How to scale a company profitably

00:00The number one spend that it takes to grow your business is marketing spend. And that can come in the form of, you know, is it spending on marketing or people? That one carries kind of a labor, can carry a labor component as well. The other one is pre-spending on capacity, which in generally is labor. It's not fully utilized to then fill it up and sell into it. Now, in the scaling process, the black hole that I talked about in the first book of between a million and five million revenue is painfully real.

00:38And $3 million of revenue is the deepest, darkest moment of the black hole. And the reason for that is it's where the next person or the next catalytic spin that you have to put out is far more significant to your overall financial picture than it is when it's $5 million or $10 million or $20 million. And so you got to get through that period before the catalytic steps that you take aren't so critical between an edge of life and death.

01:12You're listening to the Growth Manifesto podcast, a Zoom video series focusing on what it takes to drive growth in today's competitive business environment. Brought to you by Web Profits, a fully integrated end-to-end specialist digital marketing agency that helps challenger brands drive improved performance in a complex and fragmented digital landscape. If you like this episode, please do us a favor and share it with one person who you think will get value from it. We put a ton of time and effort in putting this content together and would really appreciate it if you could share it. And I know there's a ton of podcasts out there.

01:44So thank you for taking the time to listen to this one today. Now, let's get into it. Today, we're talking with Greg Crabtree. He's the author of the book, Simple Numbers, and he recently published Simple Numbers 2.0 Rules for Smart Scaling. He founded his own firm to focus on helping entrepreneurs to build their economic engine. And he recently merged with a top 20 accounting firm in the US to help to broaden their impact on the entrepreneur community. Today, we'll be talking about his rules for smart scaling

02:16and how to scale smartly and profitably. And just quickly, before we get started, make sure to go ahead and hit that subscribe button so you get the latest episodes as soon as they're released. And let's get into it. Welcome, Greg. Yeah. Thanks for having me. I'm excited to speak to your folks. Yeah. And I purchased your first book, Simple Numbers, straight after I interviewed Vern Harnish and he talked about it. And it was such a simple way to think about scaling up a company, right? And obviously then I bought your second book, Smart Scaling, which is the follow-up to

02:51that book. And I really appreciate how you've taken complex accounting speak and converted it into what people in business can actually understand. So where did you get the idea for this book? It really came from the fact that I joined the Entrepreneurs Organization in 2001, which is not common for accountants. There's more accountants in it now. But when I joined, I was one of a handful of accountants in the world that were members. And in my forum,

03:23I was doing a presentation about what we did. And I just happened to ask my other nine forum mates who I couldn't do business with. So I was kind of in a safe space. And I said, how many of you would recommend your current accountant? And the answer was zero. It's like, they didn't hate them, but they didn't like them. And they might've liked them as a person, which made it kind of this uncomfortable relationship because, well, it's like, I kind of need them, but I don't, you know, I really wish they could do this, but they say they can't. And I said, okay, well, what, you know,

03:56So I dug deeper. I said, well, what is it that you need that you're not getting? And it really launched our practice into what we do today is we flip the script of saying, you know, the most important thing I can do to help a business is to help them run a profitable, fully capitalized, wealth-building, cash flow-producing business. That it's a good thing to sell it and it's a good thing to keep it. You know, there's no bad idea. and whereas most of my profession who had tried to get into consulting, they did it as an add-on

04:30of, oh, when I'm not busy doing taxes, when I'm not busy doing audits, then we'll try to do some consulting, but nobody could define what that was. And I said, okay, well, tell me then, you know, what is it that you want to know? And they said, well, the first thing is, is we don't like the tax day surprise. So it doesn't matter where you're at in the world, you got to deal with taxes for the most part, even if you're in a no tax country, but if you do business in a taxable country, you got to deal with taxes. So taxes, it's the surest thing is death. And so, okay,

05:02well, let's deal with that, but let's predict it. Have you set the money aside, irregardless of when the taxing authority tells you to send it in? So that's not a surprise because it's not your money and it's not going to be your money. And that led to a few other things about intellectual honesty about taxes of when are you truly saving taxes versus when are you just postponing it to a different period. And I think there's a lot of bad discussion around that concept of always try to be clear, you know, when we tell somebody, well, I helped you save taxes permanently in this idea,

05:36this one, hey, we just moved it from this year to next year. And I can't guarantee that the rate's going to be the same. So it is what it is. I said, okay, well, I got that. I said, I understand that. And I think I've got some ideas already that I can fix that piece, you know, just require some communication process. Good. What's next? Says, well, we don't like being billed by the hour. And this became a lot of people who are going to listen to this podcast do business this way and that they bill by the hour. I got news for you. This is going to shock you. But if you bill by the hour, there's only two possible outcomes.

06:08I either gave away my expertise or I charged for my ignorance. You never get to an economic equilibrium. And it's essentially a lazy way of doing business because you don't pre-plan enough to scope what really needs to be done. And two, you're not confident in crafting your offering to charge a market price to then make the cost fit. And really, we've proven this over and over again with our clients to get them off of an hourly billing mindset wherever possible to say, what will the customer pay for this?

06:44We see this in the contracting business that does cost estimating and job estimates all the time. And they fall into the other trap is that they do this cost buildup, add a little profit. And they say, oh, well, this is what we've got to charge. And I go, no, no. You start with what is the customer willing to pay? Now, let's see what is the least amount of cost it's going to take to do it and how much profit can we make? and and it's and and this is really what i would say is my passion that i've i've come to learn but i didn't i didn't know it existed as a formal course of study is behavioral economics i mean i

07:19i would say probably i've become a a practical practitioner of behavioral economics to understand how humans interface with economic issues and questions and and i want to stay away from manipulation, but I do like to help everybody get the optimization of understanding those things. And so that hourly billing thing was just one of the big ones. And so today, everything we do on a consulting basis is all fixed price. And then the last piece I said, okay, what else? This is,

07:49oh, well, oh, by the way, you see hundreds of businesses, most intimate details. You got to have some idea what works and what doesn't. And to me, this was what just hit me right between the As a profession, we constantly do this. Now, we don't. We really have made a study of looking at the data and saying, what is all of this data telling us? And now it's a little more common for people to think that way because of big data and all those things. But essentially, study the data, study trends. I can't share, obviously, intellectual property or trade secrets or those things.

