resources you’re will­ing to spend to acquire a new prospect.

Allowable Acquisition Cost (AAC) is the marketing component of Lifetime Value. The higher the average customer’s Lifetime Value, the more you can spend to attract a new customer, making it possible to spread the word about your offer in new ways.

Having a high Lifetime Value even allows you to lose money on the first sale. Guthy-Renker sells a topical acne treatment called Proactiv using long- form television infomercials, which are expensive—they hire celebrity en­dorsers like Jessica Simpson and spend millions to produce and air those commercials. At first glance, it doesn’t make any sense: the first sale is for the “low, low price” of $20. How on earth are they not losing money hand over fist?

The answer is Subscription. When a customer purchases Proactiv, they aren’t just buying a single bottle of face goo—they’re signing up to receive a bottle every month in exchange for a recurring payment. The Lifetime Value of each new Proactiv customer is so high that it doesn’t matter that Guthy-Renker “goes negative” on the initial sale—the company makes a ton of money, even if it loses money on a few customers who don’t continue with the program.

The first sale is sometimes called a “loss leader”—an enticing offer in­tended to establish a relationship with a new customer. Many Subscription businesses use loss leaders to build their subscriber base. Magazines like Sports Illustrated, offer gimmicks like football phones and spend a fortune on their annual Swimsuit Edition in an effort to attract new subscribers.

These enticements may absorb up to a year’s worth of Subscription rev­enue, but the company comes out ahead when you consider the Lifetime Value of each customer. Each new subscriber allows Sports Illustrated to charge their advertisers higher prices, which provides the bulk of the com­pany’s revenue.

To calculate your market’s Allowable Acquisition Cost, start with your average customer’s Lifetime Value, then subtract your Value Stream costs— what it takes to create and deliver the value promised to that customer over your entire relationship with them. Then subtract your Overhead (discussed later) divided by your total customer base, which represents the Fixed Costs (discussed later) you’ll need to pay to stay in business over that period of time. Multiply the result by 1 minus your desired Profit Margin (if you’re shooting for a 60 percent margin, you’d use 1.00 – 0.60 = 0.40), and that’s your Allowable Acquisition Cost.

Here’s an example: if your average Lifetime Value is $2,000 over a five- year period, and the cost of Value Creation and delivery is $500, that leaves you with $1,500 in revenue per customer served. Assuming your Overhead expenses are $500,000 over the same five-year period and you have 500 customers, your Fixed Costs are $1,000 per customer, which leaves you with $500 in revenue before marketing expenses. Assuming you’re shooting for a minimum 60 percent profit margin, you can afford to spend 40 per­cent of that $500 on marketing, which gives you a maximum AAC of $200 per customer. Knowing that, you can test various forms of marketing to see if they work—if your assumptions are correct, any customer you can attract for $200 or less will be worth the investment.

The higher the Lifetime Value of your customers, the higher the Allow­able Acquisition Cost. The more each new customer is worth to your busi­ness, the more you can spend to attract a new customer and keep them happy.

Overhead

Beware of little expenses; a small leak will sink a great ship.

—BENJAMIN FRANKLIN, EARLY AMERICAN POLITICAL LEADER, SCIENTIST,

AND POLYMATH

The larger your rent or mortgage payment, the more money you need to make each month to pay your expenses. The same general principle applies to businesses.

Overhead represents the minimum ongoing resources required for a busi­ness to continue operation. This includes all of the things you need to run your business every month, regardless of whether you sell anything: salaries, rent, utilities, equipment repairs, and so on.

The lower your Overhead, the less revenue the business requires to con­tinue operation, and the more quickly you’ll reach your point of financial Sufficiency. If you don’t spend much, you don’t have to make much to cover your expenses.

Overhead is critically important if you are building your company on a fixed amount of Capital. Venture capitalists and other forms of investment can provide “seed capital”—a fixed amount of money you can use to start the business. The more money you raise in capital and the more slowly you spend it, the more time you have to make the business work.

The faster you “burn” through your capital, the more money you need to raise and the more quickly you need to start bringing in revenue. If you burn through all of your start-up capital and can’t raise more, game over. That’s why investors and savvy entrepreneurs watch the business’s “burn rate” very closely—the slower the burn, the more time you have to create a successful business.

The lower your Overhead, the more flexibility you’ll have and the easier it will be to sustain your business operations indefinitely.

Costs: Fixed and Variable

Watch the costs and the profits will take care of themselves.

—ANDREW CARNEGIE, NINETEENTH-CENTURY INDUSTRIALIST

There’s an old business adage: you have to spend money to make money. There’s some truth to that statement, but not all expenses are created equal.

Fixed Costs are incurred no matter how much value you create. Your Over­head is a Fixed Cost: no matter what you do in any given month, you still have to pay your salaried employees and the lease on your office space.

