Profit Definitions

 

This article was published on 19 May 2020 in Twinkle Magazine.

Profit and the Value of Online Businesses

In takeover processes, there is often a lack of clarity around the concept of ‘profit’. Both buyer and seller usually believe they have a clear understanding, but in practice, their interpretations often differ. Surprisingly, each party may have its own definition. The answer to the question, “What is the profit?” depends on who you ask—hence the well-known saying: profit is an opinion.

Why a Clear Definition of Profit Matters

A clear and consistent understanding of profit is crucial. In many cases, the value of an online business is estimated using a so-called “multiple” (i.e. value = multiple × profit). While the theory behind multiples can be debated, the fact remains that they are widely used in practice, making the definition of ‘profit’ a central issue in the valuation process.

This article outlines how to best approach the concept of earnings in the context of an acquisition, focusing on the three most common areas of disagreement:

  1. The definition of profit
  2. Profit normalisation
  3. Entrepreneurial remuneration

Would you like to know the value of your company?

Defining Profit

The first question most buyers ask when approaching the seller of an online business is: “What is the profit?” This is typically followed by: “And how was that calculated?” These are entirely reasonable questions, as misunderstandings at this stage can lead to complications later in the acquisition process. Several different profit definitions are commonly used:

  • EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation): This represents the profit before interest, taxes, and depreciation. It is particularly useful when comparing companies with different capital structures, tax jurisdictions, or asset profiles.
  • EBIT (Earnings Before Interest and Taxes): Similar to EBITDA, but includes depreciation. EBIT is often referred to as ‘operating profit’.
  • Net Profit: This is what's left after deducting interest and taxes from EBIT.

In practice, the difference between EBITDA and EBIT is often minimal for online businesses, as they typically have few tangible assets. Intangible assets may appear on the balance sheet, and inventory can be written down as current assets, but their impact is usually limited—especially when compared to capital-intensive sectors like manufacturing.

Most online business owners and buyers tend to focus on net profit—what remains at the bottom line at the end of the year.

Profit Normalisation

Normalisation involves adjusting the income statement to reflect the true underlying performance of the business. This may include removing non-recurring or non-operational items, or adding missing operational costs and revenues.

The aim is to present a "pro forma" income statement that reflects the expected financial performance post-acquisition.

Although the idea might sound questionable at first, normalisations are common and often necessary. Here are some typical examples:

Revenue Adjustments:

  • 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.

Cost Adjustments:

  • One-time legal costs may be removed.
  • Private expenses recorded as business costs are excluded.
  • Costs for unrelated projects funded through the business should be removed.
  • Investments incorrectly recorded as immediate costs may be capitalised and depreciated appropriately.

While normalisations can sometimes enhance reported profits, they can also reveal lower profitability:

  • The business may occupy premises for which no rent is charged.
  • Staff from a related company may be supporting operations at no cost.
  • Family members may be contributing unpaid labour.

Entrepreneurial Remuneration

The entrepreneur’s salary is one of the most contentious issues in valuation discussions. The treatment differs depending on the legal structure of the business:

Private Limited Companies (Ltd):

The entrepreneur may pay themselves too much or too little. A reasonable benchmark is the statutory DGA (director-major shareholder) salary, adjusted for the actual hours worked. For example, 8 hours per week would equate to 20% of the full-time DGA salary.

Sole Traders and Partnerships:

In these cases, the reported net profit also represents the owner's income. However, from a valuation perspective, the entrepreneur’s time is a cost. A buyer—whether stepping into the CEO role or hiring someone—must account for this time. Therefore, a fair, market-based salary should be deducted to determine the true ‘clean’ profit, whether you're looking at EBITDA, EBIT, or net profit.

For smaller businesses, once a fair entrepreneurial salary is factored in, there may be little or no remaining profit. This doesn’t mean the business isn’t worthwhile—it may still provide a solid income for the entrepreneur—but it raises the question: how will a buyer generate a return on their investment if there’s no ‘excess profit’? A lack of "excess profit" is therefore not only disappointing for the seller, but also a possible obstacle to a successful sale.

Starting with Clarity

The value and price of an online business are closely tied to its financial performance. That’s why it’s critical to establish at the outset what the actual results are—and how they’ve been calculated. Discovering discrepancies during due diligence can delay or derail a deal.

Would you like to know the value of your company?

Summary: Key Points When Assessing Online Business Profitability

  • Ask the seller for a clear summary of financial results.
  • Confirm what profit definitions have been used so that both parties are aligned.
  • If a pro forma profit and loss account is provided, request a breakdown of all adjustments.
  • Review the income statement yourself to identify any additional normalisations. Comparing it to that of a similar business can be helpful.
  • Pay close attention to how the entrepreneur’s salary has been treated. This often has a significant impact on valuation.