08:24But I can certainly study the data to see trends. One of the things we do today, which has become hugely beneficial to our clients, we monitor a hundred company model. So one of the things that doesn't exist anywhere in the world is economic, real-time economic data on privately held businesses. What actually is happening? Every government is hamstrung because they know nothing about your business at the moment. Literally nothing. and and so when you talk to the economist at the the central banks you don't want to know how they

09:01come up with the data i'm telling you because it's it's a it's a little bit manufactured and so we said you know this is a problem i want to know and and so okay well since our practice we have clients all over the u.s and canada we have several clients in australia um so we get snippets, but we said, okay, well, let's focus on the U.S. at this point, and let's see if we can come up with our own index. And so this is our simple numbers company model. It's a billion dollars of revenue. So I'd say that's a pretty good data set. It's got 100 companies. We didn't

09:35just pick the winners and losers. We said, hey, here's the first 100 companies we can come up with. We have data for this at least a minimum three-year range of time, and we monitor it every month. And I'm telling you, the learning has just been off the chart fascinating because, you know, what the economy is doing versus what the media and the government says it's doing are just diametrically opposed. Now, last year, you know, so obviously, especially during COVID,

10:05this was extremely fascinating to watch is, you know, certainly we fell off the cliff. We were running that a hundred companies was running about an 8% growth rate coming into COVID year over year coming off of six years of double digit growth rates by mind you so we the the private company economy been growing at a massive rate you know bigger than what anybody was reporting gdp was at and and so but it's sort of slowed down because we ran out of labor i mean literally in the u.s we were just out of people and so covet hits and there's a shake up and you know

10:40You see a 25% decline in April. You see about a 20% decline in May. And then, boom, June comes back a little bit as things try to reopen, settle back down. And by the end of the year, we actually ended up in 2020 up 6%. Now, if you ask people what they thought happened in 2020, that would not be the answer. And these are the kind of things. Now, the other thing is like we see trends like we specifically focus on things like marketing and we have marketing clients that we communicate with, but we also are big fans of effective marketing and what's the right number to spend and how do you leverage and scale your business with effective marketing spend.

11:27But it's fascinating to see that the marketing spend for these 100 companies have still not gotten back to the pre-COVID levels. So that's telling you that the market does not believe that there's open and willing customers in certain segments that are willing to buy yet. And so they're holding back on that cash and it's going to release it. So these are the kind of things that, you know, that my forum taught me to say, listen, you know, I mean, nobody's paying me directly to go look at that model. but it's incredibly valuable insight that we can then share across our client base and our community,

12:02you know, and really give them some tangible answers that other people are just kind of making it up. And at least there's some indication you can accept that it's not a big enough model. Okay, I get that, but I think it is. I think it's pretty good. Yeah, I have the two books which are highly recommended. everyone that is listening on the podcast right now, highly recommend it to really simplify the thinking behind, I guess, operating the business. That's the first book, profitably. And then the second book is scaling smartly, but let's just jump straight into scaling smartly. What do you

12:37mean by scaling smartly? So, you know, this is, this is this discussion that we have with entrepreneurs and, you know, I, I mean, it almost comes up every day and, you know, had a client on a caller earlier this morning that said, you know, they had some extra money. He says, what do I need to spend it on? I said, well, I mean, you don't, you don't need any cash. I mean, he said, your business is producing enough free cash flow that everything that they needed to grow their business with is an expense, but it's a finite number that would not drive them to a loss. So you just need

13:13to decide, you know, what is the catalytic spend that is going to scale your business? Now, what we've learned from studying the growth path of all of our clients is this, the number one spend that it takes to grow your business is marketing spend. And that can come in the form of, you know, is it spending on marketing or people, that one carries kind of a labor, can carry a labor component as well. The other one is pre-spending on capacity, which in generally is labor that's

13:50not fully utilized to then fill it up and sell into it. Now in the scaling process, you know, so the black hole that I talked about in the first book of between a million and five million of revenue is painfully real. And $3 million of revenue is the deepest, darkest moment of the black hole. And the reason for that is, is it's where the next person or the next catalytic spin that you have to put out is far more significant to your overall financial picture than it is when

14:24it's $5 million or $10 million or $20 million. And so you got to get through that period before where the catalytic steps that you take aren't so critical between an edge of life and death of the business and where you can't afford to miss. Whereas I can afford to miss if I'm at 10 million and I try the next test of something in that process. But then what it really came down to is 90 plus percent of the things that we spend money on to grow are an expense. It's not a capital

15:00asset. It's not a piece of equipment. It's not a building. It's not a plant or a factory, you know, those kinds of things. I mean, they can be, but even if you do those things, there's a way to look at it from a practical standpoint of, you know, framing the return on investment of my choice to spend. Because I want, the thing that struck us was, it kind of goes back to what we say there's four types of capital three of them exist on your

15:31balance sheet one of them hides on your pnl and i think to me that's kind of discovering you know the you know the the ninth planet of the universe in a sense it was sitting there in plain sight we just didn't have a telescope strong enough to see it okay well the reason why is we had our mindset saying capital means balance sheet no it doesn't i'm producing profit on my pnl and then making choices to redistribute that profit into something that I didn't need to spend on to create what I'm currently doing. Every person that runs a business listening to this podcast, I want them

16:06to stop and think for a moment. What did you spend to try to grow the business in the last 12 months that wasn't needed to be spent to produce what you did in the last 12 months? You spent it to get to someplace else next. That's not a current operating cost. It's an investment in the future. It just happens to be on your P&L. And so what we've done is try to design techniques. And you'll see a couple of these examples, like we've got the launch cat. The term we named the baby is

16:41the capital component on your P&L is called launch capital. It's an expense that I use to launch an activity, whether it's a business in total, a segment, the next new customer, whatever that. So the key is putting words to it to give people, you know, kind of like what we did with LER in the first book of labor efficiency ratio, we've named the baby. So there's two critical names that we really came up with in the new book, one of them being trade capital, which is that key component of that cash that just turns over AR inventory minus AP, you know, that component,

17:17it's a slightly different derivation than working capital. But to me, it's the accurate way of looking at, hey, this is the cash piece, this investment piece that as the business gets bigger, that dollar amount is going to get bigger, but it's going to stay in relation to my revenue. I'm just going to jump in quickly now because I'm just trying to clarify a few things, right? Because there's a lot of concepts that are being shared right now and you're talking very quickly about them. So to be clear, scaling smartly is, and just to confide, I could be wrong again,

17:50but scaling smartly is how you invest your launch capital and separating launch capital from trade capital. And just to confirm, trade capital is what you need to produce the thing which you're selling at the time. Launch capital is how you are taking the profit and spending it for future performance. And so what companies often do is they combine the two. They just think everything's an operation and that's where the confusion is. So scaling is how you choose to invest

18:26the launch capital versus the trade capital. Is that the best way to think about it? In essence, you're sitting at the blackjack table, you're on a good run, and you're trying to say, well, this is the amount that I kind of need to hold on to, but here's the amount that I'm willing to bet. And I like kind of getting the entrepreneur to think about launch capital is a bet. I don't know if it's going to work. How many people have artists? So then is effective marketing or marketing, is that launch capital or is that trade capital? So all sales and marketing is launch capital because you don't need them to satisfy your current customers.

