Reported Net Profit vs. True Net Profit

article

23 Apr

Did You Know There Are Two Types of Profit a Buyer Will Consider When Valuing an SME?

Reported Net Profit and True Net Profit

Note: You must remove yourself from the day-to-day running of your business, or it will affect your ability to sell the business or achieve the valuation you want. Buyers aren’t looking for jobs, meaning they aren’t looking to become the head worker of your business. They want managers already in place, managers with a proven track record to run the business.

The difference between reported net profit and true net profit is what catches a lot of business owners out. They tend to be owners who are heavily involved in the business. It is one of the big reasons why initial valuations are reduced by tens of thousands. It is because reported net profit is not the same as true net profit.

Reported Net Profit

This is the figure that you see at the bottom of your profit and loss statement (income statement). It is the figure that shows whether you made a profit or a loss. It is the first figure that most of us, including me, would have looked at.

True Net Profit

To understand true net profit let me explain using an example. Let’s assume you have a business producing £100k net profit, and you as the owner work five days a week in the business and are crucial to the day-to-day running of the business and its success. You may assume that if you were to sell your business today, you could expect a three-times multiple of profits. And for simplicity, let’s assume this would give you a valuation of £300k.

Along comes a buyer who asks you some key questions about your business, starting with this one: What is your involvement in the day-to-day running of the business?

I would most certainly be honest here as the truth will come out during the due diligence phase. You tell the buyer that you work five days a week and are fairly involved in the running of the business.

This then leads to series of other questions:

What roles do you perform?
How many members of staff do you think you would need to replace you for the work you do?
What do you think would be a reasonable salary to offer these members of staff?

Now you as the owner will do a lot more work than the average employee, so you reckon that the buyer would probably need a manager at a salary of £40k and an admin person at £20k to take care of all the little organisational jobs you have inherited over time.

Assuming the multiple of three-times net profit is still true, this owner has just wiped out £180k off their valuation.

How Did That Happen?

You see, your reported net profit of £100k was not the true net profit. Because the owner is intrinsically involved in the business, the buyer would either need to assume the role of manager or employ a manager at £40k as well as an admin person at £20k. This would reduce the net profit by £60k, resulting in a true net profit figure of £40k. If you were to use the multiple of 3x profit, this will give you a valuation of £120k for your business.

However, let’s use the same scenario, but this time the reported net profit is £100k, but there already is a manager and admin person in place. Then the reported net profit and true net profit would be the same number. And the valuation of £300k would be correct.

Therefore, it’s so important to get yourself out of the day-to-day running of your business and build a team around you. Surrounding yourself with key people won’t only add value to your business but will also make your life a whole lot easier.

In the end, an SME is worth:

What owners are willing to sell for and
What buyers are willing to pay

The key here is to know what you are willing to sell for and you can only do that by having a financial plan and knowing your number, which is the amount of money you will need to retire and live the lifestyle you want without the fear of ever running out of money.

To understand what buyers are willing to pay you can use valuation methods like the ones we discussed above. This will act as a reference point to give you an idea of the value of your business and then use the valuation as a potential starting point for negotiations.

For many small-business owners, that value is the result of years of hard work and sacrifice to create the successful venture they currently have, so it makes sense to get the best return you can for all your time.

In the hustle and bustle of running a business it is very easy to take your eye off the ultimate end goal—successfully exiting your business. Keep focused and do not be afraid to ask for help.

Would you like to make sure your business is ready for sale? Learn more about how we can assist you. Please contact Cliff at Business By Design for a free confidential phone call to see how we can assist you.

Download PDF Version