People invest in and maintain ownership in a business for the benefits they may garner. The most basic benefit is income. Or the means of living and quality of life an income stream may afford. As such, the owner strives to nurture and care for the business to keep it healthy and consistently able to provide the desired benefits. Moreover, the prudent owner will seek to avoid circumstances that could cause him or her personal economic harm stemming from his or her investment in, or management of, the business.

Elementary, you say? Business 101?

Well, common sense is not always common knowledge, and it certainly is not always common practice. Proof is in the fact that business owners regularly:

• Fail to care for and nurture the health of the business
• Leave the business exposed to unacceptable levels of risk
• Place themselves in harm’s way (personally) through their actions as owners/managers

Personal Financial Risk

A core reason to own a business is to IMPROVE one’s financial life. As such, the business owner should avoid – as he/she acts as owner and manager – becoming liable for corporate debts. Here are the most egregious ways the owner can place himself/herself personally at risk in his/her role as owner and manager:

• Dip into Uncle Sam’s Money. Officers of a business that fails to remit taxes — sales, payroll and income — to the taxing authorities on a timely basis become personally liable for the funds (jointly and severally with the business and other officers). Additionally, taxes owed are NOT dischargeable via bankruptcy. In short, you DO NOT want to borrow from the government to fund short-term cash flow problems. Look elsewhere.
• Mortgage the Home. Many a business has been capitalized with funds pulled from equity in the investor’s home, but it’s a risk only the young with “little to lose” should take. The top priority for the business owner who’s “getting on his/her financial feet” should be to reduce the debt on his/her homestead. This is because, in the very worst-case scenario (personal bankruptcy), creditors will not be able to go after your home if it is not pledged as collateral. For this reason, as you age, the loan balance on your home should only go down, not up. Avoid adding debt on your house at all costs.
• Commit Fraud. Desperate people do desperate things, but don’t commit fraud in an attempt to save your business. One of the great inventions of our modern economy is the ability to invest and conduct business through a legal entity. In this manner, you can shield yourself from personal obligation for corporate debts. But commit fraud as the officer of a company, and you may become personally liable for corporate obligations.
• Fail to Operate on an Arm’s-Length Basis. The owner who fails to conduct the affairs of his/her business in an arm’s-length manner — such as by commingling funds (personal with corporate) and self-dealing — risks becoming personally liable for the debts of the business. Creditors could bring action against the owner and “pierce the corporate veil.”

After the home mortgage is paid down and pledges of it as collateral are eliminated, the next big hurdle is getting off personal guarantees of business debt. For many small businesses, the only way to achieve this is to eliminate secured debt entirely. However you are able, the day you accomplish this is a day you can take some time to celebrate.

Business Exposed

Unmitigated concentration risk and random catastrophe risk are things that can kill a business in short order. As such, they must be mitigated or eliminated. No business owner should leave the business exposed to things that could put it out of business.

Concentration risk is the opposite of diversification. Overreliance on a single customer, supplier, employee or other resource that could be lost has to be addressed to minimize the risk of loss and maximize the odds that the business will continue in perpetuity.

Risk of random catastrophe can be mitigated through insurance, by spotting risk areas and developing mitigation strategies such as the consistent and reliable backup of critical electronic files, and developing contingency plans designed to enable survival from fire, flood or tornado.

Care and Nurturing of the Business

A business that is able to pay generous compensation and a fair return on investment has great value.

One should nurture and protect valuables. And when such a valuable asset is sick, it should be given the time it needs to return to health.

Businesses, like all things, ebb and flow. From time to time, they need inputs of time and money. At other times, they operate smoothly and throw off cash. Failure to give the business what it needs – such as cash and investment and attention when it’s needed – is a surefire way to kill it. Treat it like a money machine or allow your personal lifestyle to dictate when and how much money is removed, and you may join the legions of business owners who have killed their proverbial Golden Goose.

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We invest in a business for the benefits we can garner. Our task, then, as owners, is to manage the business in a manner that will maximize the odds that it will perpetually provide the desired benefits. Similarly, we most certainly will endeavor to avoid any situation in which we could suffer personal harm from our association with the business. As a result, as we get older and have more personal assets to protect, what we may be willing to do for the business will naturally decline.

Many entrepreneurs become less willing to “risk it all” as they have more to lose and less time to recover from loss. Others would benefit from having a friendly little robot companion much like the Will Robinson character in the 1960s science fiction TV series Lost In Space. His robot would wave his flexible plastic arms and audibly output, “Danger, Will Robinson” anytime Will approached trouble.

