Will Your Startup Make Money?

Printing dollarsThe expression “making money” is widely used but what does it really mean?  There isn’t one correct answer; there are several.  When you talk about making money, make sure that you know exactly what you are trying to achieve.  Making money could mean:

 

  • Revenues
  • Gross Profit
  • EBITDA
  • EBIT
  • Earnings After Tax
  • Cash

Let’s talk about each of these.

Revenues

Revenue is the money that you take in as the result of selling your product. If you expect to sell, say, 10,000 units of your product in the first year, and you will be pricing the product at, say, $200, you are forecasting your revenue to be $2,000,000.

Your actual revenue may be higher or lower depending on several factors.

  • Whether customers buy more or fewer of your product
  • Whether $200 is the right price
  • Whether you can produce sufficient quantities of the product
  • Whether you have the sales resources (e.g., salespeople) to facilitate the sale of the product

Gross Profit

Gross profit is the difference between what it cost you to produce your product and the price you sold it.  Let’s say you have learned that $200 is really the right price for your product; what does it cost you to produce a unit of your product? In the case of a manufactured product, we’ll assume the raw materials and cost to manufacture add up to $180.

In this case, the per unit gross profit is $20, and if you do sell 10,000 units in the first year, you will achieve a total gross profit of $200,000 for that year, i.e., 10,000 × ($200 – $180).  In this case, you appear to have “made money”.

EBITDA

In the above example, you have a gross profit of $200,000. But you have many other expenses that are not related to the creation and selling of each product. For example, you will likely have:

  • Research and development expenses. These are the costs of designing the product initially.
  • Sales and marketing expenses. These are the costs of salaries for your marketing and sales staff, the cost of travel for these people, the costs to create and maintain your website, and the costs of advertising, just to name a few.
  • General and administrative expenses (aka G&A). These include salaries of individuals who are running the company, and all your office expenses like rent, utilities, telephone, postage, and so on.

All together, these are called operating expenses. Let’s say that you incur $120,000 in operating costs during the first year. Once you deduct this $120,000 from the $200,000 in gross profit, you are left with $80,000 in EBITDA (Earnings before Interest, Tax, Depreciation and Amortization) for the first year. That can also be a valid use of the expression “made money.”

EBIT

After you subtract depreciation (and amortization) from EBITDA, you get EBIT (Earnings before Interest and Tax). For the sake of this continuing example, let’s assume that you have not made any capital purchases, and thus have no depreciation, so your EBIT equals your EBITDA, or $80,000.

Earnings after Tax

In most locations, your country, state, and perhaps municipality collect tax on your profits. Let’s say the effective rate of these taxes is 25%.

If your EBIT was $80,000, and you earned no interest, and your combined tax rate is 25%, or $20,000 (25% of $80,000), your earnings after tax (aka EAT) is just $60,000, but at least you have still “made money.”

Cash

Perhaps the most difficult concept for a new entrepreneur to comprehend is the difference between cash and profit.

More Cash than Profit

Let’s say that during the first year, you sold part of your company to another person for $100,000. At the end of the first year, you actually have $160,000 in the bank ($100,000 from the sale plus the $60,000 in EAT).

Thus you have cash in the bank, and you may consider this to be a situation in which you “made money.” Notice that even if you had negative earnings after tax (commonly called a loss), the inflow of $100,000 from the above investment would mean that you would still end up with more cash in the bank than you started the year off with.

In such a case, you might claim to have “made money” even though you actually sustained a net loss.

Less Cash than Profit

The opposite situation in which you have profit but no cash can also occur. For example, you might have positive EAT of $60,000 but at the end of the year, some of your customers have not paid you for some products or services that you have already shipped to them[1].

If your customers owe you $100,000, and you have already incurred all your expenses for the year, you will end up with “negative cash” of $40,000 (i.e., the net profit after tax of $60,000 minus the $100,000 in accounts receivable).

A negative cash balance means that you cannot pay your bills, and you will likely be out of business, even though it looks like you had a profitable year (of $60,000!).

Summary

As you can see, making money can mean many things. Make sure you understand what you are really trying to achieve.

If your goal is to support your family financially, focus on cash.  If your goal is to provide investors with a satisfactory return, focus on internal rates of return (which are derived from company valuation, which in turn is usually derived from revenues, EBITDA and Earnings after Tax).  If your goal is to make enough money to retire, focus on staging your business for acquisition.

At a minimum, every entrepreneur should aim to have positive EAT and not run out of cash.

Finally, most companies tolerate a period of time of negative “money made” in order to obtain larger amounts of “money made” later (just don’t run out of cash on the way!)

 

Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.

 


[1] In B2B (business-to-business) situations, it is quite common that customers will pay you 30 to 60 days after you ship them something. According to Hoover’s, the average is 51 days for small manufacturing companies and 41 days for small wholesale companies in contrast to just 31 days for small retail companies.