Profit Pitfalls

One of the most common misconceptions about startups deals with the basic definition of profits:

Profits = Revenue – Expenses

Pretty straightforward—right?

But, here is the problem: many people make some fundamental mistakes about what constitutes revenue and expenses. Mistakes are understandable, not everyone has studied accounting. I, myself, have never studied electrical engineering and only have a vague understanding of the difference between an amp and a volt. Someone who does understand amps and volts could teach me the basics even though it might take much longer to teach me the nuances and implications of amps and volts.

So, while I can’t teach you about amps and volts, here are the basics of revenue and expenses:

  • Revenue = sales. Sales happen when people buy your product or service and either pay you or promise to pay you (in which case you’ll have to go collect the cash). Revenue does not include investment dollars or grants or loans. Your accountant can help you sort out things like how to handle non-sales income like interest received, sale of assets, etc.
  • Expenses = all costs associated with running the business including—and this is VERY important—everyone’s full fair market salaries. Your accountant can help you sort out things like how to handle long and short-term debt, interest payments, depreciation, etc.

Other Terms

There are a couple more really important concepts to understand:

  • Dividends are the portion of the profits the management team decides to pay out to shareholders. In other words, getting a share of the profits depends on whether there is a decision to actually distribute those profits to shareholders. In the rare case that a startup actually earns profits in the short term, it would be even more rare to actually make a dividend distribution. But, if the decision is made, your percent share of the dividend payout should equal your percent share of the equity. This means that managers can’t pay a dividend to some shareholders and not others (yes, there could be different classes of shares, but I’m just covering the basics. In Slicing Pie, you should have the same shares as everyone else.)
  • Retained Earnings are the portion of the profits the management team decides not to pay out to shareholders. In a startup, this is common because founders want to use the money in invest in growth.

Common Mistakes

The most common mistake is that people forget to include their fair market salaries as expenses. Someone will tell me, “we’re profitable! We made $40,000 last year!”

Me: “Did you pay yourself a salary?”

Him: “Um, no.”

Me: “How much is your fair market salary?”

Him: “$100,000.”

So, this guy actually lost $60,000. In the Slicing Pie model, the $60,000 is unpaid fair market compensation and would convert to slices which will all the company to later allocate equity fairly. If and when the company has enough cash to pay a full salary the Pie will stop accumulating slices.

Notice I said “enough cash,” not “enough revenue” when it comes to paying salaries. The Pie stops accumulating slices when there is cash to pay expenses even if it comes from non-revenue sources like Series A investment or large grants, for instance. If there is enough revenue to pay all expenses then you have reached breakeven. The Pie bakes after either of these situations.

Paying from Profits

Sometimes the founders tell me they are going to “pay people from profits”. If you think about it, there is no possible way this can happen because unless you are paying fair market salaries it is impossible to calculate profits, ergo impossible to pay someone from profits. People try all the time, but it does not work and, therefore, they never feel quite right about it. This is because profit distributions (known as dividends) have nothing to do with compensation. Yes, you could be like Steve Jobs and take $1 salaries, but this does not reflect logic, it’s a PR stunt.

Imagine you bought some shares in Apple, Inc. (AAPL). You own these shares and, therefore, are entitled to dividends. Apple has been paying a quarterly dividend of around $0.60 for the past few quarters. So, if you owned 21,000 shares you be paid about $50,000 per year in dividends. Of course, you would have had to pay over $4,000,000 to buy the shares (the shares are $216 right at the moment I’m writing this…which means the annual ROI for Apple is around 1.5%. Hmmm…I guess Apple investors like to speculate…don’t we all…)

Now imagine you go get a job at Apple, Inc. and you negotiate a $40,000 salary. Your manager says, “hey! You own shares in Apple, Inc. so we’ll just ‘pay you from profits’ instead of paying your salary. It’s cool, though, because you’ll probably make more than $40,000 in dividend payments.”

Not cool. Obviously, you would expect to be paid your salary in addition to the dividends paid to shareholders. The two sources of income are not substitutes. Your salary should be paid before profits are calculated and, thus, before dividends are paid.

In Slicing Pie, you share of the equity was obtained by not being paid fair market compensation. This is the “price” you pay for your shares. Once the shares are yours, you own them until you sell them.

Hand-Me-Down Shares

Here is another example to make sure this concept is perfectly clear. Pretend that I’m your dad and I get killed by a Monster Truck as I’m running through the Monster Truck rally trying to catch a balloon. It’s a mess. Blood and guts and popped balloon parts everywhere!