The result: less research and development and fewer new inventions, ideas and products. Intellectual-property laws also protect consumers from confusion, deception and harm.

Patents:

A patent is a grant by the federal government of a monopoly right to an inventor to make, use or sell an invention to the absolute exclusion of others for the period of the patent, currently 17 years from the date of approval or 20 years from the date of filing, whichever is longer. The owner of the patent also may profit by licensing to others a right to use the patent. Once the original patent term expires, it may not be renewed, the invention enters the “public domain,” and anyone then can use it.

The Patent Act specifies the types of inventions that may be patented: any new and useful process, machine, manufacture or composition of matter or any new and useful improvement thereof. To be patentable, it must be novel, have utility and not be obvious. Naturally occurring substances or “discoveries” are not patentable because the invention must be made or modified by humans.

Copyrights:

A copyright is a form of protection provided by federal law that protects an original expression of an idea. It extends to authors of original works such as literary works, musical works, dramatic works, pictures, graphic and sculptural works, motion pictures and sound recordings. Applications for copyright are filed with the Register of Copyrights, Copyright Office, Library of Congress. A copyright is actually a bundle of separable rights, including the rights to reproduce, distribute, adapt, perform or display a work. For example, an artist who sells a painting might give up the right to display that work, but none of his other rights. The owner of the painting does not automatically buy the remaining bundle of rights when he or she purchases the painting. The owner of the copyright has the exclusive right to use or reproduce the work or license such rights to others. The doctrine of “fair use” allows for limited use of any copyright in ways that facilitate criticism, comment, news reporting, teaching, scholarship, or research, but this is a very limited exception and often fails as a defense to copyright infringement.

Registration is not required for protection because copyright law protection begins as soon as the work is fixed in a tangible medium. There is no truth to the myth that you must send yourself a sealed envelope by registered mail to get a “do it yourself” copyright. Copyright registration is advisable, because it expands the remedies for infringement. Regardless of whether a federal registration is obtained, it is wise (though not required) to place a notice of copyright on all publicly distributed copies so as to give reasonable notice of the claim of copyright. A copyright notice typically consists of an encircled C, the author’s name and the year the work was created, e.g., © The Business Owner, 2003

The copyright law has been revised several times, resulting in different life spans of a work depending on when it was created and which law applies to it. Recently the Supreme Court upheld extension of copyright terms, meaning that many works from as far back as 1928 are still protected by copyright. It is wise to contact an intellectual-property attorney before making use of artwork or literature, since it is not easy to determine what’s in the public domain.

Trademarks:

A trademark is any word, symbol or device (even colors or smells) that identifies and distinguishes the source of a product or service. There are four types of marks: trademarks (used to identify goods, like cookies or clothing), service marks (used to identify services, like an insurance agency or car repair center), certification marks (indicating compliance with certain standards, like the Good Housekeeping seal of approval) and collective marks, which indicate membership in an organization, like The Boy Scouts of America. The federal government protects organizations and consumers by making it illegal for a person or organization to “palm off” or “pass off” goods from one source as goods from another, or “cash in” on the good will, good name or reputation of another.

To be federally protected, a mark must be distinctive so that it identifies the origin of the goods or services. Marks that are fanciful or arbitrary satisfy the distinctiveness requirement, whereas generic or descriptive designations do not. To obtain federal protection, the mark must be registered with the Patent and Trademark Office. Registration serves to notify all that the registrant has exclusive rights to use the mark, and permits the registrant to use federal courts to enforce the mark.

Trade Names:

A trade name is any name used to identify a business and its assets. The difference between a trademark and trade name is that the first distinguishes a particular product as coming from a particular source, even if that source is unknown. (For example, a consumer may be able to easily distinguish OREO cookies from Hydrox, without knowing what company makes either one of those cookies. A trade name, on the other hand, is the name a business uses to identify itself, like McDonald’s Corporation. Sometimes a company will use its trade name as a trademark on products or services (Coca-Cola or McDonald’s are good examples), but that’s not always the case. A holding company might be organized to own trademarks and service marks for tax reasons. Although a trade name may not be federally registered, trade names are protected and any person who attempts to “palm off” his goods as the goods of another is liable for damages.