19:02Is that? Unless you're in a business that literally nobody's going to come to you without, you're in a transactional business. And if you don't market, nobody comes through your door. Well, that, so to a certain degree, and this is what we do with our online retail clients. We consider direct marketing of social media, pay-per-click, those kind of things. That's actually a cost to get sold in the way that we look at online models. Now, marketing for branding, awareness, content, those things, that's lost capital in those.

19:38Because you can get by without spending anything. It won't optimize the business, but you'll keep getting business from that other. most of the rest of service businesses, people that have a brand, they're known in the community. You know, I've got an oil change client that literally, whether they market or not, somebody is going to drive past their place, see it says oil change, and they'll go in and get their oil change. But if they want to drive new activity, find new customers that don't know about

20:10them. That's large capital. So then if I am looking at my P&L, right? And I've got a net profit, right? I actually don't have a true trade profit. This is a trade plus launch profit, right? And so what would you recommend as an action for people to do to really get the true number of how much is the business required to spend to just operate with the existing customer base and how much to spend on growth? How do they separate this out? So there's two techniques and we go

20:46through those in the launch capital chapter of the 2.0 book. So we show one technique where you're intentionally making this decision and evaluating the results. So that's one where it's actually a client that allowed us to share their exact data. So it was a client that grew from 700,000 in revenue and in five years grew to 10 million. And the only catalyst was they increased their marketing spend each year. And then they evaluated the increase in net profit from that increase in marketing spend. So notice this is the difference. This is one of the

21:20weaknesses that you get in the marketing. That's a difference, right? It is. Because this is the difference of net profit based on marketing spend, not the actual total net profit. Is that right? Yeah. I don't care how much your revenue went up because you had other ancillary costs that had to be added to support that additional revenue. So those are what we call reflection costs. They're an echo of the initial catalytic activity. And so what you're really trying to get to is what was my net gain? And I want to recover the cost of my investment

21:54plus 50% or more on top of that original bet that I made. And in the example that was shown in the book, it worked four out of the five years. One year, they just got their money back. They kind of missed. They put too much money in and hit that point of the marketplace that says, you can spend all you want, but we're not moving anymore because of it. You've tapped out the effectiveness level of that marketing spend. So you're really, I think, like you talk about in the book, return on invested capital. Is that

22:24right? Is this what we're talking about right now? Is this like that invested long capital? This is a subcomponent of that. And so there's an overarching return on invested capital that we now use. When I did the original book, I had an observation of profit levels. And I made a statement in the first book. And also I restated it in the chapter I wrote for Burns book. At 5% profit, you're on life support. 10% you're good. 15% you're great. Anything above 15%, take it while you can get it because the market will complete you back.

22:56And that works for about 70% of the companies out there. But it was the 30% that I had to do some kind of excuse to say, why didn't that work? Because I had clients that had 3% profit that were nicely profitable, but it's like, why? And so I kept studying it. And fortunately, through my EO organization, they let me chair an executive ed program at Horton. And so I always say it's kind of nice that they let a little kid from a chicken farm in Alabama hang out with like real professors.

23:31And I had to give all the credit to David Wessels. He was the one that really turned me on to the idea. And I don't think even he really knew what I would do with it because he didn't have access to the data I had access to. So I've got access to private companies. All he has access to is a college professor, even at one of the premier learning institutions. He only has public company data. I got news for everybody out there. There's a public company. It does things for different reasons than we do in the private real world. And so that's why I'm focused on the private business community, because you do some crazy stuff when it comes to public stock.

24:10and so but financial concepts are what they are and so i said okay what is i had to define what do i think is the minimum standard of return of capital for private companies and i established to me 50 return is the minimum viable standard um i've got a couple of clients below that number but they can get the 50 i've not modeled a north american company yet that couldn't get the 50 there's some that don't get there just because they're making bad choices and it is what it is

24:40just for the listeners that are not across the concept yet so invested capital is what could you just clarify so invested capital capital yep so let's let's start with equity and and this was a point that professor wessels made that i thought was quite clear. He said equity is a flawed calculation. And he's absolutely right. What you got to do is look at the equity of your business and make a couple of adjustments. Do you have the appropriate

25:11amount of cash? So I make a big deal about you need two months of operating expenses in cash. So if I'm operating at less than full capitalization, I got to take equity and plus it up for how much cash really should be in the business to meet our minimum capital standard. Secondly, then you start adjusting plus or minus. Do you have any assets that are on your business balance sheet that aren't necessary for the operation of the business? Fixed asset, related party loan, whatever.

25:47Intangible assets, which really aren't real. They were just a plug number to buy something. So you take all of those things off. If you can't convert it to value for what it's stated, you take it off. Same thing on the liability side. Do you have debt that really is unrelated? Maybe I took on an investment round of mezzanine debt. Well, that was just an investor putting money in for me to take some money off the table. And that really didn't create any value. It's just kind of there. So to me, I take that out of it. So I'm looking at true operating liabilities and accrued expenses and operating debt.

26:23There's a lot of credit, term debt on hard assets, those kind of things. Once I make those adjustments, that number is my invested capital of an existing operating business in that process. Once I get that clean invested capital number, then I look at my net income before taxes. And to make it universal globally, I want to stick to a number that's pre-tax because everybody's got different taxes. So let's take taxes out of the equation. Let's say whether I pay taxes on it or not, what is the pre-tax return on this asset?

26:57And that's what you're looking for. And that changes frequently though, doesn't it? that changes like that should change frequently depending on how you're spending your, how you're investing your capital or spending your money, right? Like, well, it, it does historically until people focus on it. And what's amazing is, so this has kind of been a passion of mine is, is I see people start a really good business that's building value and then they get distracted.