Variable Costs are directly related to how much value you create. If you’re in the business of creating cotton T-shirts, the more T-shirts you produce, the more cotton fabric you’ll need. Raw materials, usage-based utilities, and hourly workers are all Variable Costs.

Reductions in Fixed Costs Accumulate; reductions in Variable Costs are Amplified by volume. If you can save $50 per month on your phone bill, that savings Accumulates to $600 per year. If you can save $0.50 on each T-shirt you produce, you’ll save $500 on every 1,000 T-shirts you make.

The better you understand your costs, the more likely you are to find ways of producing as much value as possible without spending everything you make.

Quality, quality, quality: never waver from it, even when you don’t see how you can afford to keep it up. When you compromise, you be­come a commodity and then you die.

—GARY HIRSHBERG, FOUNDER OF STONYFIELD FARM

Believe it or not, many of the chocolate products found in the candy aisles of grocery stores are no longer “milk chocolate”—they’re “chocolate- flavored candies.” What gives?

To make high-quality chocolate, you have to buy high-quality cocoa beans, which are ground up to make cocoa butter. Cocoa butter is then

combined with sugar, water, and emulsifiers, which help the oils in the cocoa butter “stick” to the water-saturated sugar. The liquid chocolate is then heated, poured into molds, and cooled to produce solid chocolate.

Over the years, mass-market chocolate manufacturers decided to use cheaper ingredients to keep costs down and increase profitability. Instead of buying high-quality cocoa beans, they bought less expensive beans from mediocre sources—who would notice? Then they replaced cocoa butter with vegetable oils—so much that food regulatory bodies wouldn’t allow them to call it “milk chocolate” anymore. They added more emulsifiers, pre­servatives, and other chemical additives to keep the zombified chocolate together and to make it last forever on the shelf.

Sounds appetizing, right?

Saving money doesn’t help you if you degrade the quality of your offer. At the time, these “cost saving” measures didn’t appear to have a huge impact on the chocolate’s quality—they seemed to be a Trade-off worth making. Over time, however, the Accumulated effects undermined the taste and quality of the product. People noticed, and so did the manufacturers: you can now buy “premium” versions that contain the original high-quality ingredients.

Finance and accounting executives get their “bean counting” reputations from focusing primarily on cutting costs—reducing expenses in an effort to make an offer or business more profitable. Cutting costs can help you increase your Profit Margin, but it often comes at a steep price.

If your goal is to increase your profitability, cutting costs can only take you so far. Creating and delivering value will always cost at least some amount of money, so there is a lower limit to how much you can cut costs before the cuts begin to diminish the value you provide. Cutting costs that are wasteful or unnecessary is certainly a good idea, but Diminishing Returns (discussed later) always kick in—be careful not to throw the baby out with the bath water.

Creating and delivering more value is a much better way to enhance your bottom line. You can never spend less than nothing, but there’s no upper limit on the amount of value you can provide or revenue you can collect.

Control your costs, but don’t undermine the reason customers buy from you in the first place.

Breakeven

It is unusual, and indeed abnormal, for a concern to make money during the first several years of its existence. The initial product and initial organization are never right.

—HARVEY S. FIRESTONE, FOUNDER OF THE FIRESTONE TIRE AND

RUBBER COMPANY

Assume your business is bringing in $100,000 per month, and you’re spending $50,000 each month in operating expenses. Are you making money?

It depends.

When you create a new business, it typically takes a while before you’re able to bring in more than you spend. Systems need to be created, employees hired and trained, and marketing efforts launched before revenue starts coming in. During your ramp-up period, those expenses add up.

Let’s assume our hypothetical business took a year’s worth of $50,000-per-month expenses to launch—that’s $600,000. Now that the business is bringing in $50,000 per month more than it needs to cover operating expenses, it can start to recoup that initial investment.

Breakeven is the point where your business’s total revenue exceeds its total expenses—it’s the point where your business starts creating wealth instead of consuming it. Assuming the business keeps bringing in $100,000 each month and expenses stay the same, it’ll take twelve months to pay down the initial investment. After that, the business will really be making money—before that, it just looks like the business is profitable.

Your Breakeven point will change constantly. Revenue naturally fluctu­ates, as do expenses. Keeping a running tally of how much you spend and how much revenue you collect from the start of your business’s operations is the only way to figure out whether or not you’ve actually made money.

The more revenue you bring in and the less you spend on an ongoing basis, the more quickly you’ll reach Breakeven, making your business truly self-sustaining.

Amortization

Before every action, ask yourself: Will this bring more monkeys on my back? Will the result of my action be a blessing or a heavy burden?