Internet marketing expert Matt Bailey guesses businesses own somewhere between 20 and 30 Web domains (aka URLs) each, on average — a surprisingly high number. I think I own maybe 15 or 20. But a quick check revealed we own 88.

Holy smokes! These things stack up like junk in a storage closet. They’re basically impulse buys, just a click away, $3 to $10 a pop.

Business owners buy the URLs for their business names, and pick up product names, too. Oh, and common misspellings of each one, with dashes between the words? Goodness, better be safe and also control each in .net, .org, .biz, .us, .info, et al.

Need a bigger closet.

But why waste $100 to $1,000 per year and some administrative time on domains with no utility? Will someone please explain which ones we should own or not own?

We talked to Matt Bailey, president of SiteLogic, and Steve Schneiderman, president of Schneiderman Marketing, two people who should know — if anyone should. Here’s what they agreed on:

1. Buy your company name, product name(s) and personal domain name (e.g., JohnDSmith.com) if you can get them.
2. Buy common misspellings of your main URL. Example: AcquisitionAdvisors.com owns www.AcquisitionAdviser.com and www.AcquisitionAdvisor.com and forwards them to the main URL.
3. Buy your company name and main product name(s) with dashes between the words, e.g., www.The-Business-Owner.com. Direct them to the domains they mimic. This keeps them out of the hands of others who might use them to your detriment.
4. Concern yourself only with .com, .net and .org. Don’t worry about .info, .biz, .us et al.
5. Buy your business name + sucks. Example: This publication is The Business Owner. We own www.TheBusinessOwner.com. We should buy www.TheBusinessOwnerSucks.com. Disgruntled employees or customers could have a lot of fun with a URL like this (often do)!

Schneiderman says you have to think about what the devious might try to pull, such as buying derivations of your name, business name or product name, and using them to make a defamatory message pop up when people search for you or your products or services. That’s why we suggest you buy your “sucks” URL as described above.

Bailey and Schneiderman both explain that while it’s wise to own your business names and trade names — to keep them out of the hands of others — it’s even better to put them to productive use. For example, use a URL for a particular product by creating a dedicated landing page. This allows for enhanced traffic tracking as well as a Web “place” that focuses exclusively on a single task, e.g., selling a particular product or service.

When a company embarks on a venture that’s high risk, it may make sense to protect the established company from liabilities that will or could arise in the new venture. A commonly used and quite effective (and relatively inexpensive) means is to set up a subsidiary corporation and operate the new venture within it.

A subsidiary corporation is one in which another corporation, the parent corporation, owns at least a majority of the subsidiary’s stock and therefore has control over it. Such a structure can be effective at protecting the parent company from liabilities that arise in or as a result of the activities of the subsidiary, but only if the subsidiary is managed in a certain manner:

• Both corporations are adequately capitalized.
• Corporate formalities (e.g., election of officers, annual board meetings, filing of separate tax returns, etc.) are observed for each entity.
• Both corporations are held out to the public as separate enterprises.
• The two corporations keep separate financial records and do not commingle funds.
• The parent corporation does not completely dominate operations of the subsidiary to advance only the parent’s interests.
• The parent corporation avoids contractually guaranteeing debt of the subsidiary.

Failure to adhere to these could result in creditors being able to “pierce the corporate shield” and hold the parent corporation accountable for the debts of the subsidiary.

• Valid Incorporation. The corporation must be set up correctly, according to laws of the state it is incorporated in. This typically means filing articles of incorporation in duplicate with the secretary of state. This is, in effect, an application for a corporate charter. If accepted, the state will issue a certificate of incorporation. Then the board of directors named in the application must meet to adopt bylaws, elect officers and transact such other business as may come before the meeting.
• Conduct Business on a Corporate Basis. This entails following requirements of the state the business is incorporated in. This typically means holding regular directors meetings, maintaining a corporate book with minutes of meetings, keeping corporate funds separate from funds of stockholders, and maintaining financial records on the business. For closely held corporations, the requirements may be relaxed. Check the laws of the state your legal entity is incorporated in and see Closely Held Corporation below.
• Provide Adequate Financial Basis for the Business. This typically means shareholders invest sufficient capital to meet reasonably anticipated requirements of the business. But once the business is initially capitalized, investors are not obligated to contribute additional dollars, even if the entity has financial trouble.
• No Illegal Activity. If the business is used to commit fraud, officers and directors can be held personally liable.

