When your small business starts turning a profit, what do you do? The more impulsive among us might decide to spoil themselves with dead-end purchases or luxury goods. Although these luxuries are tempting, they’re antithetical to long-term growth.
Reinvesting small business profits back into your company is the best way to ensure its longevity. While more short-sighted business owners might grow complacent once they start generating substantial profits, every successful entrepreneur should look to the future when deciding where to allocate their new cash inflows.
If your business has recently become profitable, you may be considering reinvesting your earnings to drive development. To help ensure you’re reinvesting wisely, we put together this quick guide to putting your profits to work.
We’re often asked: what is reinvestment? In so many cases, aspiring business owners and new entrepreneurs haven’t taken the time to learn about the value of reinvesting profits.
In short, reinvesting occurs when net profits (i.e., the income left over after all operating costs and overhead are paid) are retained and invested toward activities or expenses that aim to increase the value of the business. Alternatively, reinvesting can also refer to a cash payout to shareholders in the form of a dividend.
Small business owners are usually concerned with the former—using net profits to increase the value of the company over time. As a business expense, reinvested income isn’t taxable.
Where to Reinvest Your Profits
The decision isn’t always so clear-cut regarding where you should be putting your profits to work. Depending on your business’s growth stage, you may be better served by starting small and upgrading your website’s servers and hosting. Or, on the other hand, it may be wiser to hire a high-level employee or even purchase one of your competitor’s assets outright.
Below, we’ll break down the top five areas where profits should be allocated when reinvested. While it might entail taking a small pay cut, cycling cash through the business can go a long way toward ensuring future growth.
Marketing and Advertising
There are few line items in a small business’s budget more important than marketing and advertising expenses. Today, digital marketing is quickly becoming a necessity for small businesses to enter the market and capture a sizeable portion of market share.
A marketing strategy is a must for business owners. The only downside, however, is that leveraging traditional marketing platforms can be costly. This is why online digital marketing is now one of the most cost-effective means for increasing a small business’s exposure. Today, a small business’s marketing strategy should include the following components:
- Search engine optimization (SEO)
- Content marketing (blogs, videos, etc.)
- Affiliate marketing
- Influencer marketing
- Facebook and Google ads
- Email marketing
As digital technologies become more pervasive, digital marketing is becoming more and more effective. For instance, 87% percent of U.S. internet users with an income of $70 thousand or more use Facebook. Who wouldn’t want to tap into that market demographic?
Investing in human capital is a necessary expense for any small business that wants to ensure its long-term growth. The expertise required to grow and lead your team is invaluable, so to reinvest profits into hiring new personnel is imperative from time to time.
However, retaining your top talent is equally important. Therefore, we recommend reinvesting some of your business’s net profits to provide continuing education and training for your employees and, eventually, offer benefits packages and bonuses. This way, your team will be more motivated to stay on board and will be better equipped to face new challenges.
For most small business owners, reinvesting small business profits usually implies the purchase of new infrastructure, personnel, tangible assets (like company vehicles), and equipment. Whenever we’re asked, “what do companies do with profits,” this is our first answer.
Spending on capital upgrades is not only a wise decision for new businesses, but it’s usually long overdue when it happens. If your product is manufactured overseas and you’ve been receiving complaints about the build quality of the material, you should consider switching to a higher-cost producer. This is just one case of an overdue capital improvement investment that often leads to higher profits in the long run.
Most small businesses lack the cash flow for acquiring other businesses or their assets. However, as your business grows, one of the best long-term decisions you can make is to buy the rights (or outright acquire) another company’s assets to do to your portfolio.
To be sure, mergers and acquisitions are complex—but they tend to pay off when companies leverage them effectively to acquire greater market share. Facebook is an excellent example of a private company that was able to buy out some of their fiercest competitors and add their technologies to their portfolio (such as WhatsApp and Instagram).
A Cash Buffer
One of the best ways to safeguard against early failure is to invest in a nest egg to be used if problems arise. Many entrepreneurs enter the market with the assumption that their startup capital will be enough to last them through to self-sufficiency. This isn’t always the case.
Instead, make sure you set aside a contingency fund. This money will be there as emergency liquidity if disaster strikes. For peace of mind, we always recommend having a nest egg for the following unplanned contingencies:
- Cash flow issues
- To capitalize on low prices
- Buying out a competitor
- Rent Increases
- Tax bills
- Penalties and fines
Accountants refer to emergency funds as “retained earnings” because they are, well, exactly that: profits that are held in reserve for undetermined future use. This “just in case” cash fund should be seen as a deferred reinvestment of your profits, only for use later.
Knowing how to reinvest profits into your business starts with knowing your worth as the chief executive of the company. Even if you view your role as being more “hands-off” than other business owners, you need to prioritize the development of your skills and personal assets if you expect the company to develop too.
Taking continuing education classes at a local business school, or enrolling in a professional development workshop can go a long way in developing the “soft skills” needed to succeed in business leadership positions.
The Advantage (and Disadvantage) of Reinvesting
Distributing profits back into the company encompasses a range of benefits beyond the obvious. For instance, allocating profits toward capital improvements, rather than financing the expenses through high-interest loans, can help keep expenses low in the long run. Plus, nothing shows that you have faith in your company than taking a pay cut to improve its long-term standing.
Also, by avoiding external equity you can concentrate ownership of the business in your own hands. Financing capital projects and other expenses by selling equity to investors dilutes ownership of the company, which means you will have less control over your own business.
However, the downside of reinvesting too early is that it can come at a high personal cost. Many business owners rely on their company’s net profits to sustain themselves.
Reinvesting small business profits when net earnings are low can cause financial uncertainty for some entrepreneurs. For this reason, we recommend not reinvesting profits until the owners are financially secure themselves.
The Warren Buffet Philosophy
For decades, business magnate and Berkshire Hathaway chairman Warren Buffet has recommended reinvesting small business profits to help launch fledgling enterprises. To Buffet, the logic is simple: compound interest leads to exponential growth.
When small businesses take their early net profits in Year 1 and reinvest it on capital improvements, a higher rate of return is produced over time. By Year 10, the value of those reinvested profits will far exceed what it would’ve amounted to in Year 1.
Reinvesting: The Smart Strategy
When profits first start to trickle in, many entrepreneurs and business owners get caught off guard. Rather than making their money work for them, inexperienced small business owners will treat themselves to lavish rewards and loosen the belt a little too much.
Profitable businesses should always look to the future with long-term sustainability in mind. This is why we recommend taking your initial profits and using them to expand your product range, hire new staff, or consult experts. In this way, reinvesting small business profits should be seen as a way of “paying it forward” in the sense that you will reap the reward in future earnings.
Startups and small businesses cannot afford to be complacent. Every reinvestment in your organization represents a seized opportunity: to add an interest-free cash infusion to your balance sheet that will create lasting value for your business that will be worth more tomorrow than it would otherwise today.