Proper Profits Please

One of the most common mistakes that startup founders make, in my experience, is what it means to be profitable. I know this sounds basic, but bear with me and you’ll see what I mean.

Most startup founders—even rookies—understand that Revenue – Expenses = Profit. The mistakes lie with how founders understand revenue and expense.

Consider this scenario: Merrily starts a lemonade stand. Her dad gives her $20 to buy supplies. She spends $15 on cups, lemons and sugar. She sets up a lemonade stand on the front yard and sells 30 glasses of lemonade for $1 each. She counts the money in her pocket and finds $39.50! “Look dad!” She exclaims, “I have almost 40 bucks in profits! I’m going to buy a boatload candy!”

“Good job, honey!” Replies dad, “I’m so proud of you! You’re running your own big-girl profitable company and you’re only 35-years old!”

As you may have already observed, there are a number of problems with how Merrily calculated her profit. The first pertains to how she accounted for her revenue: $30 in drink sales and $9.50 in change from the $20 when she bought supplies that “forgot” to return to dad. The $30 is revenue, the $9.50 is unspent investment capital that should be recorded on the balance sheet, not the income statement.

But there is a larger problem: the expenses. Consider this income statement:

So, if you subtract the actual expenses from the actual revenue, it is clear that Merrily’s profits are much lower than $39.50. She was way off.

But there’s more, Merrily didn’t include other costs like ice, water, poster board (to make signs) and rent for the stand and equipment which consisted of a card table, a folding chair and a pitcher. She didn’t include these in the costs because her mom and dad provided them at no cost. But, I think this is a mistake, just because she didn’t pay these expenses doesn’t mean they aren’t expenses and ignoring them gives her a false sense of success. By covering these costs, Merrily’s mom and dad have helped her maintain positive cash flow, they did not help her improve her profits. Let’s include these costs.

This gives us a much clearer picture of the actual profitability, but it’s still missing an important element: Merrily’s time. Time is by far the most common omission in startup costs that I have seen. Founders don’t charge the company for their time and, instead, plan to divide up the profits. Unfortunately, unless you account for cost of a person’s time, profits are not clear. Running a lemonade stand is a low-skill job. The fair market rate for a manager’s time is probably minimum wage, currently set at $7.25. Merrily spent an hour setting up and running the stand. So here is what the numbers look like fully-loaded (not including taxes):

Now that all the expenses are accounted for it’s clear that profits are much smaller than Merrily originally thought. Now the question is, who gets the profits? Slicing Pie gives us the answer. Below I’ve color-coded the contributions and converted to Slices using the recommended multipliers. Red is Merrily, Blue is mom and dad:

Dad’s $9.50 in change was never at risk so Merrily just gives it back to dad. When you tally up the results, dad made 79% of the bets and walked away with $4.17. Merrily only made $1.08. Neither partner fared very well on this venture, but each person got what they deserved.

Let’s pretend Merrily used dad’s investment to pay herself $7.25. This would not change the income of the company, but would change the allocation of profits. Dad and mom would have covered 100% of the costs and, therefore, would get all the profits ($5.25). Still not a great venture.

In a startup company, it’s important to keep track of all the expenses, even those you don’t pay—especially fair market salaries. Inaccurate accounting for inputs will lead to an unfair split.