In addition, when executing agreements for the corporation, officers and directors must clearly sign in the name of the corporation — as corporate representatives and not individuals. The corporation also must file its own tax return, separate and distinct from individual return(s) of the owner(s).

Closely Held Corporation

Most companies are closely held, meaning that they have few shareholders, and shareholders serve as directors and officers. The result is a flattened corporate structure like the following:

Figure 1. Management Structure of Typical Closely Held Corporations

The result is that many statutory requirements of corporations — such as annual meetings of shareholders, elections of directors and appointment of officers — are simply formalities. Therefore, most small companies do not even bother. But failure to “act like” a corporation and adhere to legal requirements may result in forfeiture of limited-liability status. Fortunately, many states have enacted laws that relax nonessential governance requirements for closely held corporations. Such laws permit operation without a board of directors, broad use of shareholder agreements, waiver of annual meetings, and execution of documents by a single person acting in more than one capacity, such as chairman of the board and president.

To operate under these relaxed rules, some states require that the corporation both qualify as a closely held corporation (typically fewer than 50 shareholders) and elect “statutory close corporate” status. To avoid potential loss of the corporate veil, it’s critical that you understand the laws of the state your company is incorporated in and abide by them.

1. Preserve control by restricting transfers or sales of company stock to persons outside the company or owner’s immediate family.
2. Protect business assets and ongoing operations.
3. Provide cash or other assets (e.g., life insurance proceeds or promissory notes) to the retiring or disabled owner or family of the deceased.
4. Establish a method for determining the value of the business for estate tax purposes and transfer or sale of company stock.
5. Assure sufficient liquid assets are available to fund a buyout, pay federal and state estate taxes, and meet financial needs of surviving family members.
6. Reduce some of the risks inherent in grants of incentive stock awards to key employees.

Structuring a Buy-Sell Agreement

A buy-sell agreement can protect business value, reduce the likelihood and severity of shareholder disputes, and provide for continuation of the business beyond its current ownership. A buy-sell agreement can also be designed to provide income to the retiring or disabled partner or to the family of a deceased partner. Initial questions that need to be considered are:

• Should the buy-sell be cross-purchase or stock redemption? In a cross-purchase, share buyouts are affected by one or more partners buying the shares of another. In a stock redemption, the corporation does the purchasing.
• Should the buy-sell be funded with proceeds from life insurance on each owner’s life, and what cautions should the surviving owners take to assure payment?
• How will the business, or partial ownership interests in the business, be valued under the buy-sell agreement and will it conform to IRS valuation guidelines?
• Is the valuation method dynamic so that the valuation of the business changes as the business changes?
• Will changes in the business value trigger adjustments to mechanisms that will provide buyout funds?
• If insurance is the financing vehicle, should the premiums be paid by the company or the individuals?
• How can you structure the insurance policies to reduce or eliminate income and estate taxes?

Buy-Sell Agreement Checklist

Here are major items to include in a buy-sell agreement.

• Names of individuals, number of shares (ownership percentage), purchase price, and the corporate or partnership entity involved in the buy-sell arrangement.
• When the agreement will become effective: death, termination of employment, retirement or disability.
• Method of stock purchase: stock redemption, cross-purchase, combination of both, or survivor’s option plan, where the decision is not made until death or retirement of the owner.
• Buy-sell value (price) and method for updating the value over time, preferably every year or two. Keep in mind that the value of many closely held businesses can increase (or decrease) substantially from year to year.
• How the owner(s) will be paid for the stock: life insurance proceeds, promissory notes, other owners’ personal assets, company cash or a combination.
• Circumstances in which the ownership position (i.e, actual shares of common stock) can be hypothecated or otherwise encumbered for loans or other purposes.
• Whether the buy-sell is a legal obligation or only an option to buy or sell.
• Conditions in which the buy-sell is to be amended or terminated. Written approval of all parties or just a majority of shareholders or shares outstanding.
• State law governing the agreement and any alternative dispute resolution provisions.
• “First-offer” or “right of first refusal” clause stating that before a stockholder can sell his or her stock, it must first be offered to the corporation and/or other stockholders.
• Clause binding future owners to the buy-sell agreement (i.e., covering stock options issued to key executives and other employees).
• Provision for an independent trustee if the purchase price of shares is substantial and funded by life insurance. Recommendation: Use a law firm or financial institution to make sure insurance proceeds are disbursed directly to your designated heirs/beneficiaries.