27:28And I mean, just imagine an entrepreneur that's, you know, attention deficit. We all are. And we start chasing the shiny object. And I kept looking for what can I, how can I present the incredible value of what this business is that's in front of them and get them excited about it as an investment. And that's why I make a big deal to separate, here's the job that you get and the income that you get off of the thing that you do. But let's really nurture this business as an investment and stop doing business activity that just provides you a job.

28:07And let's do business activity that is a phenomenal leverage to create value. And so, Alex, if you said, hey, I got $100,000 that I'm looking to invest, I says, great, you give me $100,000. What if I give you a 50% return? Is that a little better than what the bank or the markets are doing? You know, okay, sounds good. 1% needs that. Yeah, so you give me $100,000. A year from now, I give you your $100,000 back plus 50,000. Oh, by the way, you got to pay tax on that 50,000

28:38because it is taxable. But depending on your tax jurisdiction, you know, you've got, probably at least 130,000 to reinvest. Here's the dirty honest truth. 50% returns the minimum. Most of our clients operate between 75 and 100%, some as much as 200% return. And this is really kind of the explosion of understanding, categorizing business operations in terms of understanding a business's return on investment potential. So I'll give you a great

29:10example, probably the best return on invested capital business model we work with is in the IT managed service environment. So MSPs and those guys, if they run their model correctly, so one, they've got monthly recurring revenue for the fixed services. They'll occasionally bill for projects and activity of those existing customers. But if they do it correctly and get money up front so that they're not out of pocket any of that cash. They're one of the leanest capital structure businesses

29:42because all they need to operate from a capital perspective is their two months of operating cash and a little bit of equipment. Most of them don't even have equipment. Everything is in the cloud or lease kind of stuff. And so the average, we run a couple of mastermind groups for MSPs and the top 25% of those companies in those mastermind groups have a 200% return on invested capital. And so their only challenge is to grow.

30:14But is that calculation based on trade capital or is that trade plus launch capital? Is that combined? So their trade capital is zero because they get paid in advance. Okay, so trade capital is a cashflow discussion. Is that right? Yeah, exactly. Yeah. But just to clarify, right? Because there's quite a lot of concepts here. But if you can change your cash flow strategy in terms of actually how you invoice your customers, your payment terms, that shifts your speed of scaling or your speed of growth significantly.

30:54Is that right? Right. And why is that? Well, what you're doing is, like I said, you're one, taking away a barrier to growth. Because when you start to quantify trade capital as a percentage of revenue, so traditional accounts receivable, maybe plus inventory with very little trade support, those businesses, 20% of revenue has to be sitting there in trade capital. And so in those cases, and we make a point of this, we call this the cash power ratio.

31:27If your trade capital percentage is at 20% and your profit percentage is at 10%, what it tells you is for every new dollar of revenue growth, I've got to put 10% of my money in just to get it started. If I can invert that and make trade capital 10% and profit 20%, percent, I'm 10 percent positive cash on every new dollar of revenue. Which which business do you think can grow faster? A business that that creates positive cash with every new dollar of

32:00growth or a business that has to go get bucketfuls of cash to keep throwing into the company? I've got this food distributor in Central America client that I mean, it's just dreadful. I mean, It takes them, they have to pay for their inventory when they order it and they have to wait 60 days to get paid by who they sell to. That's a bad business model. So on the face of it, and I'm going to check in now, correct me again if I'm wrong.

32:33But on the face of it, it seems that you can scale faster if you change your payment terms. And so that for every new client that you get, it adds cash to your business instead of it kind of adds cost. Right. Is that the first one? Yes. Yes, but no. Yes. But let me put it to you in a different sense. Yes. So my good friend, Alan Miltz, he's probably, I don't know if he's done your podcast, but he's certainly known in the same community.

33:06He works with both of us and we both contributed to his book. And Alan talks about those components. And really, a lot of my thinking in 2.0 came from Alan and I do a lot of joint presentations together. And the thing is, is working on those individual components, the answer is yes. But here's the bigger issue. I've got to look. I can't just focus on AR. I can't just focus on inventory. I can't just focus on accounts payable. I can't just focus on deferred revenue.

33:37I can't just focus on profit. And so that's why we put it in relation. I've got to look at trade capital as a net number because there's trade-offs in there. There's things that sit on the asset side and things that sit on the liability side that can net against each other. And so I want to give you more tools to say, listen, just look at the framework and say, if I'm at 20% trade capital and 10% profit, okay, what are my choices? Can I bring down my trade capital? I mean, that's obviously one of the things.

34:12But you may be in a market to where as hard as you try, the answer is, nope, that's just the way it is. And I'll share an interesting story with you in a second about that, though, breaking through bad thinking. But so then what you have to do is, OK, well, let's shorten the gap. Let's get our profit up. So if I'm if I'm handed a trade capital in the 20 percent range, I just got to get profit up to 15, 17, 18 and narrow that gap. I will tell you that once people understand both data points and we're hammering them with it with every call every month and showing it to them, this is the power of data.

34:51They start to do things about it. They start to question the status quo. And I'll give you a good example. So one of our Australia clients is a staffing business. And so we have several staffing clients in the U.S. And staffing businesses are notorious for bad trade capital. And so typically they don't have- So by staffing business, like a service business, is that what you mean by staffing business? Yeah, so you're going to them for either temp services and they may be specialized in an industry. They may be general temp services.

35:21For actual staff. Yeah, yeah, okay, got it, yes. Right. So this is where you're not, I mean, they might do some placement for fee, but it's mostly you're renting a body from them for a particular task. And so typically those companies have about 8% to 10% profit and they have about 20% to 25% trade capital. Just dreadful business. And so I pick up this client in Australia and we start going through his numbers and I go, well, he's got 15% profit.

35:54Well, that's good. And I look at his balance sheet and it's like trade capital is a negative number. So here's the thing that you want to know. When your trade capital is negative, That means that you're holding your customer's money before you do anything. Now, there's a bad side to that. You got to make sure that if you're holding your customer's money, that you don't spend it unwisely before you complete what it was that they gave it to you. But if you're disciplined and do it right, it's a wonderful place to be. Because in this guy's case, he had found a way to get his customers to pay him in advance.

