Pay Yourself First vs. Invest for Growth
Our Business by the Numbers: May '24. We're bootstrapping founders. We don't pay ourselves unless our business makes money, but if we pay ourselves, the business lacks funds to grow. What comes first?
Bootstrappers’ Dilemma
We’re almost at the halfway point of 2024, and yet we feel like we haven’t made much progress at all. We’ve known how much work starting this venture would be, but we didn’t know how much time and resources our primary responsibilities as stay-at-home moms would take.
We are constrained by:
Time - Because we have kid(s), finances, and households to manage, we already have a full-time job and then some. Those take priority because they enable our partners to work, who play the role of primary bread winner. Hence, we have less than half the time that other founders in our situations.
Capital - This is somewhat a self-imposed constraint. We are choosing to bootstrap instead of actively getting financing. There are a few reasons for our deliberate decision to bootstrap.
These two limiting factors are significant.
What to do with $50K?
By the end of June, we estimate we’ll have $50K in net income to tap into. This level of capital can make a sizable impact on our business to help remove capital as a constraint at least for the rest of 2024.
However, should we use this capital to re-invest back into the business or contribute to our 401Ks?
Recall that to date, we have not paid ourselves anything from the business’ profit.
Pay Ourselves First: Maxing Out Our 401Ks
For as long as I’ve been making money, I’ve followed the budgeting framework as “pay yourself first”. Naturally, in my own business I want to ensure we do the same. A follow-up saying goes “it’s not timing the market, but time in the market.” One of the primary reasons to pay yourself first is to ensure you’re giving yourself enough time to invest in the market for the effect of compounding to pay off.
Example: Scenario #1 - Pay Ourselves First - Pre-Tax
That’s start with…
Net profit of $50,000
Then withhold 15.3% for self-employment tax
401K Maximum individual 2024 limit is $23,000 per person
Therefore, invest $42,350 into 401K all into S&P 500 index fund (i.e. VOO)
Assuming an annual return on investment of 7.5%, which is the 30-year inflation adjusted annual return for the S&P 500:
Investment balance after year 1 — $45.7K
Investment balance after year 3 — $52.8K
Investment balance after year 5 — $61.0K
There are some inherent assumptions not stated here. For example, we the tax rate upon withdrawal will be minimal, which is why we look only at the balance and not consider capital gain taxes.
Example: Scenario #2 - Pay Ourselves First - Post-Tax
That investment balance is significantly lower if we take a look at after-tax dollars, ie after we max out our 401K contributions. Using the same numbers, we re-run the previous example but instead take a chunk out for taxes.
Using the same numbers (with changes from Scenario #1 in bold)…
Net profit of $50,000
Then withhold 40.0% for federal, state, and self-employment taxes
401K Maximum individual 2024 limit is $23,000 per person
Therefore, invest $30,000 into 401K all into S&P 500 index fund (i.e. VOO)
Assuming an annual return on investment of 7.5%, which is the 30-year inflation adjusted annual return for the S&P 500:
Investment balance after year 1 — $32.3K
Investment balance after year 3 — $37.3K
Investment balance after year 5 — $43.1K
Because of the high tax brackets we sit in along with our higher state income tax rate, our income takes a huge hit from taxes.
Note that even after 5 years, our investments don’t even climb back to the original net income balance of $50K.
Reinvest for Growth: Outsourcing Work
If we were to invest the full amounts towards the business, we would want to know what is the breakeven return on investment. We also know that it takes time for our business to pay for itself, so let’s make some assumptions and some simple calculations.
Starting assumptions…
Assume that an investment into the business will take 3 years to pay off
We ignore all future cashflows to simplify the calculations
We assume any return on investment will be taxed at 15.3% self-employment rate up to $50K and 40% for every subsequent dollar.
What return is needed if it pays out after 3 years?
Breakeven return on investment for Scenario #1 (Pay into 401K) — 34%
Breakeven return on investment for Scenario #2 (After tax profits) — 10%
This return on investment isn’t actually outrageous. For example, Morgan & Westfield, an M&A firm, estimates that small businesses that aim to be sold or purchased should yield an ROI of 25-50%. This gives us confidence to proceed to invest as much as we need to for our business. If we aim to be a successful small business, we’ll need to be able to yield those returns anyways. If we can not yield these results, we will have to fold.
So we’re going to bet on ourselves and plow capital back into the business. Onwards and upwards! 🚀🚀🚀
May 2024
The Numbers
All numbers on a cash basis, i.e. transactions that take place in May 2024.
Revenue: $4.65K
Expenses: $4.25K
$1.3K from one time travel expenses and event expenses
$1.9K from contractor expenses. ~$75 per hour cost.
Net Income: $400
Cash on Hand: $34.9K
Accounts Receivable: $12K
Accounts Payable: $0
Project Net Income Jan-Jun 2024: ~$45K