Being good at software development requires you to estimate responsibly and accurately. One element of a responsible estimate is knowing how to buffer estimates for risk or uncertainty. The same need arises in your business. How do you financially buffer your business for risk and uncertainty?
If you have a pure project company and have no sources of recurring revenue then the uncertainty you need to buffer against is future demand for your services. The risk you need to mitigate is that you don’t have enough work at some point in the future to keep your people busy. The extreme realization of this risk (you need to lay people off) is obviously an awful place to be. But even the milder forms have negative consequences. If you’re worried about having enough work in the future you may take on a client or a project that you’re really not well suited for. This might be bad for everyone: your client, your staff, and your company. A properly sized financial buffer can effectively mitigate these risks.
A financial buffer doesn’t have to consist solely of debt. Atomic’s financial buffer has four lines of defense:
- accounts receivable
Assuming you are consistently and predictably profitable your net profit is your first line of defense. By sacrificing your profitability you can survive situations of having less work than your billable capacity. Profitability can be used as a buffer in several ways. You might put people on projects and not bill clients for their time. You might have people work on internal projects, or explore and learn new technology or practices. You might selectively offer a lower rate to bring in a project you want but otherwise can’t win.
How much protection does your profitability buffer provide? For the examples below I’ve used the following company finances:
|Cost of Sales||$600,000||60%|
As a fraction of your revenue, given the cost of sales and expenses above, your net profit is $200,000 and your net margin is 20%. In this case, without reducing any of your costs, you could generate only $800,000 in annual revenue and run at break-even. This means that 20% of your billable people could be learning, working on internal projects, or giving uncompensated value to existing clients. While you need to be profitable to survive, knowing that you can have 1 in 5 of your billable staff “on the bench” with no immediate consequences is a good first line of defense in your financial buffer.
The second element of your company buffer is your accounts receivable. Assuming you don’t need to discount them for the possibility of non-collection, then you can look at your AR, minus your current accounts payable, as money to cover future expenses. Since AR eventually turns into cash, I’ve always combined AR and cash and thought of them as a single thing, at least for the purposes of financial buffers. I call this our rainy day fund.
How large should your rainy day fund be? A simple way to figure that out is to determine how long you could run the company under various dire circumstances. The most dire of course, is an absolute cessation of paying projects. Unless you’re very small, very new, or have all your eggs in one client basket, this is unlikely to ever happen, but it’s still an interesting extreme case to consider.
Here’s the crazy worst case. If disaster strikes then you’re clearly not expecting to be profitable. If you can’t reduce any of your expenses (a conservative assumption), you have $800,000 of cost to cover every year, or $66,666 per month. If your rainy day fund is $200,000 then you can operate the company with no reductions in staff or expenses for three full months before considering going into debt. (Remember, this assumes that you trust your AR.)
How long your rainy day fund will last in more likely but still dire circumstances can be determined in a similar fashion to the profitability buffer. Suppose a really slow time means that 50% of your billable staff are on the bench. That means you’ll only be generating revenue at an annual rate of $500,000, or $41,666 per month. Without reducing any of your costs (again, a very conservative assumption) you’ll need $800,000 per year or $66,666 per month. The short fall of $25,000 is made up from your rainy day fund. You’ll have eight months before you need to consider your line of credit.
The table below shows the duration of time in months that a $200,000 rainy day fund will last given different levels of slowdown.
|Percent of Capacity Utilized||Monthly Profit (+)
/ Loss (-)
Your final line of defense is the line of credit. It should be comforting to think that you won’t even consider tapping your line and going into debt before you’ve exhausted the substantial buffers of your profitability, AR and cash. In fact, with the 50% scenario above, you will have gone eight months with half your billable staff underutilized before you need to consider debt. But what then? It seems to me you’d have to be very confident that there was light at the end of the tunnel, and it was close, before tapping the line of credit.
Financially buffering your company is the responsible thing to do for you and your employees. It helps you sleep at night, and it can be done in such a way that the consequences of using the various buffers ramp up progressively.
- Atomic Ownership, Part 5: Distributions - May 1, 2019
- Atomic Ownership, Part 4: Financing employee ownership - April 4, 2019
- Atomic Ownership, Part 3: Valuation - January 2, 2019
- Atomic’s purpose: to be a company where work matters - November 5, 2018
- Elevating & distributing “glue work” flows out of our core principles - October 18, 2018