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This weeks post was inspired by this tweet from @noahlt:
Noah Tye @noahlt
I'd love to read an explainer on how different industries dole out profits. eg tech has equity and exits, law/accounting firms have partners, hollywood movies are always "break-even"
5:16 PM ∙ Jun 29, 2021
His tweet got me thinking about all the different ways different types of businesses transfer value to their owners, and why it matters to those of us who aren’t business owners.
I also wanted to share The Swipe File, which featured MoneyLemma recently. The Swipe File is a hand-picked list of ideas, books, and all around through-provoking reads.

Businesses try to make money for owners. Some businesses have other goals alongside making money, but making money is always the goal: it’s the bottom line. Patagonia has a goal to protect nature. Tesla wants to accelerate the world’s transition to sustainable energy. Comcast wants to levy more unfair fees on the American people than King George. These companies have many unique goals and one shared goal: making money for owners. In this respect, all owners are alike. Whether you own an influential political consultancy, a power plant, or one of the five hundred million vape shops in this country, making money is the goal.

Make It Rain Money GIF by SpongeBob SquarePants

Here’s a deceivingly simple question: how do business owners actually make money? Not the businesses themselves, but the business owners? This post is going to answer that question, and it’s an important one. Businesses routinely mislead the public about their profitability for all sorts of reasons. Maybe they don’t want customers angry about big profits. Maybe they don’t want competitors. Maybe it’s for tax purposes. Maybe they just need this ponzi scheme to last until they can charter a flight to a Caribbean island with no extradition treaty. No matter what the reason, it’s in the best interest of the public to understand how business owners make money because it means smarter customers, buyers, voters and investors.

The four types of value-extraction

A good business has value. In its simplest form, value is cash. Apple is a valuable business that has about $100 billion sitting in various bank accounts. But value doesn’t have to be in cash form. Somewhere there’s a warehouse with the liquidated inventory of Sam Goody, a pawn shop with a drawer full of Aztec gold, an Olympic pool of purified canola oil. All that is non-cash value and accounted for by a business somewhere. In fact, most of the collective value of American businesses isn’t even tangible: it’s software and patents, it’s brands, it’s seedy political connections, it’s that intern that writes hilarious tweets. Value is not just today’s profit, it’s the prospect of future profit.

richie rich money GIF by MANGOTEETH — Most of Richie Rich’s fortune is tied up in future profit (if you count inheritance)

The financial system is built to transfer this value, to allow participants to trade oil, buy banner ads, or acquire the territory of Louisiana for a nickel an acre. Businesses can be vessels for that value - they are functional units, entities that have legal ownership over land or brands or a factory that makes kickstands. Owners of businesses can extract that value, convert it from business value to business-owner value, the way one can wring a sponge and collect the water in a bucket. There are four ways this business to business-owner value transfer can happen: profit, equity, debt, and expenses.

Option 1: Profit

Profit is an accounting term with a thousand aliases. Sometimes it’s called net income or earnings. Sometimes it’s earnings per share or adjusted profit or EBITDA or operating income. The Eskimos have a thousand words for snow, capitalists have a thousand words for profit. All of these terms are trying to define the same thing: how much money did this business make in a year? As in, how much can the owners take home at the end of the day? At the simplest level profit = money in - money out. It’s whatever the business brought in minus whatever the business spent.

Business owners can take profit as personal income. Small businesses set up as sole proprietorships can commingle business and personal accounts: owners can literally treat business profit like it’s their own money. Companies structured as corporations can pay out profits as dividends, where each owner gets a cut commensurate with their ownership stake. Large partnerships, like a lot of law or accounting firms, divvy up profits according to some pre-ordained system. For example, the partners who brought in the most business get the biggest cuts. There are also more sophisticated ways to distribute profit: corporate share buybacks are effectively identical to dividends, and carried interest is how private equity firms distribute profit. Companies always have the option of doing nothing with profits - they can just keep the money in the business, reinvest for the future (hence why Apple has $100 billion in its corporate coffers).

