Let me, in apolitical, practical terms, explain why this happens and what successful businesses need to be super careful about.
And just to make this broken-record admonition: Remember this isn’t a political blog. We’re not going to talk about the fairness or the unfairness of our tax system. Rather, we’re going to talk about how income taxes can seem to kill a successful business. And about what business owners can do to sidestep the trap.
Setting the Stage
Let me set the stage with a sort of extreme example, but one that will make this all rather clear.
Assume you’ve got a decent little business. You work hard. And you’re not exactly living the high life. But you do pretty well, thank you.
And then, let’s assume, that one year something clicks. And your sales explode along with your profits. In fact, to pick a number, let’s say your profits grow by $1,000,000. Boom.
How Good Times Turn into Bad Times
Despite what lots of people might think, you my friend, are in potentially dangerous territory in many industries. And here’s why. If your profits have grown by, per our example, a $1,000,000, your business revenues have really grown. Maybe revenues are up $4 million? Who knows, but some big bump.
And this growth means there’s a something else “financial” going on. If your revenues grow, your balance sheet’s assets need to grow.
If your profits are up by $1,000,000, for example, your revenues might be up $4 million and your expenses up $3 million. (This gives you that extra $1,000,000 of profit.)
And almost surely, this growth in revenue and expenses and profits also means that all the stuff on your balance sheet grows, too.
Probably you’re holding more cash. (You need to.) You’ve got way more money tied up in inventory. And in accounts receivable. And then, probably, you’ll find yourself growing other assets, too. Maybe you need more fixtures and equipment.
In a sense, nothing seems wrong with this scenario. You have grown your business revenues by $4,000,000 and grown your profits by $1,000,000. Surely that means you can grow your balance sheet, too, right? By as much as you need to?
Actually, no. You can’t. And that’s the cruel reality that often first appears when you go to pay your business taxes after a period of fast growth.
Here’s why: You will find it amazingly easy to forget that you need to pay taxes on the $1,000,000. Probably roughly $400,000 in income taxes. (I’m guessing here. The actual rate could be a little higher or a little lower depending on the industry you’re in and on the state or states were you operate.)
By the way, just to make this point: You of course know you need to pay taxes on the profit you earn. But what’s easy to forget if all that profit gets reinvested in inventory or accounts receivable or other assets is that you still owe the taxes.
The real problem is you would like to grow your business (or maybe need to grow your business) by reinvesting pre-tax business profits. But you can’t do that. You need to grow your business by reinvesting after-tax business profits.
What’s Really Going On Here
As noted, the scenario described in this blog post seems like a tax problem. But really the tax problem is a symptom of a common entrepreneurial challenge: funding sustained growth in your business.
Often small businesses primarily or solely fund growth by reinvesting profits. And that’s tricky because you often don’t know the taxes you’ll pay on the profits until long after you’ve reinvested the profits.
And then there’s something else going on here, too. Often, small business owners not only don’t recognize up front that they need to plan for the bump in taxes they’ll pay on the bump in their profits. They also don’t connect the amount of after-tax profits they have to reinvest with a growth rate they support.
The reality is this: If you want to grow your revenues and expenses and profits by some percentage (say 50%) yearly, you need to grow your balance sheet’s values, such as your working capital, by that same percentage (so that would be 50% in our example).
If you made $1,000,000 pre-tax, paid $400,000 in taxes, and have $600,000 leftover and if you were willing to invest all of that after-tax profit in the business, the ratio of $600,000 to your total assets roughly sets the limit to your growth.
If your business requires $1,200,000 in assets, because $600,000 divided by $1,200,000 equals 50%, the $600,000 of after-tax profit suggests you can comfortably grow by 50%.
If your business require $6,000,000 in assets, because $600,000 divided by $6,000,000 equals 10%, that $600,000 of reinvested after-tax profit suggests you can comfortably grow by 10%.
Different Industries Experience Difference Levels of Pain
I’m going to talk about how you can sort of fix this problem and then the way that big sophisticated businesses fix this problem (which they face too). But let me make three tangential comments.
First, entrepreneurs operating in industries that require lots of working capital get hit hardest with the conundrum we’re talking about here (which is broadly known as the “sustainable growth” issue.) The reason is additional investments in things like inventory and accounts receivable may require lots of cash that comes from reinvested, after-tax profits. However, any business, even lean service businesses, can experience financial constraints to growth from taxes if the business grows fast enough.
Second, while taxes (because they represent the biggest allocation of a small firm’s profits) often represent the obvious and most significant constraint when you’re talking about the sustainable growth a small business can run, taxes aren’t the only constraint. Even if a firm’s tax rate was zero, the firm would still find revenue growth limited by the rate at which the firm can grow its balance sheet.
Third, I used gigantic numbers in the example above… examples way bigger than most small businesses would find “real.” But everything discussed here applies if you’re talking about a smaller bump in revenues and profits, too. A small business might get into real trouble even with numbers that are all only ten percent the size of those provided in the preceding paragraphs.
Nibbling Around the Edges of the Problem
A business owner can deal with this constrained growth problem in two general ways.
A first way—what we might call nibbling around the edges of the problem—is to try and come up with a bit of cash here and a bit of cash there to pay the taxes or to grow the balance sheet.
A credit line from the bank. A loan from your father-in-law. A midnight raid on your pension account. Stuff like that.
The nibbling, as a very short term approach, sort of works. But only as a very short-term “solution.”
Nibbling, as a tactic, quickly runs out of juice. Nobody can continue to go back to the bank or the father-in-law or the retirement account time and time again.
Nibbling, then, isn’t a way to support sustained growth. It’s only a temporary Band-Aid on the problem.
How Big Businesses Solve Sustainable Growth Issue
The only practical way to not turn strong growth in your business into a cancer that may kill the business is to limit your growth to the rate you can grow your balance sheet.
In other words, if you can only grow your balance sheet by ten percent a year, you can only sustainably grow your revenues by ten percent a year.
Don’t like that ten percent limit? No problem. To grow instead by 50 percent a year, you just need to figure out how to first grow your balance sheet by 50 percent.
Note: The Wikipedia article on sustainable growth rates is pretty good. (Check it out here.)
This blog post is getting a little long in the tooth, so let me close by making a handful of quick final comments about creating a long-term solution to a sustainable growth problem:
First, finding your growth constrained by taxes isn’t really a tax problem. It seems like it is. But it isn’t. Your problem is actually an imbalance between available resources and opportunities to grow revenue.
Second, some problems can be ignored and they eventually go away. This problem, however, doesn’t go away simply because you power through the financial stress. In fact, if you keep growing, the problem only gets worse. By the way, note that I’m not saying the problem stays just as bad… I’m saying however bad the problem is today, if you keep growing faster than you can sustain, the problem will get worse. And worse. And worse.
Third, the only two answers in the situation where you’re constrained financially by the growth you can support is to either (a) slow your growth to the rate that the existing ownership can grow their capital investment in the business or (b) to find outside investors who can share in growing the balance sheet. No kidding if you stop growing, things will quickly come back into balance. And if you slow growth, things will begin to noticeably improve.