36:30And I said, you know, I got, you know, these staffing clients in the U.S. I haven't seen this in ours. How did you get to a negative trade capital? And he said, well, we asked. Really? You asked? He says, yeah. You know, I mean, the customers we were dealing with, they had the money. We convinced them we were going to do what we said we were going to do. And we just asked for the first month up front as deposit. And he just kind of stays there, you know, throughout the length of the contract. First month up front as a deposit. I like the framing of that.

37:00You know, it's not prepaying for a month. It's just a deposit up front. I like it. Yeah. So anyway, so I get him. I mean, they don't compete. So I get him to talk to a couple of my staffing clients in the US. Guess what magically happened when they were at 25% trade capital and 8% profit. All of a sudden, trade capital comes down to 17. Profit goes up to 15. Gap is closed. and all of a sudden they become magically powerfully cashflow positive.

37:32So why does the profit increase as the trade capital number reduces? Like what causes that relationship? When you see, they kind of get connected, but not in a direct one-to-one way. You start to see what's possible. So when you see that it is possible to be that profitable, you start questioning all of your decisions of your profit matrix. you know am i am i not charging enough you know what what's you know in the you know what's my

38:02direct labor efficiency ratio and that you know i'm you know in in the staffing world i mean their their labor efficiency ratios are really low you know you're looking at kind of about 35 to about 50 and then the next thing you know you start to say well if these guys are getting a dollar 55 why can't i get that and you so you start trying you start questioning things because you see that somebody actually is doing it and it's validated information. It's not just somebody talking about it in the public. You know that it comes from a validated source of data.

38:34So then is it that the one way to improve the operations to scale smarter is through improving or reducing your trade capital through improved terms in terms of how you charge your clients and so on, but there must be the other part of your expenses. Like, you know, people spend on launch capital, but they don't think it's launch capital. They just think it's operating. Is that the two levers? Here's what I think causes that. So when you start to look at trade

39:08capital and then you say, okay, well, here's my overall trade capital. Now let's look at it. So this is another one of the chapters in the new book, segment P&Ls. So when I take the company as a segment and I start looking at it as a line of business and see which lines of business that I'm doing has the best trade capital positions. And then I look at it on a customer basis and say which customers are abusing me on terms, which generally are the least profitable customers.

39:40And I stopped doing business with them because I can't get them there. All of a sudden I become more profitable because I've figured out the picture of what is the type of work that we need to focus on that's the most profitable and cash flow generating. And what is the type of customer that fits that pattern? And really, I mean, at the end of the day, all we do is pattern recognition. Show me an industry, show me a line of business, show me a customer, show me a production unit of an employee or a unit of operation and see who's the pattern. And now we've got a standard that we

40:16can validate and perform to. And it's not theory, it's proof. And I think that's really typically what drives up profitability because I attacked it from another thing to see who are the bad actors. So for the people that are listening, there would be the aha moment of going, oh, there's this way of doing it. And then there's like the getting the numbers in place and so that you know what is your trade capital percentage and your profitability percentage.

40:48But then there's the transition period of when you're now having to make decisions on, just taking your previous example, there's an unprofitable client, this is an unprofitable service line, but you can't just rip them out completely because they probably support a part of the operation. Maybe it's not profitable. We always tell ourselves that. Yeah. Well, okay. So please, can you then maybe, could you dispel this myth then, right? Because there's a thing where it's like, well, it's contributing to the overheads, for example, right?

41:21Not to profit, but to overheads. This is, yeah. One of the things that I kind of rail against is the contribution to overhead customer. So that's why I'm loving this podcast because I know that you're going to just fill every myth. Yeah, I hate that idea because I'll give you a good example. One of my clients right now is the concrete contractor. And so things got a little slow over the winter for us, which is December. And so they took some contracts at really low pricing to cover overhead.

41:55And they didn't tell me about it until it came up on the next consulting call. And I go, I understand your thinking, but let's talk through this. I said, here's why that was a bad idea. And I mean, I hate to tell you, I'd call you out, but I mean, it was a bad idea because you would have been better off just covering those operating costs because we know that the good work was coming. It's a no. It wasn't. We weren't hoping. We knew that the Department of Transportation's that they generally deal with were going to

42:27be letting some better contracts. And it's like the company was well capitalized. It wasn't in any danger. And now because we've taken on these low cost deals, it's getting in the way of now the full margin jobs that are available that we can't start because we're still working on this stuff that we took to cover overhead. And client to client to client that takes on those bad jobs, those are the blockers of the high value work and you've got to put prioritization on getting those

43:02high margin things to the top of the list but i i get it once you make a commitment you you've got to flush out that those bad words bad work and and get those out of there and i it's not to say that you would never do it but boy i yeah i can't remember a time that i've i you know when i sit down and work through the math with the client unless they're just, I mean, if you're going to start taking on that work, you got to do some other cost mitigation to turn off cost in the business. And if you're not willing to do that, then just don't do it. So it's better to take

43:37the harder path of reducing your overheads than take on additional low margin work because that will limit your scale potential and then you'll get stuck in a period where the growth is flat potentially well and and you also teach people bad standards that's because yeah oh i mean we're seeing this with covid right now we we see we see two diametrically opposed production uh outputs from covid the companies that kept everybody on staff and had activity drop and they just said

44:13You know, we had some government PPP funds that you guys may have heard about and all that, which is great, you know, but but all of a sudden with limited work, people settled into a slower workplace. And they're having a really hard time now that their backlog is there. They can't get back up to the same speed that they were working at pre-COVID. Everybody who trimmed to what work they had, they're coming out like a rocket ship. I mean, they're profitable, and they've set new productivity standards with, I mean, really what we saw.

44:50And this was, I mean, because we got to 100 companies, we could look at this. There was about a 10% reduction in direct labor and about a 5% reduction in management labor out of that billion of revenue. And essentially, it kind of goes back to what Jack Welch, the famous CEO of GE, used to say is, everybody's got 10% of your labor that really you ought to get rid of right now. it's a harsh statement unfortunately it's probably true and covid forced the companies that really looked hard at it um that's what they did and they never looked back and never missed those people

45:26fortunately they felt okay those people actually weren't harmed too bad because we've had extended unemployment benefits that continue today that those people are probably doing better you know not working than some of them did even working. That's going to be a problem. Can we jump to what you talked about, I think in your first book called labor efficiency, it's called LER, I think. Correct. Can you just explain what that is? Because I want to just jump into that because this is where I

45:56get a bit confused between trade capital and launch capital if you're staffing up for the future, but could we start with that? So what is this ratio? Yeah. So essentially, you know, one of the things I always felt like was bad psychology is looking at labor as a as a fraction of something and or as a cost. And so realistically, I mean, you guys tell me, but I don't see anything productive in the world happening without labor. And so until we're totally inundated with artificial intelligence, it takes humans to make things happen of value.