Valuation Methods to Use in Buy-Sell Agreements

Be aware that the IRS can challenge the price at which shares change hands. This occurs most often when no documentation exists to support the business’ value and price per share. Documentation is particularly important if the buyout is substantial. You can support your valuation and buy-sell price by using one or more of the following accepted valuation methods.

• Book Value: Simply the company’s total assets less total liabilities as presented on your financial statements. Tangible net book value also could be used. It excludes all intangible assets such as capitalized financing costs and goodwill.
• Adjusted Book Value: Amends the company’s book value to reflect any difference between book value and fair market value of certain assets and liabilities. For example, book value of depreciable assets such as buildings or equipment are often understated. The adjusted book value method usually renders a value higher than reported book value.
• Replacement Cost: Adjustment of all assets to their replacement value and then subtraction of all liabilities. Usually leads to a valuation that exceeds that of book value and adjusted book value.
• Price-Earnings Multiple (P/E): Value of the business is determined by applying a multiple to earnings of the business. The multiple, and how to apply it, is described in the buy-sell agreement. Important elements should be stipulated, such as type of earnings (pretax, after-tax, EBIT, EBITDA); earnings period (most recent 12 months, most recent fiscal year, average of the past four fiscal years); how debt of the business will factor into the valuation; and what to do if earnings are zero, near zero or negative. Earnings-based methods typically yield valuations far greater than balance sheet methods during periods of high profits. The reverse is true, of course, during periods of low or no earnings.

Your accountant can help you design and apply your valuation method. You might also use two or three of the methods and take the highest average or weighted average.

Additional Considerations

You should take other precautions to assure the buy-sell agreement’s validity and effectiveness. These ideas apply to both existing and new buy-sell agreements.

1. Each stock certificate subject to a buy-sell agreement should have a written legend stating such on the face of the certificate.Example: “These shares are subject to a buy-sell agreement dated ______________.”
2. If the company is to purchase shares, you will have to provide for it in the corporate minutes and possibly obtain approval, in advance, from any minority shareholders. Check with your lawyer.
3. The signed buy-sell agreement must be bona fide, entered into in good faith, and effected on an arm’s-length basis, particularly when transacting with family members. For example, you can’t set a low value on a small portion of your company stock and expect the value to apply to the remaining holdings for estate tax purposes.
4. The buy-sell price per share must be reasonable and legally binding. It cannot be a device to transfer ownership to family members at less than its full fair market value.
5. Include provisions that will aid if an active partner becomes disabled.
6. To defer taxes, you might want to consider building in an installment sale provision. Keep in mind, though, that delaying payments could increase risk of nonpayment.
7. In crafting an effective buy-sell agreement, consider also seeking advice from a mergers & acquisition expert and/or business valuation expert.

Financing the Buyout of Your Stock

Establishing the procedure by which stock is bought and sold on the departure or death of a shareholder is the first step in protecting the company. Providing money to carry out the procedure is the second.

You can’t assume that surviving owners will have enough personal liquidity to finance the purchase on their own or that they will be eligible to borrow the required amount. The price tag on shares in a profitable, growing company can be substantial. Nor can you assume the company will have sufficient liquidity or access to capital to fund the purchase on its own. You might want to consider another approach for providing the needed money.

Life insurance. Life insurance on the life of each owner can supply all or part of the needed cash. In the case of a stock redemption plan, the company buys the insurance and names itself beneficiary. A cross-purchase agreement could incorporate life insurance by each shareholder buying a policy on the other(s). Any insurance payout is then used to purchase the deceased owner’s interest.

How much insurance? Shares to be covered by insurance on each owner’s life represent a certain percentage of the company’s value at the time the insurance purchase is made. For example, if each of four stockholders owns 25 percent of a company valued at $1.2 million, then $300,000 life insurance must be purchased on each owner’s life. To reflect future increases in the value of the stock, the dollar amount needed to purchase the shares should be adjusted periodically along with the amount of life insurance relied on to finance the purchase.

Joint life or first death. Another possibility, where several owners have roughly equal shares of the company, is joint life or first death insurance. The policy covers all of the owners but pays the life insurance proceeds when any one of the parties dies. The insurance proceeds can be paid to the company or to the others in the group, depending on how the agreement was set up. Of course, if this type of insurance is used, it will be necessary to work out a new arrangement and take out a new policy after the death of any one of the owners.