Option 2: Equity

Equity means ownership of a business. Oftentimes businesses are really valuable but don’t have much (or any) profit. Amazon didn’t turn a profit until 2001, at which point the company was worth $2 billion. If an owner wants or needs more cash than a business has profit, the owner can sell all or part of their ownership stake. That’s what Napoleon did with Louisiana, it’s what Russian moguls do with pro sports teams, it’s what Scrooge McDuck did with the shoe-shine business he had as a kid in Scotland.

Depending on the type of business, there are different ways this equity sale can happen. Simple businesses can be sold the same way one sells a house or car: have a lawyer draw up a contract and exchange the money. Sales of larger businesses are more complicated because there are lots of details to work out. Private Equity firms specialize in buying businesses and dealing with these challenges. Venture Capital firms specialize in buying partial ownership of small but ascendant enterprises and helping those firms navigate their growth (MoneyLemma covered how venture capital unicorns are made). The most famous way to take value from equity is through an initial public offering (IPO). During an IPO, a company slices its ownership into fractional pieces called shares. Existing owners can then sell their shares to the highest bidder on stock markets. IPOs require an expensive and highly-regulated process, but they also give companies flexibility with selling (and usually a higher sales price).

*Sometimes when companies IPO the founding team gets to “ring the bell” to mark the morning opening of the stock market. Here’s the Google team doing that in 2004.*

Option 3: Debt

Debt means that a company borrows money. Debt is not a direct way for a business owner to extract profit. In fact, it’s the opposite - money flows into the company, not out. Usually debt has to be combined with equity for owners to extract value. For example, a technique called a dividend recap involves a company borrowing money and then paying out that money to owners as dividends. The New York Times reported that American company owners paid themselves $27 billion in debt-fueled dividends in the second half of 2020 alone. There’s also an entire class of Private Equity firms dedicated to something called leveraged buyouts, which involves using debt to buy equity. Extracting value using debt is the most complex way to extract value and probably deserves its own standalone post, but the key point is that businesses can borrow money and give that money to owners.

Option 4: Expenses

In the simplest terms, expenses are the difference between revenue and profit; they are anything the company spends money on. Expenses can disguise value-extraction. Take payroll. Owners can be employees too. If an owner is serving as CEO of a company, shouldn’t that owner get a competitive salary? That may seem strange since owners get the profits anyways, but there are perfectly legitimate reasons to have owners on payroll: it makes budgeting easier, there are tax benefits. Salaries also distinguish between owner-operators, those owners who also contribute labor to the company, and regular passive owners:

On the other hand, there are illegitimate reasons for business owners to salary themselves. The now-defunct Cancer Fund of America, a charity that claimed to support cancer research, was a non-profit. By definition owners are not supposed to make money. Yet the founder of the charity, Jim Reynolds, ended up pocketing 80 cents out of every dollar donated.

Beyond payroll, owners can extract value through all sorts of expenses. Company cars, steak dinners, home offices, private jets, unlimited pens, rolls of toilet paper ripped off the restroom wall and pocketed. Ever heard the phrase “ah, I’ll write it off as a business expense?” The law states that anything purchased “in the course of business” can be paid for by the business.

That makes sense - if a car is used for business, the business should pay for it. This is, however, a slippery slope. Business expenses bleed into personal expenses, especially in the case of owner-operators. If a company needs to decorate a new office and the owner buys art from their brother, that transfers value from a business to a family member. That’s perfectly legal, but it is a way for owners to extract value from their business. Even with large corporations, there’s opportunity for owners and/or operators to extract value using expenses - sometimes illegally. Dennis Kozlowski, former CEO of the giant conglomerate Tyco International, spent six years in prison after he bought himself $15 million in art and paid himself another $81 million without getting approval from shareholders (i.e., the owners).