—ALFRED A. MONTAPERT, AUTHOR OF THE SUPREME PHILOSOPHY OF MAN:

THE LAWS OF LIFE

ou’ve created the toy of the century: a stuffed animal that looks and acts exactly like a real dog but doesn’t need to be fed, watered, or let out in the middle of the night. Kids go absolutely crazy for your Prototype, and parents are already throwing their credit cards at you to make sure they get one the minute it’s available. It’s a foregone conclusion that you’ll sell millions.

There’s only one problem: in order to make these faux dogs affordable, you’ll have to tool up a major factory, which will cost at least $100 million. Your bank account has nowhere near $100 million in it—that’s a heck of a lot of money. How can a business afford something as expensive as a factory and still make money?

Amortization is the process of spreading the cost of a resource investment over the estimated useful life of that investment. In the case of the faux dog factory, let’s assume the factory is capable of producing 10 million units during its useful life. On a per-unit basis, that brings the cost per unit of the factory down to $10. If you sell every unit you produce for $100, that’s a very healthy Profit Margin.

Amortization can help you determine whether or not a big expense is a good idea. As long as you have a reliable estimate of how much it will cost and how much you can produce, Amortization helps you figure out whether or not investing large amounts of Capital makes sense.

For example, a book designer may choose to purchase a copy of Adobe InDesign, the software commonly used by professionals to typeset books. Compared to most software packages, InDesign is pricey: a single-user license costs $700. Is it worth it?

The answer depends on how many books the designer uses the software to typeset. If they never complete a project, they’ve wasted their money. If they use it to typeset ten books for $1,000 each, they’ve earned $10,000 by making a $700 investment—not bad at all. Amortized across ten proj­ects, the cost of the software is only $70 a project, or 7 percent of the revenue each project brings in. The designer’s credit card may hurt when the purchase is made, but the tool offers the ability to earn more money than would be possible otherwise.

Amortization depends on an accurate assessment of useful life, which is a prediction. Amortization doesn’t work well if you don’t sell what you pro­duce or if your equipment wears out more quickly than expected. Predic­tions are a tricky business—if you’re wrong in your estimate, your investment may cost a lot more on a per-unit basis than you originally assumed.

Crocs makes funny-looking rubber shoes. After becoming an unexpected hit, the company ramped up for huge volumes: they opened a factory in China and started producing millions of shoes in the expectation that they’d continue to sell each unit produced. As it turned out, Crocs were a fad—sales plummeted, and the company was stuck with a lot of expensive manufactur­ing capacity and huge amounts of inventory it couldn’t sell. Amortization couldn’t save the company from careening toward bankruptcy.

Using Amortization to figure out whether or not a big investment is worth it is smart—just remember you’re making a prediction, and proceed accordingly.

The job of the entrepreneur is to make sure the company doesn’t run out of cash.

—BILL SAHLMAN, PROFESSOR AT HARVARD BUSINESS SCHOOL

ere’s an old business adage you may have heard: “Cash is king.”

It’s true. You can have millions of dollars in orders on the books, but without cash in the bank, it doesn’t matter. IOUs don’t pay the bills—if you can’t pay your employees or keep the lights on, you’re done.

Purchasing Power is the sum total of all liquid assets a business has at its disposal. That includes your cash, credit, and any outside financing that’s available. More purchasing power is always better, as long as you use that power wisely.

Purchasing Power is what you use to pay your Overhead and your suppliers. As long as you continue to pay them, you’re in business. As soon as you run out of Purchasing Power, you’re finished. Game over.

Always keep track of how much Purchasing Power you have avail­able. How much cash do you have in the bank? How much available credit do you have access to? The more Purchasing Power you have, the better off you are.

Keeping track of your available Purchasing Power makes it much easier to run a business. Instead of constantly worrying about paying the bills, Purchasing Power gives you room to breathe, secure in the knowledge that you’re not going to suddenly run out of money. That frees up a great deal of mental and emotional energy you can put to better use—figuring out how to improve your business.

Always pay close attention to how much Purchasing Power you have left—it’s the difference between a business that stays open and a business that fails.

All truth is found in the cash account.

—CHARLIE BAHR, MANAGEMENT CONSULTANT

Money flows through a business in predictable ways. If you understand how revenue, expenses, receivables, and credit work, you can ensure that you continue to have enough Purchasing Power on hand to continue opera­tion and maximize your available options.

The Cash Flow Cycle describes how cash Flows (discussed later) through a business. Think of your business’s bank account like a bathtub. If you want the water in the bathtub to rise, you add more water and keep it from leak­ing out via the drain. The more water that flows in and the less that flows out, the higher the level of water in the tub. Revenues and expenses work the same way.

