Unless you have a background in accounting, managing your business’s finances might not feel intuitive. Many of us begin our entrepreneurial careers with a great idea. We spend the rest of that career trying to understand all the moving pieces that will make it profitable.

There are people that will give you numbers. They'll share formulas, frameworks, rules, and guidelines for how to structure your business’s finances.

The truth is that there’s no clear rulebook. These profit and investment calculations are individual to each business.

So why even write about it?

There isn’t a one-size-fits-all solution. That doesn’t mean there aren’t concepts every business owner should think about as they answer the crucial question: do we maximize profitability or do we spend money?

Profit first? Profit last? Profit never?

If you start looking, you’ll find all those recommendations for exactly how to do it.

Invest 30% of your profits back into your business.

Invest 50% of your profits back into your business.

Invest all your profits in the first two years.

Take your profits first, so you don’t end up investing everything back into your business.

Let’s talk about that last one - the Profit First model. I’m picking that one out because it’s popular right now, and some of my clients follow it.

The profit first model, created by Mike Michalowicz, is a relatively simple concept — a budget for businesses. Michalowicz flips the traditional idea of paying expenses first and taking profits second. Instead, he encourages business owners to allocate a percentage of every dollar that comes into their business to profit. Similarly, a percentage goes to taxes, to expenses, etc.

By following this method, Michalowicz says companies will be more profitable. They’ll think more carefully about each expenditure they make. Their profits will be more than what's left over at the end of the year.

I see the benefits of Michalowicz’s model for creating discipline, especially for people who’ve never run a business before. It could be helpful if you’re worried about your emotions getting in the way of your financial decisions.

My problem is that it takes away an entrepreneur's agility and creativity. Sometimes huge growth leaps come from taking financial risks that lead to a year with very little — or no — profits. Hopefully, they turn into huge profits in the future. Tying yourself to a predetermined budget that focuses on profits (rather than growth) first may come at the expense of...well, growth.

You could coast along, doing what you’re doing. Maybe you pull a million dollars out each year as your salary. You roll like that until you run the business into the ground. Maybe it goes seven years, and you walk away with $7 million.

But what if, instead, you took half a million of those dollars each year and reinvested them in the business? Maybe in seven years, you’re worth $50 million.

It’s like the famous Stanford marshmallow experiment. As a four-year-old, would you have waited 15 minutes to get two marshmallows? Or jumped for a single marshmallow right now?

Scenario analysis for agility

At the most basic level, if you’re not reinvesting in your business, you’re not going to grow. And yet, choosing when, where, and how to make those investments can be challenging.

Scenario analysis helps you identify what you’re actually choosing between (or among — maybe there’s a third option? If you wait 30 minutes, you get 100 marshmallows).

To make those decisions about whether and where to reinvest, you need to have a thorough understanding of the landscape.

So imagine you’re sitting at a blackjack table. (Humor me as I jump from toddlers to gambling.)

You know what you’re starting with. You’ve got your bet and your hand of cards. The minute the dealer puts the first card out on the table, the scenario changes. There are new possible outcomes, and you have to consider those as you make your next move. Do you draw another card? Do you double down?

You know where your business is today. You know how you got there. Scenario analysis is all about looking forward and improving your agility. No matter what card gets played, you know how you’re going to respond.

And you’ve made the necessary investments to allow for that response.

If this pandemic has taught us anything, it’s that we need to prepare for and expect the unexpected.

How to create a scenario analysis

Start with where you are today and your hypothesis for the future. For instance, say you made $1 million in profits this year. You hypothesize that reinvesting half of that profit will increase your business’s valuation.

Next, you map out the scenarios. What are the actions or events that might help make that happen? What are the decision points? What are the other scenarios that could occur?

You can assign probabilities to each of those scenarios. This one’s 50% likely to happen - that one’s only 25%.

What you’re building is a decision tree. You’ve got your hypothesis. You’ve got the scenario that gets you to your intended outcome.

But there are lots of other scenarios that could happen at each of these critical points. How do you respond to a scenario that takes you off your hypothesized path? Does it change your goal? Does it invalidate your path? Do you need to change your strategy?

This decision tree becomes your guide for identifying where to reinvest your profits.

If you know that you want to increase your revenue by a certain percentage next year, you can analyze the paths to that outcome. You can identify which investments have the highest probability of success.

Maybe you anticipate an economic downturn. So you put extra cash aside (increasing your operating reserves) rather than reinvest as much as you normally would.

You’re making decisions based on your understanding of these probabilities. None of us is infallible, so are you ready for what happens if the less probable scenario actually occurs?

At one of my startups, we’d invested everything in one path. We were on the road to being acquired, and we put all our eggs in that basket. The acquiring company backed out at the last minute, and we weren’t prepared for that possibility.

We made a quick and emotional decision to prepare to file for bankruptcy.

It was the next safest path for us. Fortunately, we knew enough to simultaneously pursue some alternative paths in the hopes of a different outcome. We were lucky to make one of those happen. Planning for the unexpected path is one of the most important lessons I’ve learned as an entrepreneur.

Avoiding analysis paralysis

Of course, the danger with scenario analysis is that you’re never done analyzing. You’re always learning new things, and markets are always changing.

Perhaps you’re too highly detail-oriented, and struggle to make a decision. (Not sure? Get assessed.)

You can’t let it push you into analysis paralysis.

You’re an entrepreneur. You must make decisions and take risks.

A common scenario we see with early stage entrepreneurs is struggling to decide about a tipping point hire. It’s risky because the company has just gotten to the point where they’re profitable. But everyone’s working too hard. If they hire that next person, they’re no longer profitable.

So when do they take that risk and reinvest the profits in personnel?

They have to go back to their goals and identify whether that hire will move them forward. If it will, then waiting to take the leap will only hold them back.

Final thoughts

As with many aspects of starting and running an organization, there’s no simple answer. Or perhaps there is: Your business should invest the exact percentage of profits that will allow you to achieve your goals.

Maybe the answer is simple after all. Figuring out how to get there is the challenging part.

We’ve been there many times, and we’re ready to give that outside-in perspective that will help you use scenario analysis to your best advantage. Contact us.