Defining the Health of Your Business

0:00Ryan:Don't focus on growth as much right now. I mean, yeah, grow, but if you grow, you might grow yourself into oblivion. Like, let's focus on profitability for a season.

0:10Roland:How much more successful would you be if you had lunch once a week with insanely successful entrepreneurs who share their biggest secrets on how they think and achieve success? Grab your seat at the table, because this is Business Lunch with Roland Frazier and Ryan Dice.

0:28Roland:Welcome to another episode of Business Lunch. And today's a snackable episode with Roland where he's going to get into some more tactical strategies that you can start using to live a rich and happy life. If this is the first snackable episode you're hearing, I'd encourage you to go back and listen to some of the other episodes that Roland has put out. And if you want to get notified every time we release a new episode, go to the new businesslunchpodcast.com website, and we'll send you detailed notes along with every episode. That's businesslunchpodcast.com, www.businesslunchpodcast.com. And you can sign up for the free email newsletter where you'll be able to get all the highlights and resources from the episodes.

1:03Roland:Hey, everybody. Welcome to another episode of Business Lunch with your host, Roland Frazier. That is me and your other host, Ryan Dice, which is not me. That's me. How are you doing?

1:14Ryan:I'm great. I'm really good. I'm feeling like feeling like things are getting back to what I would classify as some version of normal. You know, we've had quite a season of late with lots of I think a lot of entrepreneurs and, you know, people go through this where you get into a super busy season. And even though it's your work, it doesn't feel normal. I guess it's I guess it's equivalent to like if you're an athlete and you're in the playoffs kind of thing. Like that's the goal of what you want to have happen, but it doesn't feel normal. And so it's kind of nice, I think, to get on the other side.

1:42Ryan:It's like, I'm just going to be doing spring training and kind of getting ready, getting back to quote unquote normal.

1:46Roland:So, so you had a kind of an interesting conversation with one of our founders board people, as I recall, with a pretty cool question. You want to share a little bit about that?

1:55Ryan:Yeah. Yeah. We were doing just every, every month, like just in kind of an open AMA office hours, like let's talk about whatever you want to talk about with our founders board members. And somebody asked a question and they're always good questions. I mean, these are smart people, successful entrepreneurs, but it's rare that people ask me a question where I just don't have some kind of answer. And that sounds super arrogant. I get it. But, you know, you do enough of these things. You kind of get asked the same questions a lot of times. It's not that they're bad questions. It's just we dealt with them.

2:23Ryan:But I've never been asked this question before and I didn't have a good answer. So I told him, I was like, I'm sorry, I don't have a good answer. Let me think about it. And the question was, what do you believe is the number one business health metric? Like what is a metric that you could track to really understand the health of your business? So not I mean, there's lots of metrics out there with respect to growth, profitability, value, things like that. But when they use the term health, like how healthy, you know, really is, you know, is my business? I thought it was such a good question because, you know, I think as as entrepreneurs and CEOs, we want to make sure we're building healthy businesses as as investors.

3:00Ryan:Right. If we're going to invest in a company, if we're going to acquire a company, I think it's important that you, you know, have a really good understanding of how healthy is the business that you are buying. And so it's such a simple question that didn't have a great answer. I didn't have a great answer to maybe you will. And maybe other people like Ryan, there's this obviously these things out here that everybody knows about. And I'm going to be exposed for the moron that I am. But I'm just curious, like, I've thought about a lot. I'm happy to reveal what I was thinking. But I'd love to know just kind of first glance, since we're talking about this first time, what do you think?

3:29Ryan:I'd love to hear what what was the first thing that came into your mind when they asked? So the first thing that popped into my mind was NPS, Net Promoter Score. You know, I thought about that. And if you don't know what Net Promoter Score is, it is basically on a scale of one to ten. How likely are you to refer this product or service to a friend or colleague? And I know the folks, and I believe in NPS. I think it's great. I think it's certainly limited if you take it out of the context, if you don't look at overall engagement and stuff like that. And I know that the people at Net Promoter Score would love to say that this is absolutely your kind of number one health metric.