Receivables are promises of payment you’ve accepted from others. Re­ceivables are attractive, because they feel like a sale—someone has prom­ised to give you money, which is great. There’s a catch, however: Receivables

don’t translate into cash until the promise is fulfilled. IOUs are not cash— the more quickly that promise is translated into payment, the better your cash flow. Many businesses have closed with millions of dollars of “sales” on the books.

Debt is a promise you make to pay someone at a later date. Debt is at­tractive because you can benefit from a purchase now while holding on to your cash until later. The later you pay, the more cash you have at your dis­posal. Debt can be useful, but there’s also a catch: Debts typically cost ad­ditional money in the form of interest. Very often, you’ll also have to pay back a portion of your Debt over time, which is called “debt service,” which you can treat as another type of expense. If you can’t cover your debt ser­vice, you’re in trouble.

Maximizing your cash tackles the issue directly: bring in more revenue and cut costs. Increasing your product margins, making more sales, and spending less of what you bring in will always improve your cash flow.

Deferring or negotiating a longer repayment period with your creditors can also help alleviate a cash crunch. If you have a supplier, vendor, or part­ner who is willing to let you pay later in exchange for receiving materials or capabilities now, that allows you to keep more cash in your bank account now. You must watch this carefully: Debts can easily get out of hand if you don’t keep track of how much you owe and when it’s due. When done prop­erly, however, paying creditors later can be quite useful, particularly for mar­keting expenses. Borrowing $1 to make $10 is a good trade; it’s even better if you’re able to do that for months before the first bill comes due.

To bring cash in more quickly, it’s best to speed up collections and re­duce the extension of credit. The faster you get paid, the better your cash flow situation. Ideally, try to get paid immediately, even before buying raw materials and delivering value.

It’s common in many industries to extend credit to customers, but that doesn’t mean you have to as well. Always remember that you’re a business, not a bank (unless your business involves Loans)—collect any outstanding payments as quickly as possible.

If necessary, you can increase your Purchasing Power by taking on ad­ditional Debt or opening lines of credit. It’s best to avoid using Debt or lines of credit if you don’t absolutely need to, but increasing available credit

certainly increases your Purchasing Power. Think of these accounts as backup funding sources—for emergency use only.

The more Purchasing Power you have, the more Resilient (discussed later) your business is and the better your ability to handle the unexpected.

Business, more than any other occupation, is a continual dealing with the future; it is a continual calculation, an instinctive exercise in foresight.

—HENRY R. LUCE, PUBLISHER AND FOUNDER OF TIME INC.

Let’s say you decide to quit your $50,000-a-year job and start a business. Starting the business will certainly have costs of its own, but it will also cost you the $50,000 you would have made had you stayed at your job.

Opportunity Cost is the value you’re giving up by making a Decision. We can’t do everything at once—we can’t be in more than one place at a time or spend the same dollar on two different things simultaneously.

Whenever you invest time, energy, or resources, you’re implicitly choos­ing not to invest that time, energy, or resources in any other way. The value that would have been created by your next best alternative is the Opportu­nity Cost of that decision.

Opportunity Cost is important because there are always other options. If you’re working for a company that’s paying you $30,000 a year and you have the option to move to a company that’s paying $200,000 a year for the same work, why would you stay? If you’re paying your employees or con­tractors less than they could make elsewhere for the same work, why would they work for you? If your customers can spend $20 to get something you’re charging $200 for, why would they buy from you?

Opportunity Cost is important because it’s hidden. As we’ll discuss later in Absence Blindness, humans have a hard time paying attention to what’s not present. Paying attention to what you’re giving up by making a Decision helps you consider all of your options accurately before making a decision.

Obsessing over Opportunity Cost too much can make you needlessly crazy, however. If you’re a natural maximizer (like I am), it’s tempting to overanalyze every Decision to make sure you’ve chosen the very best option available, which can easily go well past the point of Diminishing Returns (dis­cussed later). Don’t get bogged down with all of the options available— consider only what appear to be the best alternatives at the time of your decision.

If you pay attention to the Opportunity Costs of your decisions, you’ll make much better use of the resources at your disposal.

They always say time changes things, but you actually have to change them yourself.

—ANDY WARHOL, ARTIST

Would you rather have a million dollars today or a million dollars five years from now?

The answer is obvious: why wait? Having the money now means you can spend it now, or invest it now. A million dollars, invested at a Compound­ing (discussed next) interest rate of 5 percent, will be $1,276,281.56 five years from now. Why give up the extra quarter of a million dollars if you don’t need to?

A dollar today is worth more than a dollar tomorrow. How much more depends on what you choose to do with that dollar. The more profitable op­tions you have to invest that dollar, the more valuable it is.

Calculating the Time Value of Money is a way of making Decisions in the face of Opportunity Costs. Assuming you have various options of investing funds with various returns, the Time Value of Money can help you determine which options to choose and how much you should spend, given the alternatives.

