When does reinvesting profit make sense? Are there other things you need to prioritize before making a reinvestment in your business?
Reinvesting profit allows you to reframe profits as business expenses and avoid extra taxes. Knowing when to reinvest profit is key to doing this successfully.
This article will detail the steps you need to take and the things you need to consider before reinvesting your profits.
Endure and Prosper Through Profit
An important element of running a business is helping your business endure and prosper through profit. Profit is money that can be withdrawn or distributed to shareholders without hurting the company. By earning enough profit, you can safely withdraw revenue as a personal reward. This means the company also has enough revenue to grow and safely withstand emergencies. Additionally, you have the option of reinvesting profit to help your business grow.
(Shortform note: For your company to endure and prosper, it must be profitable, but this may depend on your industry and your company’s age. In Zero to One, Peter Thiel says many high-tech startups aren’t profitable for their first decade of operation, but they still grow and withstand emergencies. They do this by selling stock, the value of which often depends on their profit potential, not their current revenue. If a company’s profit potential is high, investors buy stock, giving the company enough money to grow and withstand emergencies. However, you still won’t receive a personal reward until your company becomes profitable: The company relies on investment money, so you can’t withdraw it.)
You can spend profit on almost anything—in contrast with your comfortable salary, which provides enough money to maintain your current lifestyle but excludes luxury expenses. The only exception is that you technically can’t spend profit on your company. If you reinvest the money, it’s an expense, not profit, because you’re using that money to help your company survive or grow. However, many business owners still refer to this concept as reinvesting profit.
(Shortform note: American tax laws classify reinvested profit as a business expense. While some use this classification to discourage reinvestment, some business owners see it as a reason to reinvest: Business expenses are generally not taxed, while profit is. So, some business owners reinvest to avoid higher income taxes. The money they save on income taxes could arguably be considered a reward for running their business (as they can use more of their salary for personal or even luxury expenses).)
Here, we’ll highlight two steps to complete before reinvesting profit:
Step #1: Separate Profit From Revenue
Separate profit from revenue before paying the company’s expenses. You can do so by allotting a percentage of your revenue to profit and putting it into a separate bank account. This ensures you’re rewarded for running the company, as that money is saved for your personal use regardless of the company’s expenses. This reward then encourages you to keep working hard and helping your business succeed.
(Shortform note: How does rewarding yourself for running your company encourage you to keep working hard? Psychologists say that receiving a reward releases dopamine, a neurotransmitter that improves happiness and encourages you to earn more rewards. In this case, it would encourage you to work hard so you can keep earning profit. Putting this money into a separate bank account could arguably increase this encouragement: Some banking experts say that using several bank accounts can make it more obvious when money enters or leaves a particular one. Having an account dedicated to profit makes it easy to see when you earn that money, emphasizing the reward instead of burying it under other transactions.)
Step #2: Eliminate Debt
Eliminate your business debt. Being in debt prevents you from achieving financial freedom and increases anxiety, as you’re constantly aware that you owe other people money. (Shortform note: Eliminating debt isn’t just important for business owners seeking financial freedom and relief from anxiety—it’s important for anyone seeking to become rich. In The Automatic Millionaire, David Bach discusses clearing debt as one of the essential elements of becoming rich. Bach explains that interest accrues rapidly on debts. If you don’t pay them off quickly, you can end up paying far more than the initial amount—making it much harder to become rich.)
To avoid the problems that come with having debt, use your profit to eliminate your business debt: After separating your profit from revenue as discussed above, use 95% of that profit to pay off your debt and keep 5% as your personal reward. (Shortform note: This method may work for business debt, but how can you pay off personal debt? Some financial experts suggest using the 50/30/20 method: Devote 50% of your salary to paying for needs like rent, devote 30% to wants like streaming subscriptions, and use 20% to pay off your debts. Alternatively, you could use this 20% to both pay off debt and build savings.)