4:08Ryan:They would want us all to believe that. But we know from experience, both businesses that we've owned and businesses that we've been partners in, that it is a metric that if you want to game it, you can game it. And so I was thinking, you know, if this is going to be like the number one business health metric, it should be something that isn't easy to game. and it also should speak to more than just what is the the customer's perception of the product and experience i think customer percent like customer experience is a big aspect of it but it's not all of it and so then i started thinking about you know in terms of um i thought about revenue per employee right revenue per employee because revenue per employee would certainly speak to how efficiently you know are you running your business since you know in general people costs are our biggest uh expense for most for most companies people's gonna be the biggest expense area, you know, but you can have a high revenue, but not be profitable.

4:58Ryan:So maybe look at profit per employee was kind of where I went to next, but that still didn't speak, you know, enough, you know, some of the other aspects of, of, of business. So, um, so those were ones that I thought about. I don't think they're bad. I think they could be really solid metrics to look at all of them. Um, and I think they could, they, you know, probably should be some of those evergreen metrics that you just track. Like I know for us at the top of our, the, the company scorecard, We're always looking at both NPS and revenue per employee. These are metrics that we're tracking. But are they the number one business health metric ultimately?

5:30Ryan:I was like, nah, I don't think so. So what did you settle on and how did you come up with it? I want to hear if you've got any ideas before I say mine.

5:37Roland:Mine is, so I think most of those things, because you could also look at some of the financial ratios like debt to equity. And all of those are things that buyers consider when they are trying to determine, is this a company that we should invest in, right? And including ENBS, like your employee net promoter score as well. How likely would you be to refer a job at this, you know, to recommend working at this company to a friend? I think those are all good. But if I was going to try to, to, as if I had to pick just one, which I think is difficult, it probably would have to be compound annual growth rate of profit.

6:16Roland:Because looking at anything that is a measurement in time right now, that's tough. Because you might have a very high NPS right now. You might have a great debt to equity ratio right now. You might have any of the things all clicking. You might have a great valuation. Your stock price might be high. You have a compound annual growth rate that's high. but um but in this moment it doesn't really tell you about kind of the health of the company it just it's a snapshot versus a trend so i would like compound annual growth rate of profitability because it'll tell me that this is a company that over several years has been able to continue to be in business and earn a profit at a higher rate and over time break that down if i don't know

7:06Ryan:immediately what that is break that down for me how would i go about figuring that out i would

7:10Roland:to say, what is the rate at which my profit is compounding my EBITDA if you're in a professionally managed business or my SDE, my seller discretionary earnings if you're in an owner-operated business, but is my profit compounding at a healthy rate over time? So I think that's a pretty good way to look at it because it's going to take a period of years into account and you're just going to basically say, how's our profit growing, right? That's the one that would work for me because it's trend-based and you have to have some way. Now you could be destroying your customers at a terrible rate and serving no one and doing a bad job.

7:52Roland:And just somehow you've got an offer that continues to drive people in for some period of time. Ultimately that will blow up, but so I think you can game anything, but that's probably the one I would look at. What did you come up with? Yeah.

8:03Ryan:And I do think it's important. I think one of the lessons is that there's probably isn't one there isn't it probably is going to be yeah it's going to be a combination of things but i think if you distill it down and say yeah but what if i had to distill down to one what would it be it creates some interesting ones so just so i understand yours um the one that the one that you recommend that you were thinking about it is not how much profit did we generate over a period of time it is how what is the growth of our profitability over time Right. Do we have that expressed as a percentage or as a dollar amount?

8:35Roland:Well, the growth rate would be a percentage. So basically it's like, is our profit growing at a healthy percentage, which, you know, 20 % would be fantastic over and compounded over a period of time, because that's going to take into account a whole lot of things.

8:50Ryan:Yeah, I think we're thinking along the same lines, which is good. I think yours, and I'm not surprised, is a bit more sophisticated than what I was thinking because it takes into account time. But I was thinking just distributable cash. And I was purposefully trying to not come up with a metric that already had a meaning because I thought about free cash flow. That can mean different things to different companies, bookkeepers and accountants, we'll call that. I didn't necessarily want to say, because I thought about profit, but my thinking about profit is sometimes you do want to pour profits back into the company.

