Separating salary from profit

Distinguish between salary and profit

Summary: Salary is the reward for time spent, profit is the reward for capital invested and risk taken.

The website makes $X and I take home $X. Isn't $X my salary? No, it isn't. What you take home is a mix of salary and profit and the two need to be separated for the purpose of valuing or pricing a business.... a lot of sellers just don't seem to understand this concept so I've tried to explain in a few different ways that SALARY = PROFIT is not true. It comes up time and time again in different fora so does really deserve a page of its own.

Any experienced business person would start feeling patronised about....now so feel free to leave this page. For the rest of you I'll take it that you may be Olympic gold winners, brain surgeons or software gurus but when it comes to accounting skills you can't be relied on to audit European politicians' expense claims.

1. You've got to see yourself as distinct from the business. The legal position is that a company can enter into contracts, open a bank account, buy and sell goods, employ and sack people; it can do most of the things you as a person are legally allowed to do. (No, it can't become Prime Minister or have sex in public with Paris Hilton. But, then, neither can you). Yes, an LTD company is a legal entity in itself and even if your business isn't an LTD you should consider it a separate "person" that can survive without you. You may own 100% of the shares but the company is distinct from you, it pays you a salary for your time just like it would pay anyone else. It has other expenses just like you have other expenses. It usually has a profit left over after all the expenses are paid - like you've got money left over to put into a savings account every month. 

That the company uses this left-over money to pay you a dividend or profit should not be confused with what it pays you as a salary. In a particular year the company can make a $0 but still pay you a $20,000 salary and end up in a negative position (yes, a company can also take on debt) BUT it can't pay you profits out of anything but money that is left over after paying for everything else.

Still don't get it? 

2. Opportunity Cost: Opportunity cost is defined as the value of a good or service in terms of what had to be sacrificed in order to obtain that item. In other words if you could get $20 an hour working as a webmaster elsewhere then the time you spend on your site is worth $20 an hour i.e. you've forfeited the $20 p.h. that you could earn elsewhere. You don't then give that time for free to the separate legal entity that is your company/your business. If you're using a room in your house to run a home business you could have rented that room out at $100 a week. The proper way to account for it is to charge the business $100 a week for the space it occupies in your house. That space has value just like your time has value.

3. Even if you don't make out a cheque to yourself for salary and don't make out a cheque to the house for rent these figures need to be deducted from the Gross Profit - along with other expenses you've actually incurred - to get the real "net profit". Not doing so is technically fraud. You're keeping secret legitimate expenses the business would normally pay and therefore artificially inflating the profit you are quoting to the buyer. This is the tricky bit of accounting: you don't actually have to make a payment to deduct it in your Profit and Loss account and reduce your profit (depreciation is a good example - you never actually pay it but you declare it in your P & L and it reduces your profit). In his first year your buyer is going to find that the business is not making the $35K you said it was making because he had to pay someone $30K to work on it, had to pay $5K for premises etc. and ended up with a profit of $0. So the business wasn't a viable business, it wasn't really a profitable business and you defrauded the buyer. He should have done his due diligence but he can still sue you for misrepresentation.

4. Let me put it another way. You buy shares in a company listed on the stock exchange. The company makes a profit and pays you regular dividends and you continue to hold the shares. Your dividends = (Total profit /number of shares issued) x the number of shares you hold. You like the company so much that you keep buying more and more shares in it till you own 100% of the company. You now get 100% of the profit. So far, so good. How many hours per week did you work for the company? How many days/weeks/months were you actually employed there? None! The money you got was purely a reward for taking a risk and investing your cash. That's what profit is - a reward for the risk you've taken. Now, the company has a vacancy, you give up your job working at the local tax office and take up a worthwhile job working full time for the company.  But, would you expect a salary? Why? Would this be on top of the profit the company pays you? The company will pay you a salary every month - just like it pays everybody else - as a reward for your time. At the end of the year the money that's left is profit and comes to you as a reward for your investment/risk. You now have more than you had last year because last year you invested only your money, this year you also invested your time. The same thing applies to any business you sell. If it requires 40 hours a week of work then the cost of employing someone to do that work has to come out of the revenue and it reduces the profit available.

Any investor looking to put $10K into your business can just as well invest that in stocks/shares elsewhere and he won't be required to do any further work to get his rewards. That's the same thing he expects of the business you're selling him. And he expects that if he does have to do some work he'll get more than profit - he'll also get $x per hour of his time. Unless you are giving him that free room in your house to run the business from and will continue to work for free in the business for the rest of your life.