Let’s go back to the million dollars example: Assume someone offers you an investment that will deliver $1 million risk free in one year’s time. What’s the maximum amount you should be willing to pay for it today?

Assuming your Next Best Alternative is another risk-free investment with

a 5 percent interest rate, you shouldn’t pay anything more than $952,380. Why? Because if you took that amount and invested it in your next best alternative, you’d have a million dollars: $1,000,000 divided by 1.05 (the 5 percent interest/discount rate) equals $952,380. If you can buy the first investment for less than that amount, you’ll be ahead.

The Time Value of Money is a very old idea—it was first explained in the early sixteenth century by the Spanish theologian Martin de Azpilcueta. The central insight that a dollar today is worth more than a dollar tomor­row can be extended to apply to many common financial situations.

For example, the Time Value of Money can help you figure out the max­imum you should be willing to pay for a business that earns $200,000 in profit each year. Assuming an interest rate of 5 percent, no growth, and a foreseeable future of ten years, the “present value” of that series of future cash flows is $1,544,347. If you pay less than that amount, you’ll come out ahead as long as your assumptions are correct. (Note: this is the “discounted cash flow method” we discussed in the Four Pricing Methods.)

The Time Value of Money is an extremely versatile concept, and a full exploration is beyond the scope of this book. For a more in-depth examina­tion, I recommend picking up The McGraw-Hill 36-Hour Course in Finance for NonfinancialManagers by Robert A. Cooke.

Improve by 1% a day, and in just 70 days, you’re twice as good.

—ALAN WEISS, MANAGEMENT CONSULTANT AND AUTHOR OF GETTING STARTED IN CONSULTING AND MILLION DOLLAR CONSULTING

ere’s a surefire way to become a millionaire: save $10 a day for forty years in a way that earns 8 percent interest. Saving $10 a day isn’t difficult—you can save $300 a month by eliminating unnecessary expenses and earn 8 percent by investing that money simply and conservatively. (I recommend

Fail-Safe Investing by Harry Browne and I Will Teach You to Be Rich by Ramit Sethi if you’re interested in tactical, low-risk investment strategies.)

Here’s what’s even more amazing: you’ll only contribute $146,110 over that forty-year span. How, then, do you end up with over a million dollars?

Compounding is the Accumulation of gains over time. Whenever you’re able to reinvest gains, your investment will build upon itself exponentially—a positive Feedback Loop (discussed later).

A simple example of Compounding is a savings account. Let’s say your bank account earns 5 percent interest. After a year, $1 in your bank account is going to be worth $1.05. In year two, you don’t start with $1—you start with $1.05. In year three, you’ll have $1.10. In year four, you’ll have $1.15. Fourteen years after you make the initial deposit, you’ll have $2.

That doesn’t sound like much until you consider that this relationship Scales. If you start with $1 million, you’ll have $2 million after fourteen years. Not bad at all.

Compounding is important because it creates the possibility of huge gains in surprisingly short periods of time. If you reinvest the revenue your business generates and your business is growing rapidly, you can multiply your original investment many times over. Compounding is the secret that explains how small companies that reinvest their profits become large com­panies in a few short years.

Accumulating gains inevitably produces huge results over time. The trick is to be patient enough to wait for the reward.

We’ve been criticized for not understanding what the word leverage means . . . We do know what leverage means, and having a few mil­lion dollars cash in the bank is much nicer than being heavily lever­aged.

—KENNETH H. OLSEN, FOUNDER OF THE DIGITAL EQUIPMENT CORPORATION (DEC), WHICH WAS ACQUIRED BY COMPAQ IN 1998

sing “other people’s money” sounds like a great way to make a fortune. Borrow some money, make a fortune, pay back your lender, and keep the rest. What could be better?

Making money by borrowing from others can be savvy, provided you’re aware of the risks.

Leverage is the practice of using borrowed money to magnify potential

gains. Here’s an example: let’s assume you have $20,000 you’d like to invest in real estate. You could use that money as a 20 percent down payment on a $100,000 property, borrowing $80,000, but that ties up all of your money in a single investment.

Instead of using the $20,000 for a single down payment, you could take the same pool of money and invest in four $100,000 properties, each with a down payment of $5,000. That strategy requires borrowing $95,000 four times—a total of $380,000 in loans.

Here’s where the magic happens. Let’s assume all of the properties double in value, and you sell them. In the first scenario, you’d make $100,000 on a $20,000 investment—a 5x return on your $20,000 down payment. In the second scenario, you’d make $400,000 on the very same $20,000 down payment—a 20x return on investment. Leverage seems like a no-brainer, right?