Covering a shortfall. If life insurance is used, consider including a provision that addresses how a shortfall will be bridged. For example, if the policy pays $200,000 but the buyout is $300,000, should the surviving partner be allowed to pay off the shortfall over a period of years? Will an interest rate apply?

Buy-Sell Taxation

If a buy-sell agreement is funded with insurance, it is critical it be structured in a way that minimizes taxes. Generally, life insurance premiums are not tax deductible and life insurance proceeds are not taxable income when received by the beneficiary. If the company is the owner and beneficiary of the life insurance policy underlying a stock redemption plan, there is usually no taxation. It’s straightforward — the premiums are not tax deductible by the company, so the proceeds received are not taxed.

Problems can occur when the company is not listed as policy owner, but the company owner is. When the company owner dies and the company uses insurance proceeds to acquire stock from the deceased owner’s estate or heirs, the proceeds will be included in the value of the estate of the deceased. This could trigger significant, unnecessary estate taxes.

Estate taxation is complex. Talk to your tax attorney and financial advisor about the proper structure of your buy-sell agreement and related insurance policies.

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Unless you wish to become a victim of cyber crime, don’t use any of these — or ones like them — for your own. Create unique ones that adhere to these best practices:

1. Use 15 or more characters.
2. Use uppercase and lowercase letters.
3. Use digits and punctuation characters as well as letters.
4. Don’t use real words, your street address, your date of birth, or the names of family members, pets, etc.
5. Don’t write them down.
6. Don’t use the “Remember Password” feature on your Web browser.
7. Change your passwords every six months.

Cyber crime is rampant. Conduct your affairs prudently and cautiously or you’ll fall victim.

A less obvious but very real threat to the survival of your business is catastrophe — the sudden and unforeseen event that puts you out of business or inflicts long-term damage. Fire, flood, data breach or events that damage your public image or reputation. Or the loss of a vital customer, vendor, license, employee or representative.

Just as the business owner must work each day to secure profit and liquidity, he or she must protect the business from loss due to sudden, unforeseen events.

Here’s how:

Step 1: Identify Your Most Critical Assets

Begin by listing the assets you use in the creation and delivery of your goods or services and in the operation of your business. The primary asset categories are facilities, inventory, equipment, personnel, data, network/connectivity, voice, hardware, software, licenses, agreements, relationships and reputation. Add to the list items necessary to prove ownership of valuable assets, rights or interests, such as titles and insurance policies. Rank each asset or asset class from most valuable and/or critical to least valuable and/or critical. Estimate the impact that each asset would have if lost. Gauge the impact in dollars, customer relationships, public perception and contingent liability.

Step 2: List Things That Could Damage Each Critical Asset

Brainstorm about all the things that could damage each critical asset and/or sever you from full access. For an asset such as your website, it could be a failure of your server by fire or flood. For a key employee or vendor agreement, for example, it could be an erosion of a personal relationship or a fire or other natural disaster. For a license, it could simply be non-renewal for unknown reasons. For something such as a patent, it could simply be the passage of time. Whatever it may be, list the things that could cause damage or separation.

Step 3: Develop Mitigation Plans

For each “thing” that could cause loss, develop a mitigation strategy. For example, if a key asset is a relationship with a person or organization, your plan might include:

i. strategy to reduce reliance on the relationship

ii. multi-point strategy for keeping the relationship

iii. development of contractual protections, such as non-compete, non-solicitation or cancellation notice provisions
iv. transfer of risk, such as the purchase of a key-man life insurance policy

If the key asset is, for example, “inventory,” you might work to:

i. reduce the risk of fire by installing a sprinkler system and/or updating the wiring in the facility

ii. ensure full loss coverage with insurance

iii. develop a strategy for quickly sourcing inventory and securing a temporary place for operations (in case of a loss of the facility)

Step 4: Periodic Review of the Plan

Over time, your business will evolve. Your risk exposures will evolve as well. To be sure you’re doing what you can to ensure the continuity of your business, periodically pull out your continuity security worksheets. Go over them thoroughly and update them. Spot new risks and develop and implement strategies for mitigating exposure.

Keep in mind that identifying your critical assets can take some time. List them yourself and then periodically revisit the list. Some key assets/risks can be difficult to spot. Persons of different vantage points and experiences can be of great help, so put some of your employees and advisors on the task. Ditto for the list of risks to each critical asset.