9:23Ryan:And so when I thought about distributable cash, it really was like, maybe we chose to put it back in, we chose to reinvest it, but we could have distributed it, right? We could have distributed it and we could have still, you know, achieved certain kind of growth. And so especially maybe if you were to look in and say, like, well, what if we weren't going to do as much, you know, lower down R &D to lower levels, Maybe you're above industry standards and those kinds of things. But to come up with and to say, what is the distributable cash? How much cash could we distribute in the form of dividends, distributions, whatever you want to call it, and still maintain a solid growth rate?

9:59Ryan:That, to me, when I thought about it, number one, it suggests that sales are strong, right? You really aren't going to be able to have distributable cash unless you have sales coming in. And the first thing that goes away, if sales dip, generally the distribution stop. Right. You're going to keep paying employees. You're going to keep paying rent. You're going to keep paying all of your other stuff. You're just going to stop paying yourself. Right. Especially for entrepreneurial companies, which is a lesson that you taught me. You don't want to do that. Right. But that is generally the first one that gets lopped off.

10:27Ryan:It also suggests that you're running efficiently, you know, from operationally speaking, because I know in the past we've been guilty. and by that I mean the companies we run, not necessarily just you and I specifically, but our companies have been guilty of reinvesting too much quote-unquote profit and basically allowing inefficiencies to run amok for the sake of and calling it R &D. Call it like we're trying this new thing out.

10:53Roland:I think we've got some giant R &D credits that we're going to be able to get.

10:58Ryan:Oh, yeah. Oh, yeah. Yeah. Yeah. We definitely have some giant R &D credits because we are indeed the hell out of some things. But I do, like, the reality is you should be able to do both. You should both budget in testing in R &D and profitability. The two are not mutually exclusive. Like, there's a point in time where maybe a business can't afford to do it, but I would say at that point in time, it's not as healthy as it could be, right? If you can't both have free distributable cash and fund growth and fund, you know, as healthy as you could and probably should be. Things just aren't turning over.

11:34Ryan:It also suggests that cash is being managed effectively because P &L is a lie. Cash doesn't. How are you calculating distributable cash? That's what I'm saying. The reason that I came up with this metric is I wanted to come up with something where the business could define it based on what they feel like it is. I wanted to add some ambiguity into it. The way that I would generally define it is the actual true free cash flow that popped to the bottom line that could be sent out. But also, let's say you're saying we want to make a big investment in something that is unrelated to the core business.

12:14Ryan:We understand that we're taking a flyer on it. We don't have to do it. I would add that back in into distributable cash. Because as a buyer, if I were buying that business, I could decide, well, I'm not going to make that investment. Whereas I wouldn't add back in all R &D or all testing because any business to continue to function, run and operate is going to need to have some budget for testing in R &D. Does that make sense? It does. It does. And obviously anything that was actually distributed would be the purest form of it. Like how much do we actually send out? And so that was, I mean, for me, that's where I came up with.

12:48Ryan:And I thought about it. I think you know this, but in a former life, the only job I ever had was as a financial planner. And one of the things that they taught us, it's like the only thing I remember, is that a really good stock investment strategy. By the way, this is not investment advice. But there are people out there who a core tenant of their investing strategy is to buy dividend-producing stocks. Like to only buy companies that are growing and that have a dividend. And specifically, you're looking for companies that have increased their dividend, to your point. and I don't remember the paper, maybe somebody else could look at it, we could drop it in the show notes, but there was a whole study that was done on if all you did was invest in companies that steadily over time had increased their dividend, you would beat the market, right?

13:35Ryan:You would steady beat the market if you factored in, especially if you were to dollar cost average and do stock purchases from the dividend reinvestment type stuff. So that to me says, if it works for the big companies, why wouldn't it work for the little companies? So make it about distributable cash. I love the idea of adding in your metric of the rate of growth of distributable cash. How much is it increasing? So anyway, that's what I was thinking. And again, it's not a hill I'm prepared to die on if somebody feels like they have a better one. But I would encourage anybody here to try to come up with what should a business health metric be?

