Profit definitions
This article was published May 19, 2020 in Twinkle Magazine.
In takeover processes there is often a lack of clarity about the concept of 'profit'. Buyer and seller both think they have a clear picture, but in practice they do not always agree. Strange perhaps, but different parties appear to have their own understanding of it. The answer to the question "what is the profit" depends on who is asked this question. Hence the famous saying that profit is 'an opinion'.
Profit and online business value
a correct and consistent understanding of profit is essential: in many cases, the value of an online business is estimated based on a so-called "multiple" (value = multiple x profit). The theory behind multiples and their use is open to question, but it is a fact that they are widely used in practice and that the underlying definition of the concept of 'profit' is therefore important.
This article will elaborate on how best to approach earnings in an acquisition setting. This will be done on the basis of the three main sources of disagreement: firstly, the definition of profit, secondly, normalizations and thirdly, entrepreneurial remuneration.
Profit definitions
"What is the profit?" is usually the first question buyers ask during the first moment of contact with the seller of an online business "And how was this calculated?" usually follows quickly. These are two logical questions, because there is quite a bit of noise on the line about both, and it's best to resolve this as soon as possible in the acquisition process. There are several profit definitions that are applied. The most common ones are:
EBITDA - The Earnings Before Interest, Taxes, Depreciation & Amortization. Or in other words the profit before interest, taxes and depreciation. This is called net profit determination and is the best application when you want to compare the profits of companies with different forms of financing ('before interest'), under different tax regimes ('before tax') and with different asset utilization ('before depreciation and amortization').
EBIT - The profit before interest and taxes. Or in other words the profit before interest and taxes. The difference with EBITDA is that EBIT includes depreciation. EBIT is also referred to as operating profit.
Net profit - When the EBIT includes the interest to be paid and received and the tax (VPB) is deducted, the net profit remains.
In practice, the difference between EBITDA and EBIT is limited for online businesses: there are usually relatively few assets to write off. The online business can be shown as intangible assets on the balance sheet and the stock can be (partly) written off as current assets. The impact of this is generally limited (especially when compared to capital intensive industries like manufacturing and industry).
What most online business owners and buyers look at is the net profit: what is left at the bottom of the line at the end of the year.
Profit normalization
Normalization is the adjustment of the effect of costs and revenues on the income statement. These may be costs/revenues that are not part of the actual operations. They may also be costs/revenues that are part of the operations but are not currently included.
The purpose of a normalization is to determine the actual results and costs that a buyer can expect after the acquisition. The result is the "pro forma" income statement with a normalized profit.
Perhaps this sounds a bit 'shady', but there are plenty of conceivable reasons why normalization is common and sensible:
Revenue
- Think of one-time benefits that a buyer cannot anticipate. For example, the sale of a valuable domain name that you still had. This is a negative adjustment.
- Conversely, sales may have declined due to a one-time setback, which a buyer would not suffer after the acquisition. You could make a positive adjustment for this unusual decline in sales.
Costs
- There was a one-time legal dispute, which involved a lot of costs. These costs depressed the profit but were a one-time event.
- The seller depresses his profit with private expenses. This is obviously not the intention but occurs. However, these costs are not relevant to the business that is being acquired.
- What also occurs is that the seller has paid for another project from the business. If that project is not also sold, the costs incurred for it are not relevant.
- Sometimes investments (a new website for example) are taken as costs in one year, while they may be written off over several years.
Now it may seem that normalizations mainly improve profits, but that is certainly not the case. The corrections can also be detrimental:
- Sometimes the online business is run from business premises for which no costs are passed on.
- There may be support from staff who are on the payroll of another company of the entrepreneur or there are collaborating family members who receive no salary.
But by far the most common correction when determining the profit of an online business is the salary of the entrepreneur. This occurs so often that we devote a separate heading to it:
The entrepreneurial reward
The remuneration that the entrepreneur grants himself causes the most discussions in practice. For B.V.'s the problem is easier than for sole proprietorships and VOF's, therefore they will be discussed separately:
Private Company
In the case of a Limited Company, it is about an entrepreneur who pays himself too much or too little given the amount and nature of the work performed. The basis for this remuneration should be at least the DGA salary. If part-time work is performed, then the corresponding part of this can be taken. So, 8 hours per week = 20% of the DGA salary as representative enterprise remuneration.
Sole proprietorship or general partnership
In the case of sole proprietorships and general partnerships, there is something else: the net profit stated in the annual report is also the owner's salary. Here the definition in the annual report differs from the definition used to determine value!
It is important to realize that the time an entrepreneur puts into his / her store is a cost: if you had worked somewhere else, you would have been paid for that time (opportunity cost) and also a buyer must make these costs (whether he or she hires someone for it, or does it himself) to be able to achieve similar results. Time is not free.
A seller tends to (wrongly) assume the net profit in the annual report, while a buyer will (rightly) say that this profit must still be corrected for a customary entrepreneurial fee. Similar to the B.V., it is realistic to include a representative cost component based on the number of hours the entrepreneur must put into the online business to achieve the results. Only then do you have the actual 'clean' profit (whether you use EBITDA, EBIT or net profit), which can be a starting point for determining online business value.
Smaller online businesses in particular may find that they are not actually making a profit when the hours of the entrepreneur are considered. This does not mean that the shop is not interesting, because it can be a great source of income for the entrepreneur. But if the shop does not produce more than a salary for the entrepreneur, how should a buyer recoup his investment in the years after the takeover? A lack of "excess profit" is therefore not only a disappointment for the seller, but also an obstacle to a successful sale.
A good start
Value and price of an online business are closely related to the results that this online business achieves. It is therefore important to ensure as early as possible in the acquisition process what these results are and how they are calculated. There is nothing as annoying as only finding out during an audit (just before the deal) that results are different from what you had interpreted them to be.
In summary: this is important when determining the profit of an online business
- Ask the vendor for a summary of the results.
- In doing so, white you know what the definitions used are, so you are definitely talking about the same thing.
- If the seller provides a pro-forma profit and loss account, ask for a list of the corrections made.
- In all cases, also go through the income statement yourself to determine whether any (additional) normalizations need to be made. One way to do this is to check against the income statement of a comparable online business.
- The salary that the entrepreneur attributes to himself requires extra attention.