The 5 Phases of Cash Flow
Something that we find true for almost all the businesses we work with is that it costs their owners twice as much and takes twice as long as they'd envisioned to make those businessses profitable.
Proof lies with the business plans we look at when working with clients or considering an angel investment. We had a similar revelation of our own when we started our consulting business, Whitestone Partners. We had expected to have enough clients to cover our business expenses and pay ourselves a salary within a few months.
Instead, it took us more than two years to match our former incomes.
These experiences made us think about the different phases of cash flow. In fact, we’ve identified five distinct cash-flow phases that businesses tend to traverse as they grow.
Phase 1: Putting personal cash into the business
If you launch a business from scratch, this phase is usually where you start. Here, you aren’t taking money out of the business; rather, you are putting your personal cash into the enterprise to pay the operating expenses, make capital purchases, etc. For instance, while our business wasn’t capital intensive, it did require that we invest in marketing and some computer equipment.
We decided to make personal loans to our business to cover these expenses. In addition, we had to pay our mortgage and other bills. During this time, we lived off savings.
Phase 2: Business not yet self-sufficient, not throwing off cash
After several months, which is longer than we had first expected, we arrived at a point where our business was making enough to sustain itself, but not our personal expenses. We were still paying those expenses out of savings. Unless you are independently wealthy, you’ll have to move beyond this step reasonably quickly.
Staying here too long will eventually deplete your resources. Some budding entrepreneurs supplement this phase by working part-time or full-time in another job while building their business. This strategy can help to pay the mortgage, but may keep you tied to a "one foot on shore, the other in the boat" mentality. At some point you will need to commit.
Phase 3: Business throwing off some cash, while owner is still paying some expenses out of savings
After several more months, our business was making enough money to not only pay its bills, but to pay some of our own. However, we didn’t cut ourselves a paycheck. Instead, we had the business repay the loans we made to it when we first got started.
You may charge the business a reasonable interest rate. However, we always encourage you to check with your accountant when making the initial loans and determining the payback. At this point, you still have to supplement your income with money you take out of savings. This is better, but you are still not home free. Sustainability and a full night’s sleep don't come until the next step.
Phase 4: Business and personal expenses are paid out of cash flow from the business
We had a celebratory dinner when we finally took a regular paycheck from our business. That step had taken much longer to reach than we had expected, but we realized that we'd beaten the odds. When you reach this step, you’ve made it -- sort of. Your business is throwing off enough cash to allow you to pay your bills. And you can sustain your lifestyle indefinitely.
However, if you stay at this point, unless you can sell your business, you won’t create much wealth, and retirement will always be a dream. You have to move to the point where the business is generating cash flow that exceeds your expenses.
Phase 5: The investment stage
This is the ultimate objective. You want your business to throw off enough cash to exceed what you need to maintain your lifestyle; you want it to create wealth for you. Of course, you have been investing in your business all along, but now you have discretionary funds. You can choose where to put them to work.
You could choose to reinvest the money in growing your business. And, in many cases, this is the best option. Alternatively, you may choose to diversify investments. You might buy or start another company. You might invest in the stock market or real estate. The options are almost limitless.
These are the five phases entrepreneurs tend to experience as their businesses grow -- we certainly did. How long it will take you to move through each step depends on your business, the economy and a host of other variables. In the case of our business, three years elapsed before we reached Phase 5. Unfortunately, most businesses don’t make it as far as Phase 4 and even fewer to Phase 5.
It’s also possible to take a step backwards. For example, you may have been living on Phase 4 for several years, but if business conditions change, you may find yourself dipping into savings again. What’s important is that you understand the five phases outlined above and have a clear plan for moving your business through each phase.
Make sure you have enough resources to get you through the early steps where your personal cash flow is negative. Finally, as we stated above, our experience is that launching a business takes twice as long and costs twice as much as you think it will. Make sure you have reserves adequate enough to cover this extra expense.