Finances are an integral part of running any business, and real estate investing is no different. Figuring out how to properly and effectively structure your finances can be confusing, but I’ve discovered a method that has totally changed our business! This concept is based off of the book Profit First by Mike Michalowicz.
Profit First is a simple and effective formula designed to help businesses stake claim on their income by prioritizing profit above sales and expenses. The system operates as a means to allocate money appropriately so that the business not only runs smoothly, but so the business owner is paid.
Mike posits that the reason so many small business are not profitable is because the system we’ve been told to use is flawed. Most businesses use the following formula: Sales – Expenses = Profit. Logically, that makes sense. But Mike explains that it defies human nature.
Profit First is based off the principle that when something is put last, we disregard it’s significance. In order to make a profit, you have to take your profit first. Profit First is Sales – Profit = Expenses. The concept is simple—pay yourself first.
In the current formula, sales and expenses come first, so profit never comes. By taking your profit first, you're prioritizing what's important. It's about thinking of your finances as a business. It's human nature to be drawn to the familiar; we are creatures of habit. But the current system doesn't work!
Profit First is so effective because it's a behavioral system. It works within your natural default behavior! Once you get the system in place, it runs smoothly and effortlessly, and your business becomes more profitable.
Profit First consists of four different divisions for money: profit, owner pay, taxes, and expenses.
Account 1: Profit. Five percent of your total income is allocated into the profit account. This is set up so that your business is designed to make money; it's how you build up cash reserves! The profit accrues, and every quarter, half of the money is withdrawn for an enjoyable, non-business expense.
Account 2: Owner Pay. Fifty percent should be dispersed for owner pay. If there are multiple owners within your business structure, that fifty percent is divided among them. This division is set up solely for entrepreneurs—it is not designed for payroll. Don't skip this step, it's important that you get paid!
Account 3: Taxes. Then, fifteen percent of total income is set aside for taxes. This allows your business to run smoothly and effectively. This account is to remain untouched until tax time, whether that is quarterly or annually for your business. It’s important to keep in mind that this money is allocated specifically for the government, and it does not belong to you or your business.
Account 4: Expenses. Finally, thirty percent of total income is distributed for owner expenses. For real estate, this could be spent on repairs or vacancy. Additionally, this account will also pay the wages of your property management team.
To help you implement Profit First in your real estate business, I’ve created a freebie called Setting Up Profit First for Your Real Estate Biz. It’s a simple spreadsheet that will automatically keep a running total of your revenue, and will help you determine the Profit First distributions for your specific business.