Your most important job, as a business owner, is to ensure the survival of your business. Profitability is essential, but don’t forget about the risk in unforeseen events. Identify your critical assets, the events that could damage them, and then develop a mitigation plan for each.

Take the analogy of the golfer. Why hold the golf club a certain way? Well, you can hold it any way you want, but over hundreds of years golfers have tried virtually every technique conceivable, and the best results are generally garnered from one particular grip.

The same concept holds true for the financial management of a business. You can organize the financial data any way you wish, but you might want to express your creativity elsewhere.

The accepted “best practice” for the organization of a business’ financial data has evolved and been refined over thousands of years. The concepts are embodied in what we call Generally Accepted Accounting Principles (GAAP).

Maintaining a Healthy Gross Margin Is Mission-Critical

Business owners and managers would also be wise to know which part of the income statement is the most important. That is: “Get this one thing right and you’ll be well on your way. Get this one thing wrong and you’ll have a very hard time ever finding success.”

This one thing is — the gross profit margin.

Keeping with the golf analogy, the universally accepted #1 swing tip is: Keep your head still. The “keep your head still” of business financial management is: Watch your gross profit margin. That is, make sure you earn a healthy margin. Don’t let it erode, and make sure you at least match what is earned by your most successful peers. Peer gross profit data can be obtained through your industry association.

Your Gross Margin Provides the Cash Your Business Needs

But to explain why the gross profit margin is so important, let’s use some more analogies.

You run on food and water. Your car runs on gasoline.

Run out of food and water, you die. If your car runs of gasoline, it becomes worthless.

Your business runs on cash. It needs cash to buy raw materials, pay the rent and employ the employees who create the products and services, market and sell them, collect the cash and deposit it in the bank. A healthy business will generate more cash than it consumes. If it does not, it will die.

So the stream of cash that flows into your business is the gross profit. The higher the gross profit MARGIN, the larger the stream. The lower the gross profit margin, the smaller the stream of cash available to fund your operations and investment in future growth.

Revenue Is Important, Gross Profit Is More Relevant

One could argue that revenue is the most important number, but this is simply foolish. Every product or service you sell has expenses directly associated with it. Let’s say you publish books. For every dollar you take in from the sale of a book, you have direct costs in the printing, payment of author royalties, salesmen or broker commissions, shipping fees, etc. So the only relevant number is the profit (cash) that remains after the direct expenses are paid. Right?

The gross profit is all you get to keep to pay the rest of your bills (i.e., operating expense, also referred to as sales, general and administrative expenses). You don’t get to keep revenue; just what’s left over after you’ve paid the direct expenses you incur in the production, sale and delivery of the product or service.

The gross margin is the ratio of gross profit to revenue. For example, if you make $50K gross profit on $200K in revenue, your gross margin is 25% ($50 divided by $200). Of course, this would mean your direct expenses (i.e., cost of goods) were $150K.

Gross Profit Margin Drives Bottom Line

To further drive home the critical nature of the gross profit margin, let’s take a look at how changes in the gross margin impact the bottom line. Take a company that has a 40% gross profit margin (i.e., cost of sales takes 60% of revenue) and a 10% operating profit margin (also referred to as pretax profit) — a healthy income statement by most standards.

Now let’s say that the owner fails to closely manage his gross profit margin and, either through a rise in cost of goods or a lowering of the price they get for their products or services, gross margin dips from 40% to 34%. This 10% increase in the cost of goods reduces operating profit by 60%. Here’s the math with percentages:

The lessons?

1. Without a healthy gross profit margin, bottom line profit is almost impossible.
2. A small erosion in gross profit margin can wipe out bottom-line profit.

Sell Quality, Not Price; Wring Direct Costs Out

How does one manage gross profit effectively? Unfortunately, there’s no magic potion. It’s just a matter of:

a.      resisting the temptation to win sales by lowering prices.
b.      wringing direct cost out at every turn.

It’s very hard to run a profitable company by competing on price. Only the firm with the lowest cost structure can win with such a strategy. The low-cost strategy is typically viable only for the firm with the highest volume, and virtually every industry has a firm that competes on price. To succeed, they must go for volume, “no frills” service and merely “acceptable” quality. The only logical and viable competitive strategy for the firms with lower volumes (most everyone) is to offer higher levels of quality and service at higher prices — prices that will more than offset the added expense incurred in the delivery of the higher levels of product and service quality.