Even more confusing, some companies never make a profit by design, instead channeling all their potential profit through expenses. Hollywood accounting is a great example. Lord of the Rings, Spiderman, Return of the Jedi, and many other blockbusters never made a profit. Warner Brother’s Harry Potter and the Order of the Phoenix made over $1 billion in revenue, according to the accounting, but lost its owners $167 million. How is that possible? The trick is that these owners extract value through expenses by way of creative accounting. For example, a studio can pay upfront excessive marketing expenses to a third-party; that third-party can be owned by the same person that owns the original studio.

*Harry Potter’s fortune was buried deep in the vaults of Gringott’s. The producer’s of Harry Potter’s fortunes are also buried somewhere.*

All roads lead to profit

The first option to extract value is today’s profit. The other three options, however, are also a function of profit: future profit.

Businesses sell for the sum of all future expected profit (in theory, at least). Therefore selling equity in a business is trading rights to future profits for guaranteed money today.
Debt is the same: lenders of loans rely on expected future earnings to cover the cost of repayment.
Money that isn’t spent eventually becomes profit; so again, expenses are just another way of extracting future profit.

*Liam Neeson trying to sell some future profit*

Profitology

The key point of this post is that businesses don’t need to make profit today to extract value. A company can make no profit, but owners can still get paid using debt, equity or expenses (i.e., expected future profit). That means that anytime a business makes claims about it’s profitability, those claims should be treated with skepticism. Here are five nauseating but common claims that merit the same response as a rare-coin infomercial.

Sorry, we can’t offer competitive compensation here because our business isn’t profitable!

The correct response: Since you’re so quick to divulge your financials, please share the salaries of senior management as well as non-salary benefits like retirement contribution and company cars. Also share your budget so I can understand where your money is going, seeing as you aren’t paying your employees as much as your peers.

Sidebar: I had a friend get a dream job offer from Boston Red Sox corporate that was about 60% (!) below market compensation and they literally used this line. This company pays it’s 26 athlete-employees a combined $191 million dollars, owns a stadium, and was recently valued at $7 billion. But sure, it’s “not profitable” enough to pay competitively. More likely, they’re exploiting superfans who would do anything to work for their childhood idols. Be skeptical!

You can trust our business, we’re a non-profit!

The correct response: Check out ProPublica’s Nonprofit Explorer, where you can search the salaries of nonprofit executives. Ask what percentage of donations are redistributed to the targeted groups in a given year. Most non-profits are awesome, but there are a few bad eggs that ruin it all.

Our company didn’t pay tax last year because we didn’t have profit!

The correct response: Pope Sixtus IV had Michelangelo to paint the Sistine Chapel, Corporate America has Ernst & Young to paint their profits into the ether. There are infinite ways (all legal) to manufacture accounting statements. Many companies avoid taxes because they have good accountants, not because they have bad businesses.

Our company gives 1% of our profits to a good cause!

The correct response: These claims obligate a company to do very little. If the Return of the Jedi can earn $475 million at the box office and never turn a profit, then whatever company is making this promise has the ability to do the same. Ask them to share the actual amount of money donated in the last year instead of a gimmicky catchphrase.

Actually, we are profitable. See this quarter’s financial results!

The correct response: Wow, this company wants me to think it’s financially healthy. If a company can turn profit into no-profit, surely it can do the inverse. Proving this is the job of the stock analyst, but it’s everyone’s job to stay skeptical.

If you have any more common claims that set off the B.S. radar please share in the comments or email me! I can keep this list going.

What is the profit formula?

Profit, like beauty or Russia’s borders, is absolute in theory but subjective in reality. In theory businesses make profit and pass it on to owners. In reality businesses create value and owners ability to extract that value is limited only by their imagination. Actual profit is the product of accounting decisions and not necessarily a reflection of value creation. The disconnect between profit and value-extraction creates an information asymmetry: business owners know how much they make from a business, but often their stakeholders, suppliers, and customers don’t. That’s why a healthy dose of skepticism is always necessary when it comes to businesses and profit.

Thanks for making it to the end of my longest post yet!! I appreciate it and would love to hear your reactions in the comments or over email. If you’re not a subscriber (or know someone who isn’t but should be) -- know that I get really pumped when someone subscribes to MoneyLemma.

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