Not so fast—what will happen if the value of each property drops dra­matically, and you sell them all to get back as much money as possible? Assuming the property value drops by 50 percent, in the first scenario you’d lose $50,000. In the second scenario, the use of Leverage will magnify your losses to $200,000—four times as much.

Leverage is a form of financial Amplification—it magnifies the potential for both gains and losses. When your investment pays off, Leverage helps it pay off more. When your investment tanks, you lose more money than you would otherwise.

One of the major contributing factors of the recession of 2008-9 was the use of enormous amounts of Leverage by investment banks. It wasn’t uncommon for banks to Leverage their investments by a factor of thirty or forty. Millions (or billions) of dollars were made or lost when the value of a particular stock went up or down by a single percentage point. When the market crashed, a bank’s losses were magnified by the amount of Lever­age they had taken on, which was more than enough to threaten the entire firm’s existence.

Using Leverage is playing with fire—it can be a useful tool if used prop­erly, but it can also burn you severely. Never use Leverage unless you’re fully aware of the consequences and are prepared to accept them. Otherwise, you’re putting your business and personal financial situation at risk.

Money often costs too much.

—RALPH WALDO EMERSON, ESSAYIST AND POET

magine you’ve invented an antigravity device that can levitate solid objects without requiring much power. Your invention will revolutionize the trans­portation and manufacturing industries, making many new products pos­sible. Demand for your invention is a given—all you need to do is create enough devices to fill the demand.

There’s a problem, however—estimates indicate that tooling up a pro­duction line with the equipment you need to build these devices will cost $1 billion. Unfortunately, you don’t have $1 billion to spare. Your device obviously solves a huge problem, but the next step is out of reach. What do you do?

Funding can help you do things that would otherwise be impossible with your current budget. If your business requires expensive equipment or many workers to create and deliver value, you’ll probably need outside Funding. Few of us have enormous sums of money in our bank accounts waiting to be used, but it’s surprisingly easy to reach out to those that do.

Funding is the business equivalent of rocket fuel. If your business needs additional capacity and is already pointed in the right direction, judicious use of financing can help you accelerate the operation’s growth. If the busi­ness has structural issues, it will explode, and not in a good way.

In order to obtain access to Funding, it’s often necessary to give up a certain amount of control over the business’s operations. Businesspeo­ple won’t give you money for nothing—they always ask for something in return.

Remember, providing Capital is a form of value for many businesses. In exchange for resources, your lenders or investors are looking for value in return—interest, lease payments, or a share of your company’s profits. They’re also looking for a way to decrease their risk of losing everything if the business goes under.To alleviate this risk, they ask for control: the abil­ity to influence the operations of the business. The more money you ask for, the more control they’ll want.

I think it’s useful to imagine a Hierarchy of Funding: a ladder of available

options. Every businessperson starts on the bottom and climbs as far up the ladder as necessary. The higher you climb, the more Funding you get, and the more control you give up in exchange.

Let’s examine the Hierarchy of Funding, starting at the bottom:

Personal Cash is by far the best form of financing. Investing cash you al­ready own is quick, easy, and requires no approval or paperwork. Most en­trepreneurs begin by financing themselves out of cash as much as possible.

Personal Credit is another low-cost method of financing. As long as your needs don’t exceed a few thousand dollars, it’s easy to finance expenses via Personal Credit. Approval is generally quick if you have good credit, and payment over time helps increase your cash flow. You risk ruining your personal credit rating (a form of Reputation) if you can’t make your payments, but for many entrepreneurs, that’s a risk worth taking.

I financed my entire business out of cash and personal credit. If your needs are modest, using personal credit to finance your start-up costs is a good option as long as you watch your budget.

Personal Loans are typically made by friends and family. If you need more money than you can cover via Personal Cash and Personal Credit, loans from friends and family are not uncommon. Just be wary: the risk that you won’t be able to pay them back is very real and can have a devastating effect on important personal relationships. For that reason, I’d advise avoiding asking your parents or grandparents to gamble their life savings on your idea—there are better ways.

Unsecured Loans are typically made by banks and credit unions. You fill out an application, ask for a certain amount of money, and the bank will evaluate your ability to pay the loan back with interest over a certain time period. The loan can be either a lump sum or a line of credit that can be used at any time. The bank doesn’t ask for collateral for smaller amounts (a few thousand dollars), so the interest rate will probably be a bit higher than a credit card or secured loan.

Secured Loans require collateral. Mortgages and automotive loans are good examples of secured loans: if you don’t make the payments, the lender can legally seize the property promised as collateral. Because the lender can then sell that property to recoup their funds, Secured Loans are much larger than Unsecured Loans: tens or hundreds of thousands of dollars.

