By keeping some powder dry and building extra capacity, you’ll weather storms, make better decisions, and capitalize on opportunities
One of the most irresponsible things you can do as an entrepreneur is fail to have a substantial cash buffer to withstand changes. That’s exactly the situation small businesses—and households, for that matter—are forced to confront today.
As we discussed in “Wartime CEO,” the average small business has 27 days of cash buffer coming into this crisis. That’s not a lot of runway, even when times are good. In a crisis like today, it’s disastrous (which explains why government loan money is running out so fast).
JP Morgan applied the same methodology of bank stress tests to households and found:
Half of all families have insufficient cash to withstand either an expenditure spike or dip in income; and
65% of all families have insufficient cash to withstand both at the same time.
Companies adopted short-termism. They’re trying to squeeze out profits instead of making investments in the future. Private equity is built around this: They buy companies and get rid of redundancies, including employees.
You can see the impacts of this in the Covid-19 crisis. It’s shocking to see bodies pile up in Long Island’s mass graves because of the lack of funeral homes. Since 1990, as large companies have taken over, roughly two-thirds of the funeral homes in New York City have closed. It’s one of the wealthiest cities in the world, and they’re burying people in unmarked plots.
Companies have traditionally viewed unutilized capacity as a dead asset, sitting idle and not generating profits. This line of thinking suggests that having “too much” cash on hand is a bad thing. Rather than maintain a cash buffer, it’s considered smart to take on debt when an opportunity presents itself. That mentality no longer works.
The only way we’ll get out of this crisis—with this huge credit bubble that we continue to kick down the road—is if we start to have an excess of savings. We need excess capacity
Whether you’re an entrepreneur leading a business and the head of household, having extra capacity is really important. For businesses, this can mean cash on hand and extra capacity in your workforce.
Extra capacity is not just about mitigating against risk and weathering a storm. It allows you to capitalize on opportunities as they present themselves. Nassim Taleb writes about the concept of being “antifragile”—meaning that when unexpected things occur, when “fat tail” risk happens, you get stronger. Excess capacity can make you robust; it can give you mental clarity to look farther ahead and make better decisions.
If your team is so overwhelmed by day-to-day tasks that they don’t have the time, energy, or mental free space to look for opportunities, you are making a gigantic mistake. If there’s no excess capacity, they’ll only do the things you already do. If you optimize to the point you’re operating with only what you need, you’ll kill your opportunity to grow.
Google famously allows employees free time to work on projects of their choosing, and that produced some big innovations for them like Gmail. If a private equity firm came in and slashed extra capacity, Gmail would never exist.
Free up mental space
By creating enough free space, you expand your choices—you’re no longer forced into making decisions that you don’t want to make. By having some food in your house, you can choose not to go to the grocery store when people are fighting over toilet paper. The same thing applies to businesses. Whether you’re a CEO or a head of a household, having that free space in your head, is critical to keep you from making terrible and irrevocable decisions.
The second way I look at excess capacity is that it’ll be clear to you when to use it. This is generally how I approach big decisions in my life: I sit on something until I’ve given myself enough mental space to be objective about it, and then I act.
I think that that mental clarity is the most valuable thing you can have, especially if you’re in any kind of a leadership role.
Building capacity is difficult
Building capacity is an incredibly easy concept that’s very hard to do, because it requires you to sacrifice. You have to go without something today in order to have something in the future. Keep your expenses lower than your operating costs and hold onto the cash.
Change your value proposition
If you’re providing something truly valuable to your customers, consider if you could charge more by offering a service that’s of higher value.
In our last episode, we discussed a local cattle rancher here in Colorado who sees opportunity in the wake of this crisis. He’s typically very price conscious, making sure to compete with large organic grocers. I’ve encouraged him to think broader than this and view his business as providing more than just producing high quality beef. Instead, he can charge more if he expands his value proposition to guaranteeing a steady and secure supply of food.
Let some customers go
Sometimes building capacity means disappointing current customers. We’ve done this in our own business. We decided we’re only going to work with a certain subset of clients that we can rely on, and we eliminated other distributors. Some expected the business would suffer, but it’s grown. Every time we’ve limited things, we’ve grown.
To avoid getting crushed, entrepreneurs have to create value for their customers that they can charge for above commodity prices of their product. Otherwise, it’s a race to the bottom.
Another way to build capacity is going without things. Especially when times are good, companies tend to take on debt. They talk about “good” debt. But, to me, there is no such thing. I view all debt as “bad” debt, because they drive your structural expenses higher—and “good” debt becomes “bad” debt very quickly in an economic downturn.
On a personal side, especially if you are single and early in your career, you should be saving 30% of your income. If you aren’t, you should make substantial changes to get there and take advantage of compound growth while you’re young. Otherwise, you’ll get forced to make decisions when none of the decisions are good.