14:10Ryan:Like, is there some metric that we just look at to know that like, OK, across the board, we're doing a good job. And I think if distributable cash, if that works for you, do that. growth and profit, you know, the profitable growth month over month, year over year. I just wanted something we could track monthly. So yeah, I like it.

14:24Roland:I think the one thing for people to think about that, that they may or may not know is that when you're thinking about choosing something like this, you're, you know, I do think over time is a good thing to look at. And so like, if you were looking at a number like cash on hand at the end of the year or something like that, that would be a balance sheet number. And the balance sheet is a snapshot in time. So balance sheets are dated as of the date that the snapshot occurs. So you would have a balance sheet that might be dated December 31st, whatever year it is. And it only represents what's happening on that day.

14:59Roland:So if cash on that day or other assets were one thing, but then the next day something bad happened or a big payment was made or something like that, the next day literally everything can change. the nice thing about an income statement or a P &L, a profit and loss statement, is that it is over a period of time. So it'll say for the period from January 1 of whatever year through December 31st. So that's representing longer period of time, not just a single snapshot. And then when we start looking at trend type things like compound annual growth rates of different numbers that are on there, we're getting to look over a span of years.

15:39Roland:And so I think whenever you're thinking about how can I see where I stand, where you stand right now today might be radically changed tomorrow. A recent case in point would be the FTX exchange that was worth, I think 30, that was, I think it was worth 34 billion one day and listed as a dollar the next by Bloomberg. So like that, which is less that snapshot in time of that one day to the next day, that was the pretty, pretty big change. But yeah, I think it's great. I don't think the number that we picked was terribly different because I would say I would be kind of curious because you were looking at being basically a stockbroker 20 years ago more.

16:18Roland:Oh God. Yeah. Yeah. 20 years ago. Cause now I think that like one of the things that we always have to think about is what's going to increase the value of the company. And so a lot of companies that don't pay giant dividends plug the money back either into buying stock to increase the net shareholder value, or they put it into growth things. And I think that, I think probably now it'd be interesting to look at that study because I remember seeing that, that as well. And I bet you over the last 20 or so years, it's that, that wouldn't still hold compared to the people like the big companies that didn't do distributions or didn't do great ones are the trillion dollar companies that are out there now, I think.

16:59Roland:So it'd be kind of interesting. I hadn't thought about that in a while, but that'd be something to look at.

17:03Ryan:Yeah. You definitely miss all the growth stocks. if you do that. You're playing in the value stock game. And so I think the idea there is, you know, you're not swinging for the fences. You're not trying to hit a grand slam. It's basically how do we do better than the market without taking too much downside risk? And I think the same, frankly, is true for us, for our companies. I mean, as entrepreneurs, as investors, we make the same decision, right? There are plenty of people, entrepreneurs, who make the decision to shoot for the stars, to take that VC money and to basically say, this is going to be a billion dollar company or bust, right?

17:37Ryan:At a certain point, you take enough, you take enough VC money, you got to get to VC level scale, or you're worth nothing, right? And so that is kind of taking that growth path. And there's plenty of other people who go the bootstrap route. And, you know, they have really solid companies, in many cases, multiple, you know, of them that deliver, you know, life changing results, but not necessarily at the same orders of magnitude as, you know, I don't know, a Zuckerberg. So, you know, I think it's a, I think it's a choice. I think it's important to know the game that you're playing, right? Are you playing a game for growth?

18:08Ryan:I think the mistake that a lot of entrepreneurs make is we don't think enough like investors, right? I think a lot of entrepreneurs think very much like, this is my baby. This is my thing. I, you know, this is the only one that I got out today. How much cash can I take out today? Or the inverse, I need to make sure that it grows and it gets all the love and nourishment that it needs. And therefore, if I wither and die, that's okay because the company's more important than me. And I think it's good. More than anything else based on what I've seen. Good Lord, it certainly is what the media has been telling us we should be doing.