Bonds are debt sold to individual lenders. Instead of asking a bank for a

loan directly, the business asks individuals or other companies to loan them money directly. Bond purchasers give money directly to the business, which is paid back at an agreed-upon rate for a certain amount of time. When the time expires (i.e., the Bond “matures”), the company must give back the original loan amount in addition to the payments already made. The legal and regulatory process that surrounds the Bond market can be extremely complicated, so Bond issues are typically conducted through an investment bank.

Receivables Financing is a special type of secured lending unique to busi­nesses. Receivables Financing can make millions of dollars in credit avail­able, but at a cost: the collateral for the loan is control over the business’s receivables. Since the bank controls the receivables, they can ensure their loan is paid before anything else, including employee salaries and vendor commitments. Large amounts of funding are available, but you’re giving up a great deal of control to the lender.

Angel Capital is where we shift from Loans to Capital. An “angel” is an in­dividual private investor—someone who has excess wealth they’d like to invest in a private business, typically $10,000 to $1 million. In exchange, they’ll own 1 to 10 percent of the business.

Taking on an angel investor is a bit like taking on a silent partner—they give you Capital, and in exchange you give them partial legal ownership of the business. Some angels offer advice and are available for consulting, but they generally don’t have the power to make business decisions.

Venture Capital takes over where angels leave off. Venture Capitalists (VCs) are extremely wealthy investors (or groups of investors who pool their funds) with very large sums of Capital available: tens (or hundreds) of mil­lions of dollars in a single investment. Funding via Venture Capital happens in “rounds” that start small, then grow as more Capital is needed. Later rounds can dilute the ownership percentage of current shareholders, so there’s typically a great deal of negotiation involved. VCs also require large amounts of control in exchange for large amounts of Capital, which usually means seats on the company’s board of directors.

A Public Stock Offering involves selling partial ownership of the company to investors on the open market. This is typically done via investment banks: companies that will provide a business with enormous amounts of Capital in exchange for the shares of that company to sell on the public

stock market. The investment banks make money by selling the shares they’ve purchased at a premium to individual investors on the open market. An initial public offering (IPO) is simply the first Public Stock Offering a company offers on the open market.

Any investor who purchases shares is legally a partial owner of the com­pany, which includes the right to participate in management decisions via electing the board of directors. Whoever owns the most shares in the com­pany controls it, so “going public” creates the risk of a hostile takeover: the mass purchasing of shares in an effort to control the company.

Public Stock Offerings are typically used by angel and Venture Capital investors to exchange ownership for money. Investors can collect their re­turns in one of two ways: reaping dividends that distribute the Profits of the company or selling their shares to another investor. Public Stock Offerings enable investors to sell their shares in exchange for money, so it’s common for angels and VCs to push successful companies to “go public” or be ac­quired by another company as quickly as possible in order to “cash out” of the investment.

The more control you must give up for each dollar of Funding obtained, the less attractive the source of Funding. The more people you’re required to consult with before making decisions, the slower your company will oper­ate. Investors increase Communication Overhead (discussed later), which can adversely affect your ability to get things done quickly.

It’s also not uncommon for investors to remove executives of a company that’s not performing well, even if those executives are the founders of the company. Even high-flying executives aren’t immune: when Apple was per­forming poorly in the 1990s, the board of directors fired Steve Jobs from the company he cofounded. A word to the wise: before you take on large amounts of Capital, be aware of how much Power (discussed later) the busi­ness’s board of directors will have over the operation of the company.

Funding can be useful, but be wary of giving up control over your busi­ness’s operations—don’t do it lightly or blindly.

Felix qui nihil debet. (Happy is he who owes nothing.)

—ROMAN PROVERB

ow much financing you need depends largely on what you’re trying to do. If you’re grasping for the brass ring—becoming obscenely wealthy by building a massive public company—you’ll probably need financing. If your intent is to be self-sufficient and free to make your own decisions, it’s much better to avoid financing in favor of retaining control.

Bootstrapping is the art of building and operating a business without Funding. Don’t assume that the only way to create a successful business is by raising millions of dollars of Venture Capital—it’s simply not true. By limiting yourself to the use of Personal Cash, Personal Credit, the business’s revenue, and a little ingenuity, you can build extremely successful businesses without seeking Funding at all. My business operates via a checking account, a sav­ings account, and a business credit card, and I like it that way.

Bootstrapping allows you to grow your business while maintaining 100 percent control over the business’s operations. You don’t have to get anyone else’s approval to make the decisions you think are best. The drawback is that growing the business can take much longer—prudently used, Fund­ing can help make things happen much more quickly than they’d happen otherwise.

If you accept Funding, make sure that you use it to do things that you couldn’t do any other way. Force Multipliers are useful but expensive—taking on Funding in order to get access to critical capabilities can be smart. Otherwise, try to operate from cash and operating revenue as much as possible.