46:33Yeah. And so in the first book, I used a simplistic measure, which is a good way for people to think about it. And part of this was driven by my disdain of this calculation that I think I make a point somewhere in my article. article. I don't think I said it in the first book, but it said, never, ever, ever represent your company as revenue per employee. I mean, I just hate that discussion because one, revenue

47:06is the most flawed number on your P&L. None of us have the same revenue quality of a dollar of revenue. Now, once you take revenue minus cost of goods, gross margin across all those businesses is a comparable number, but not labor. Everybody deploys labor at a different output rate. And I use this as a way to teach it is if I'm in a staffing business, I'm generally producing gross margin because I really don't have any cogs, but I'm gross margin of about one and a

47:40half times what I'm paying that person. And what that means from, it's a measure of how much the the marketplace respects the value of your labor. If you want to look at it in a harsh way of saying for every dollar that I'm spending on labor, the market's willing to give me 50 cents extra, which 10 cents of that 50 is for payroll taxes and minimum essential benefits. And 40 cents is for me finding the person, getting them to show up and replacing them if you don't like them.

48:13And that calculation is based on the gross margin or revenue? Gross margin. On the gross margin. Divided by gross wages of that person that you're charging out. And so that is the low end of the value scale. I always use staffing as the low end. Generally, and this is a lot, I think the data point kind of is a little bit of what I call pricing bias, is if you do kind of the cost buildup equation, you're going to see a common data point of gross margin per labor dollar.

48:46at the $2 level because that's really kind of the cost recovery of a decent profit. And if you do what you say you're going to do, that's about where the number always comes out to. But if you're really good at billing for the value and having true IP value, know-how, those kind of things, then you can move upscale. So like our IT managed service clients, they're probably an overall labor efficiency county management and direct in that 220 range

49:21to maybe 220 to 250 but their direct labor it one of the things we do in the so for every hundred thousand dollars of salaries they make 220 000 back of right price margin right pretty exactly now that simplistic measure is that hundred thousand salaries is a blend of everybody in the business. That was my next question. So that's basically the full labor of the whole company, not just cost of sales. Is that right? Yeah. Right. And so in the, in kind of the advanced

49:52way of looking at it, we go into a whole chapter of kind of splitting it between direct labor and management labor. And so direct labor, it's still looking at that gross margin number, but because it's only direct labor, you get a much finer, you know, analysis of how you make money. So in the professional services world that I live in, my direct labor efficiency ratio is going to be a two in most of those businesses. And a landscaping business is going to be a four. And here's the

50:25reason why those two things exist. In a professional services world, you're lightly managed. So I'm expected to be a professional and manage myself. And so I've got a much lower cost of management labor overseeing that professional labor. In a lower labor cost category that needs direction and guidance, I've got a much more expensive management structure to get that $4 of value. And what we see is it helps businesses as we go through these analyses and examples. We see

51:00businesses, we get a lot of data points in the managed service provider world where we see they should be a four direct LER and they should be a four management LER. And in that environment, we see a 250 direct labor efficiency company, but we see a seven on the management labor. What that's telling you is I've got very inefficient direct labor because I don't, I didn't hire enough managers to make them productive. And I'm, I'm trying to run them

51:30almost more like a professional services. And so we get them to say, Hey, you're, you're not giving your people enough guidance and coordination, you're leaving it too randomly up to their choice. And that's not the most efficient output business model. So you got to invest in management labor. What about support labor? Yeah. But what about support labor? For example, accounting like yourself. That's management. Okay. That's all part of management. Secretarial, all that jazz. I started off calling it admin labor.

52:02Yes. And I got pushback of managers, you know, the management people got offended that I called them admin. So I said, okay, we'll just call the whole bucket management labor. So it is anybody who's not direct is management labor. Got it. Okay. And so what you're trying to figure out is, you know, what is the return on the management labor, you know, just for that support, the managers, the support. the administration to the total gross margin?

52:34No. So direct to the total gross margin. Direct is to gross margin. Management labor is to what we call contribution margin. So it's gross margin minus the direct labor. So we move one more step down to hold management accountable to that number in that process. Okay. And because ultimately, as a manager, you got three variables. Your responsibility, if you're not a direct labor person, your responsibility is to help

53:04increase revenue, minimize cost of goods sold waste, and make labor efficient. I can affect that contribution margin from any of those three elements. And so typically what we see, managers tend to be overly focused on one to the detriment of the other two. And so we wanted a measure that says, listen, I don't care how you get there. You can run all kinds of plays you want, but just make a dollar drip out to justify your existence is what you have to look at.

53:35And that's the contribution margin that you're looking at. Yeah, exactly. And we say that, you know, contribution margin to me is the most important number on the P&L. Hands down. Why? That is that production of a dollar of contribution margin because that's the pure horsepower of the business engine. That is the output. It's the revenue less the direct labor or is it less cost of sale? Cogs. Yeah, cost of sale. Less Cogs and then it's…

54:08Minus direct labor. Minus direct labor. But what if direct labor is part of Cogs? You have to take out Cogs first. Okay. So Cogs is just for the product side of things. But if your COGS is labor, because it's a professional services firm, it's the same thing then. Just because I have services doesn't mean I don't have cost of sales or even cost of goods or cost of sales. It's an interchangeable term. There are things that I choose to pass. So here's the thing that you got to look at today's businesses. we're we we have basically deconstructed business to say focus on the one piece of a value chain

54:47that you really do well so why is it that a general contractor is a general contractor why don't they do framing why don't they pour foundations well now they get a subcontractor to do it well that subcontractor is a blend of two things materials and labor and and but there again, I am taking now that that subcontractor is a business unto themselves and they have to be profitable to be sustainable. And so what I'm choosing to do as a sub, as a general contractor

55:19is take the value chain of building a building and saying, I really just want to be paid for the coordination of all of the things that happen. And, and you're paying me for the value of what I do and I still make a profit off of my cost. And these other people are being paid for the value of what they do and they'll make some profit, you know, too. And we've all kind of shared that, you know, in the overall value chain, but it's not unheard of that I could create a company that knows how to pour concrete and build, put framing and put roofs on and, and, and do carpet

55:54installation. And it's not that it can't be done, but the business community has said, well, you can't be really good at all those things. And so good example, I use this one all the time is like if you're a manufacturer, well, you're a manufacturer. I got news for you. You're also a sales organization. So the question is, can you be world-class at manufacturing and sales? Probably not. Well, maybe I'm good at selling stuff and I need to do contract

56:25manufacturing. So why is it that we have stuff made in China and Latin America or just by somebody else, even inside your own country? Because they can make it faster, better, cheaper than I can. I conceptually designed the product that I needed, but maybe I don't like doing that. I may be really good at making stuff and I suck at selling it. That's why distributors exist in the world. Yeah, sure. Exactly. And every company in that value chain needs to be thinking about this the same way.