Just a Few Low Margin Sales Can Devastate Overall Profitability

Business owners should also keep in mind how sensitive the overall profitability of the business is to the profit margins earned on individual sales. That is, the impact a few money-losing products and services can have on a company’s overall profitability. To illustrate, let’s look at a consulting firm that has 20 types of consulting projects. Peerless Consulting tracks the labor hours and direct costs required to deliver each of its project types. Peerless also knows the income that each job brings. Here’s the simplified 2008 data:

• Total annual revenue was $1,000,000.
• Each of the 20 project types generated $50,000 in revenue.
• Fixed overhead costs were, and will continue to be, $205,000 per year.
• Operating profit was a negative $5,000.

A look at the data revealed that two of the 20 project types lost money. In fact, the money-losing two together cost $50,000 more than the $50,000 in income they generated (i.e., together the two products brought in $100,000, cost $150,000 and therefore lost $50,000). If Peerless were to eliminate these offerings altogether and the labor associated with the delivery of such projects, revenues would decline to $900,000, but operating profit would increase from negative $5,000 to $45,000 in the black. Here is the comparison.

Income Statement — Peerless Consulting

By simply eliminating 10% (two of the 20) of the project types and 10% of overall revenue, Peerless becomes a profitable company at a respectable operating profit margin of 5%. If fixed expenses could also be reduced, then the bottom line would rise dollar-for-dollar and the operating profit margin would increase sharply.

Now, another alternative would be for Peerless to find a way to keep the two money-losing offerings but make them profitable. The average gross profit of the 18 profitable offerings is 28%. If we assume that the two losers could also earn 28% or $14,000 gross profit each, then Peerless’ Pro Forma Income Statement would look like this:

By turning around the two money-losers, Peerless’ operating profit has increased to a respectable 7.5% margin. And that, compared to a net loss, makes all the difference in the world.

A small number of money-losing products or services can have a devastating impact on the overall profitability of a company. Peerless lost money in 2008 though 90% of its products were profitable!

The lesson: Analyze your per-product profitability. Use the information to create profitability across your entire product line. The impact of losers is too great to ignore.

In conclusion, the business world is complex, but business management, at its heart, is pretty simple. To manage and grow a profitable business, your most important task is to find ways to sell more and more at healthy profit margins. The most critical number is the gross profit margin. Deliver a consistently healthy gross profit margin and the rest of your job will be a heck of a lot easier.

The interesting thing is, the art of the possible is about envisioning the future, but humans really only move into the future by peeking into the past. It’s just the way we work.

By way of explanation, to envision what is possible we rely almost exclusively on two things:

Our own past performance

Others’ past performance

Virtually every development on earth is incremental. Evolution is incremental.

In sports, records are broken every day – in tiny increments. To break a record, the athlete’s challenge does not require him/her to create a new reality. The athlete is not required to deliver a never-before-in-history performance. The bar is set much lower – simply edge current reality by a hair.

Consider as well that each of us is heavily influenced by psychological barriers that, by their very nature, are not real. They exist only in the mind.

Take the 4-minute mile as a case in point. Though generations of runners clipped second after second off the 4-minute-mile record without interruption – and steadily approached the 4-minute-mile mark – there was a widely accepted belief that it was not humanly possible to run a mile in fewer than 4 minutes. And so, as world-class milers approached the 4-minute-mile mark, the pace slowed. The only explanation for this is the psychological barrier. Self-doubt, if you will.

Runners came closer and closer to the mark, and then it happened. In 1954, Roger Bannister finally posted a time that began with a 3 (3 minutes and 59.4 seconds) and, in the ensuing months, the rest of the field burst through with their own times under 4 minutes.

So goes the business world. Business people are obsessed with learning the accomplishments of others. Why? Because we are unsure of whether we can do such and such until we see that someone else has.

If you can, then maybe I can. And when we meet someone who accomplished X, Y or Z, we’re further emboldened. Why? He/she doesn’t look any more special than me!

Peer Benchmarking is about looking at what other companies similar to yours are doing. If you, as a business owner, can match the best of your peers in key categories such as inventory turns, collection rates, gross profit margins, labor productivity, etc., then you will secure your place in the 20% that enjoy all the spoils. Where do you find peer data? Try your industry, trade association or the Risk Management Association (formerly known as Robert Morris Associates).

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More articles on Benchmarking available in the newly release “Profit Enhancement Strategies”, a special article series published by The Business Owner.

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