You and your brother inherit my highly profitable escalator shoe manufacturing company. I love you both equally so you each get 50% of the company. You did not pay for these shares, but you are each entitled to 50% of the dividends paid by the company.

I’m dead so one of you needs to step in and run the place. Your brother couldn’t care less, but you want to work there. Do you work for free? Of course not. You should be paid a logical salary for the job. Your ownership and your job are separate things. You and your brother each get a share of the profits, but you also get a salary.

If you don’t want to work while your brother sits on his butt, you don’t have to. You could hire another person to be your CEO and pay her the fair market salary and you and you brother can go sit on your butt somewhere and split the profits. Your CEO doesn’t mind as long as she is getting a fair market salary. In fact, lining your pockets is her #1 job responsibility. If she does a great job, you could pay her a bonus and/or give her a raise. If she does a bad job you can fire her and hire someone else.

So, no matter how you acquire your equity, the dividends are yours for as long as you own your shares.

Profit Shares vs. Equity Shares

It’s common for managers to want to use profit-sharing instead of equity so they can “maintain control” of their company. This is possible, but tread carefully. There is so much convoluted profit-sharing program advice about that it rivals bad equity-splitting advice. The shear tonnage of useless crap is mindboggling!

Slicing Pie uses the relative, unpaid portion of the fair market value of each person’s contribution to determine a fair split. Fair is fair (there are not multiple versions of fairness) so other models are simply not fair. So, given the logic of the Slicing Pie model the person with the highest number of slices is the person with the most to lose. That person should have at least some influence on the decisions being made! If you strip voting rights from a person’s share you create a conflict. You are saying that the people who retain voting rights are some sort of special, mystical being with greater importance that mere humans and that humans can’t be trusted to make good decisions with their own finances. Now, while it’s true that most humans suck at personal finance (including me), humans are still humans and mystical beings don’t walk among us.

That being said, it may be impractical for daily decisions to be made by a committee of Pie slicers and consolidating control to certain people may be worthwhile from an efficiency standpoint. Control can be consolidated in many ways. Most CEOs of public companies don’t own a majority of the equity, yet they make important decisions all the time. You can grant power through a variety of employment contracts, company policy or even legal structures such as a manager-managed LLC.

Decision-making powers can be part of a job description. A CEO may have the ability to approve higher expenses than a low-level employee, for example. Just be clear about people’s roles and responsibilities.

How to Create a Profit Share

If you simply must create a profit share program instead of equity, it is important that the financial benefits of the profit share unit is identical to the financial benefits of the voting shares. This can be done by creating a separate class of stock in an S-Corp or C-Corp or a special class of membership interest in an LLC. This means that profit share participants get their share of dividends and the proceeds of a sale. Any other structure unfairly values one human being over another. Yes, it happens all the time, but it’s not fair.

Warnings about Profit Shares

When you strip voting rights from an individual participant in the Pie you immediately weaken the team because incentives are no longer aligned. Remember, there are no profits until all expenses and salaries are being paid. This means:

  • Voting members can simply raise their salaries to absorb profits.
  • Voting members can approve and invite themselves corporate boondoggle in the Bahamas that burns up all the profits.
  • Voting members can approve the purchase of a corporate jet that eats up all the profits.
  • Voting members can engage in all sorts of shenanigans that will deplete company profits.

Thus, the voting members can put themselves in a position to enjoy the company profits without actually paying a dividend and there’s not much a profit share holder can do. The profit share holder can sue, but the costs of the lawsuit would use up company profits!

In public companies or in private companies with a diverse investor pool, boards of directors are formed to represent the investors when it comes to things like management compensation and decision-making powers, etc.

Forcing Profit Distributions—Not

Whether you an equity holder or a profit-share holder, dividends are never guaranteed in a startup. In most cases a startup should retain earnings to grow the company and offset the need for outside capital. You can’t force a company to make a distribution and a company can’t really make an accurate prediction of future dividend payments. The future is always unknowable, plan for the worst but hope for the best.

Taxes and Legal and Such

How you actually make payments will certainly impact your taxes. Dividends, for instance, may not be subject to certain employment taxes. I’m not an accountant or a lawyer so be sure to engage a professional that you trust who also understands Slicing Pie. No matter what, you should always operate legally and pay the taxes you legitimately owe. Nothing, however, should prevent you from fair treatment of your fellow Grunts!

The Last Point on Profits

Profits are great! Profits are important! Profits are prince! But, profits are also easy to manipulate and cannot serve as a reliable substitute for salary compensation. Profits and salaries are separate sources of income and fully understanding and appreciating why will help ensure fair dealings with the entire team.

 

 

 

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