57:01Yeah? Exactly. So here's a great framework that I use all the time in our consulting clients. And I learned this from one of my clients, a company called QuickBarks.com, that I helped them get started. They had a great arc, sold out in about 10 years, and learned a lot from the CEO, Ron Hollis, and I got to be really good friends. But Ron, you know, this company, they were the first ones to create an instant quote for a custom manufactured part. So if you were a product designer and had a CAD program to design the part, you would upload this output file from the CAD program and you get an instant binding quote for a prototype of this mouse next day.

57:43You know, this was in the year 2000. And so the thing was, QuickParts didn't own any equipment. They didn't make anything. What they did was is they had a pricing algorithm that said there's a thousand or more data points out of that STL file, but there were only 14 that mattered for pricing, which is a very important point. And so they tested this algorithm of pricing. They hired a supplier that tested the algorithm and said, we will make any part that you quote

58:14under this pricing algorithm for 60% of whatever you quote it for. And so that establishes kind of a benchmark that we use frequently of saying in the value chain of a product or service, 60% of it is the value of doing it. But there's 40% that has three components to it. the marketing of it, the sales and closing of it, and the oversight of it. And so what Quick Parts built a business around was not owning a single stitch of prototype

58:50equipment. They got 40% of everything they sold, but they had to deliver on, they had to market to the marketplace. And we kind of think of that 40%, 20% of it's the marketing value, 10% of it is getting to contract, 10% of it is the oversight and coordination with a customer to make sure that things flow smoothly and they get what they're looking for. You can add plus or minus 5% to each of those four components of marketing, sales, oversight, production. But at the end of the day,

59:24it's an incredible framework for the separation of an economic activity. You could have four distinct businesses doing each of those elements. And many of the people doing business today are exactly that. They are one of those four components. And then that's their business. And so you have to stay true to say, am I getting the appropriate value? Am I being overcompensated for a temporary period of time? And the market eventually wakes up and realize I'm an unnecessary

59:55component at that price. And those are large things. Yeah. And so does this apply across the different business models? You know, like there's subscription, there's manufacturing, there's services, there's e-commerce, there's product. You know, like this approach, this thinking of trade capital, launch capital, the labor efficiency rate, this is the same across every type of business.

01:00:26Is that right? Yeah, exactly. So let me give you an example. So we had a client that's an Amazon reseller. And so they were doing about $55 million in revenue, losing about $2.5 million at the time. And I was worried that I was going to be doing how to wind down the business. But we got into it, and they were selling 33,000 SKUs. I mean, they had a lot of product. And so we did a quartile analysis looking at these elements of I'm looking at margin by product and I'm looking at terms by product.

01:00:58And those terms, think of terms on a per product because they didn't, this company didn't have anything of their own. They were just reselling other people's stuff. And so with each one of their vendors, there was a speed of inventory turn as well as then what are the terms I get from the supplier? You know, who makes me pay them in 30 days? Who makes me pay up front? Who gives me 60-day terms? And so this is why trade capital matters because it is a net number.

01:01:31If somebody, if I got slow-moving inventory, I don't care as long as I got longer terms. If I have fast-moving inventory, I can live with shorter terms. But it's the net of the time. That's what you were talking about earlier. Like it's on one side and then it's balanced on the other. And what you want to do is you want to slowly grow it so that you have more trade, more profitability and less trade capital stuck. Yeah. And when I'm interfacing, you know, customers and vendors all have different needs.

01:02:04And so I just have to look for where is my, if my opportunity is not on the customer side, then I have to go after the vendor side and make that vendor a partner almost, you know, in that regard. But if I can convince them that I can triple or 10x their activity, if they'll work with me, I've got a more valid argument with them to give me some support. I'm not doing it just because I've got power over them. I'm doing it in this win-win approach, which is my favorite approach in business.

01:02:35And so when you can craft those decisions that way, you can get people to move off of a hard position. So anyway, we went through all 33,000 SKUs and we said, we came back and said, well, we got some good news. We got some bad news. You know, the bad news is you need to stop selling 32,000 of the 33,000 SKUs. The good news is if you focus on just the thousand that are best, we can get you to you're going to drop the 35 million in revenue, which at the end of the day, who cares? But you'll make 750 of profit.

01:03:06And that's exactly what they did. And so part of it was, is we found a couple of flaws in there. They had created some artificial intelligence on reordering quantities, which you always got to be careful of validating when you put some AI in place that we kind of found some of that issue. But essentially, we helped them form an analysis framework of every vendor relationship. Because when it comes to product, the key is speed of margin. so i don't you know i i need a minimum quantity of margin but i also needed to move quickly

01:03:42through the equation so when i was pre-covid i did a speaking tour in the middle east and i was in um doing several of the uae uh areas and and you know i was talking to them about their their businesses and they said well you know the government's really promoting uh entrepreneurism you know, but, uh, but the government was the key offender. I mean, these guys could be profitable, but they were having to wait 120 days if they did business with the government of getting paid. And so actually I think one of them, uh, I think Oman was going to actually have me come back and

01:04:16talk to their finance ministry to say, listen, if you want to spur entrepreneurism, I got a simple answer for you. Just be the, be an exemplary payer. Pay faster. You're going to, you're going to pay it. You have the money. I, you know, don't. And, and, and I will tell you, I I've come to this very harsh conclusion. If, if you want to be a third world economy, just slow down the payment of things. If you want to be a first world economy, just make margin flow fast through the economy.

