Most businesses don’t fail because the product is bad. They fail because the business model was engineered – unknowingly – to run out of cash long before it creates wealth.

Because revenue alone doesn’t keep a company alive…

Understanding how cash moves through a business does.

Famous clothing founder and Shark Tank investor, Daymond John almost failed before we ever even knew who he was. When he first started FUBU, the young entrepreneur had the sales to get the business off the ground, but he didn’t factor in the length of the cash flow cycle he’d designed. It started with 120 days to order pre-paid fabric, and then…the killer: he’d offered 120 day payment terms to his customers, resulting in a 240 day cash flow cycle that essentially converted sales proceeds into a 0% interest rate 120-day customer loan.

FUBU was nearly out of cash and on the brink of failure even as new orders continued pouring in.

Why did this happen?

Daymond John had failed to understand the whole picture on business model math, and it’s a great example of why entrepreneurs need this knowledge when they’re starting out. Or it could end up costing you everything.

Understanding basic business model math can make or break your business

Like most other multimillionaires and all the members of the Forbes 400 list of the richest Americans, Daymond John ultimately became wealthy from owning shares in businesses he created that produced investor returns exceeding investor expectations.

The 4 elements of business returns include:

1. Dividend Yield
2. Internal Growth from Same Store/Same Business Line Sales 
3. Internal Growth from Reinvested Free Cash Flow into Expansion
4. External Growth

And the 5th element (aka the wealth turbocharger): Cash Flow Multiple Arbitrage aka Equity Valuation Multiplier. 

Cashflow Multiple Arbitrage comes from making your company worth more than what it cost to create. This is often referred to as the “wholesale to retail trade.”

As a 2x Public Company founder, we started our companies to deliver higher wholesale returns to founding stockholders and then we took the companies public and the share price got marked up to retail as a result of the Cash Flow Valuation Multiple Arbitrage. The retail shareholders were content to receive a lower rate of return, but now it’s time to graduate to the math behind the corporate return drivers.

The 6 business model variables you must know

We’re about to get into the basic business model math you need to know, but first you need to understand 6 essential variables. These are the fundamentals that separate companies that scale safely from companies that burn through capital even while making sales.

The business model math behind the variables

This is the part that makes some people nervous: business model math. The good news is that it’s mostly middle school math (with maybe a little high school math thrown in). It’s not a requirement for entrepreneurs to be math wizards, but you do have to know some basic business math. 

So pay attention:

At the highest level, there are 6 drivers of corporate returns, including:

1. Business Investments
2. % of Other People’s Money (OPM) you use
3. The Cost of OPM
4. Sales
5. Operating Profit Margin
6. Maintenance Capital Expense Requirements

These are also the 6 Value Equation Variables and they are all you need to calculate Equity Investor Current Pre-Tax Cashflow.

Calculating Equity Investor Current Pre-Tax Cashflow

Let’s say you own a restaurant for this example and assume the following:

$3M Business Investment

$2.25M OPM Funding (75%) + $750k in equity (25%)

8% Cost of OPM Annually

$5M Annual Sales

20% Operating Profit Margin

$150k Annual Maintenance Capital Expense

Now we can take those numbers and do our math:

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First multiply sales by Operating Profit Margin

$5M Sales x 20% Margin = $1M Profit

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Next, take your OPM funding multiplied by the cost of that OPM

$2.25M OPM x 8% Cost = $180,000

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Finally, subtract your expenses from your profit:

$1M Profit - $180,000 OPM Cost - $150,000 Annual Maintenance Expenses = $670,000

Your Equity Investor Current Pre-Tax Cashflow is $670,000.

Turning math into meaningful numbers

Once you know your Equity Investor Current Pre-Tax Cashflow, you can calculate the number that matters most to your shareholders:

The Current Pre-Tax Equity Rate of Return. You take that $670,000 we just calculated and divide it into your $750,000 equity.

$670,000/$750,000= 89.3% Pre-Tax Return

That 89.3% Pre-Tax Return rate surely beats investor expectations, but it still doesn’t tell the whole story.

Corporate taxes will average about 25%, making your After-Tax Return about 67%. You may elect to pay some of that equity return into the Dividend Yield and the other growth areas we outlined above.

Head to my YouTube Channel for a handy visual representation of all this math and see how the wealth turbocharger comes into play for this example.

And keep learning how money moves through a business. 

Because when you understand this (rather than simply how to make money) you can scale without running out of cash, design companies investors love, and ultimately build wealth that doesn’t depend on your time or daily involvement.