For best results, Bootstrap as far as you can go, then move up the Hierar­chy of Funding only as needed. Having 100 percent ownership and control of a profitable, self-sustaining business is a beautiful thing.

Return on Investment (ROI)

Wise are those who learn that the bottom line doesn’t always have to be the top priority.

—WILLIAM A. WARD, APHORIST

When you invest in something, you expect it to provide more value than you paid for it. Knowing how to estimate how much you’ll receive versus how much you’d invest is a very useful skill.

Return on Investment (ROI) is the value created from an investment of time or resources. Most people think of ROI in terms of currency: if you invest $1,000 and you collect $100 in profit, that’s a 10 percent return on your in­vestment: ($1,000 + $100) / $1,000 = 1.10, or 10 percent. If your ROI is 100 percent, you’ve doubled your initial investment.

Return on Investment can help you decide between competing alterna­tives. If you deposit money in a savings account, the return on your invest­ment will be equal to the interest rate that the bank gives you to hold your money. Why put your money in an account that pays 1 percent interest if you can deposit that money in an account that pays 2 percent, with no dif­ference in fees?

The usefulness of Return on Investment extends far beyond money: you can use it for other Universal Currencies as well. “Return on Invested Time” is an extremely useful way to analyze the benefits of your effort. If you were forced to work twenty-four hours a day nonstop for a year in exchange for $1 million, would you do it? When you look at the return versus the cost to your time and sanity, it’s not worth it.

The return on every investment is always directly related to how much the investment costs. The more you spend (in terms of both money and time), the lower your return. Even “sure bets” like buying a house or getting a college degree aren’t wise if you pay too much for them. Every estimate of return is speculative—you never know how it’ll actually turn out. Cal­culating returns is an exercise in predicting the future, which is fundamen­tally impossible.

Every future ROI estimate is a semieducated guess. You can only know your ROI for certain after the investment is made and the returns collected.

Nothing in this world is a sure bet—always take into account the risk of something going wrong before making an investment, no matter how high the potential ROI appears to be.

Sunk Cost

If at first you don’t succeed, try, try again. Then quit. There’s no point in being a damn fool about it.

—W. C. FIELDS, COMEDIAN

fter returning from World War II, my grandfather started the Kaufman Construction Company, building storefronts, homes, union halls, and apartment buildings in Akron, Ohio. In 1965, after twenty-five years in the business, he kicked off his most ambitious project: a five-story, twenty-six- unit apartment building on Portage Path.

The “Baranel” was to be built on the lots of two older homes, which had been purchased and demolished for the job. Steel rebar and bricks were ordered, and excavation was proceeding as planned. The expected cost of the project was $300,000, roughly $2.4 million in 2010 dollars.

The project proceeded smoothly until the excavators found huge hidden deposits of blue clay, which could make the foundation extremely unstable. To continue the project, thousands of cubic feet of clay and dirt would have to be excavated to reach bedrock, and additional concrete and rebar would be required to fill the massive hole. Completing the building would cost far more than originally expected, but it was difficult to determine exactly how much.

Instead of walking away, Grandpa decided to finish the project—he’d already spent so much money on the land and excavation that it felt wrong to “waste it” without having something to show for the effort and invest­ment. He found a few investors, put up another apartment building and the family home as collateral, and the project continued.

By the time the building was complete, they’d spent over three times as much money as originally planned: approximately $1 million, roughly $8

million in today’s dollars when adjusted for inflation. It was more than the building was worth. Grandpa spent the rest of his career handling angry investors and lawyers. It’s a sad story, but one worth learning from.

Sunk Costs are investments of time, energy, and money that can’t be re­covered once they’ve been made. No matter what you do, you can’t get those resources back. Continuing to invest in a project to recoup lost re­sources doesn’t make sense—all that matters is how much more investment is required versus the reward you expect to obtain.

Sunk Cost is easy to understand conceptually but much harder to put into practice. When you sink years of work into a career you realize you don’t want, or millions of dollars into a project that unexpectedly requires millions more, it’s difficult to walk away. You’ve invested so much that it feels wrong to “give it up for nothing.” In reality, there’s nothing you can do about your past investment—it’s gone. All you can do is act based upon the information you have now.

Making mistakes is inevitable: no one is perfect. You will make a few decisions that, in retrospect, you’ll wish you hadn’t—count on it. If you could turn back time, you’d do things differently. Unfortunately, you can’t. There will always be other projects, provided you don’t double down on a risky project to recover your losses. “Throwing good money after bad” is not a winning strategy.

Don’t continue to pour concrete into a bottomless pit—if it’s not worth the additional investment, walk away. You never have to earn back money in the same way you lost it. If the reward isn’t worth the investment re­quired to obtain it or the risk, don’t invest.