01:04:46That's cool. Because, you know, when I went to Kenya, there is no lack of demand in Kenya. it's just that it's just it's a dysfunction of terms of how fast cash flows through the system and and here's what happens when you have slow moving cash in the system or a marketplace only the big boys can play because they've got capital and see this is what has opened up like the u.s i mean cash is not a problem it execution is our only problem of creating successful growing

01:05:19businesses in the U S now that starts to separate the herd a good bit because there's those who can't actually. Yeah. Yeah. Yeah. But it's, it's a wide open, you know, race. And, and I think Australia, you know, from my clients that I talked to down there, I mean, I think you guys are pretty much kind of in that same mode. I don't, I don't see matter of fact, like I said, in the staffing business, you know, you, you know, my client there had better payment structures than our clients in the U S I I think it's the same across every country in the West is that, you know, there's a percentage that do and there's a percentage that don't.

01:05:54The percentage that do well is the smaller percentage of the general kind of business. See, here's my hope. I honestly think it's just we just don't know how to talk about it. And this is as I've, you know, we've been operating under this philosophy that's in the 2.0 book, you know, for about four or five years now. but much more so in the last three, I would say. And what I'm seeing is we've seen more success of people transform their

01:06:25business into a high return on investment business where the 20 years previous it lacked. Yeah. And I think that's because of accounting discussions and this kind of complex calculations. And, you know, like straight after I did the Vern Harnish podcast, I purchased the book because he said, you know, like to buy this book. And it just gave the words. It gave words on how to think about things. And it's from an accountant that said, don't worry about that accounting talk.

01:06:56These are the things that you need to think about, which the accounting industry just doesn't talk about, you know, across the board. And they don't teach. And you've really put words to a concept that is really easy to understand. But these two books, like they're fantastic. They're not long, but there's a lot of super simple, some calculations in there, of course, right? Like, you know, but it's just such a good way to think about that. But I think it's given, or it gives,

01:07:29especially smaller businesses concepts that they can start to apply, right? And it helps people make harder decisions on the business side of things, you know? And so it's such a fantastic book. And now I know why Vern Harnish is such a proponent of it because it's simple to grow if you know what to focus on. Yeah, I'll give you some inside baseball knowledge here. Last month, I went in the studio

01:08:01and finally recorded the audio version of the first book. So that actually will be coming out here probably in the next month or two. And then in a couple of weeks, I actually go back to record the second book. So we'll have both of them out in audio format. Which is great because, because I love to listen to books and I couldn't find that. I'm like searching for Greg, I'm trying to on the audible app. I'm like, it's not there. Damn it. I have to read it. It's coming. It's coming. Lucky enough. It was short enough that it was easy enough to read and also scan to get to

01:08:32the parts, which are maybe applicable for you. You know, I think, you know, this is highly recommended for anybody that is responsible for how, the budget is spent within an organization. It's fantastic for entrepreneurs, but it's also fantastic for anybody that has to drive profitable growth. What's been fun is, yeah, the first book I would say is definitely that aimed at the 5 million and under business because I'm trying to break through some bad ideas. But we've actually found even 20 and 30

01:09:04million dollar businesses that found the things I talked about useful. The second book, really to me, you know, is, is knows no beginning and end in terms of scale. We've actually found a lot of our much larger businesses, especially in the, the ones we do a lot of segment work with a lot of the bigger businesses, because let's face it, if you're a $20 million business, you're, you're probably four or $5 million units. I mean, they may have different values. We just did a, finished a project with a $20 million, you know, uh, HVAC, you know, client and, you know, and they

01:09:38did like they had eight divisions and just totally blew them away i mean they have a really high level controller i mean they have really good data but they had not they didn't see the late the direct labor efficiency ratio was the first thing that really jumped out at them by division because they some of the things that they were scaling were the things that had the lowest leverage of labor and it's like listen guys this isn't where the gold is this division over here. This is the one that's got the better leverage factor to it. And then when we applied

01:10:13the cash flow terms to each of those, oh man, when you start looking, so one of the things when I'm doing segment accounting is I look at contribution margin dollar per trade capital dollar invested. And boy, you want to talk about an eye opener. When you start to see here's the true operating cash flow that I generate from the trade capital invested. And here's the one that's, you know, so one, they had a parts division. They were basically paying for the parts division. I mean,

01:10:45it basically, I mean, it was just awful, you know, and once you see the data, you start to ask different questions. And I think the larger a company gets, the more one department subsidizes the other department and like that's where it gets harder to continue to get the double digit performance every year because you don't know which part is supporting the other part because it's all combined it's all connected but listen this has been such a good chat um and i've been

01:11:19so happy to just uh to completely unpack this this topic um the book's available on amazon the book is coming soon to audible um so are you taking on additional clients and if so how can people contact you yeah the you know the best thing uh there's a contact page on the simple numbers.me website that you can reach out like i said we we have clients in australia so we we work across you know all time zones there's there's a time zone that fits so typically uh we've either done you know for us either super early in the morning or late in the evening we

01:11:52we don't mind that. Just like this podcast right now. I can see the lights going up. You know, yeah. So, so these are, you know, our, our staff, I mean, you know, it's really kind of cool that, you know, it's something that I, you know, whereas our firm really, you know, doesn't think about things, you know, globally, they're, they're focused, you know, you know, pretty much in the, the, from North Carolina to New Mexico kind of, you know, kind of footprint, but, but ours is, you know, we still do what we do, you know, globally as well as some of the other units. and really to me, I've always looked at it as a way to challenge my thinking, to validate it and

01:12:27say, hey, you see different parts of the world operate slightly differently, but at the end of the day, entrepreneurism is entrepreneurism. And I do have plans to get a book tour and go through Australia, New Zealand, hopefully next year. So kind of targeting for March of 22 that I can get down and do a long awaited tour in the region. So that'll be fun.

01:12:58I've been to Sydney and Melbourne before, but we'd love to get back and see the country coast to coast. For sure. I can't wait for travel again. I think all of us would like that. Thank you so much for coming on the podcast. It's been such a fantastic conversation, Greg. Thank you so much. Good deal. Appreciate it. Thanks for listening to the Growth Manifesto podcast. If you enjoyed the episode, please give us a five-star rating on iTunes. For more episodes, please visit growthmanifesto.com forward slash podcast.

01:13:30And if you need help driving growth for your company, please get in touch with us at webprofits.io.