Too good to be true

John Paul- E-mail director for smallstarter business
Today’s lesson is about one of the most common reasons why investors reject investment proposals.

Sometimes, you may pitch to an investor or send a copy of your business plan only to get one of the following responses:

“We like your idea, but your numbers look too good to be true.”, or

“We think your business is a good opportunity but your numbers don’t add up.”

Yes, today’s lesson is about the numbers.

It’s usually the weakest link in investment pitches and business plans.

And no matter how confident you are, or how innovative your product is, an investor may love it, but the numbers have to work.

That’s because, in the end, investors make most of their investment decisions based on numbers.

And if you can’t give them the right numbers, they can’t make a decision.

And if they can’t make a decision, you don't get their money.

See the connection now?

So, today’s lesson is inspired by an email I received from Bhau who’s originally from India, but is currently based in Egypt.

Here’s an excerpt from his email.

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Hi John-Paul,

I’m asking this question because one of your students has been forwarding your free email lectures to me so I got interested.

My question is, what exactly is EBIT and what percentage is required when a business is at a prototype or startup stage?

Most of the time when I try to raise capital, the investors keep asking how come the EBIT from the first year is 74%, and in the second year it has gone up to 87%. They say the figures are too high because my business is at the prototype stage?


Please help us at this point so we can correct the mistake.

Thanks

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Great question, Bhau.

Because you asked, thousands of people are going to learn from today’s explanation.

I know many entrepreneurs find the numbers part of business planning boring, but it’s difficult to succeed in business without understanding the numbers.

And as usual, I’ll make this lesson interesting for you.

So, what is EBIT?

It’s simply = Earnings Before Interest and Taxes.

As the name implies, it’s the profit your business makes before paying interest on any loans it took, and before paying any taxes to the government.

Why are investors interested in EBIT?

Good question.

EBIT is actually an undercover name that accountants and finance people use to sound intelligent.

The real reason investors are always interested in EBIT is because of its real name.

EBIT's real name is Operating profit.

Operating profit is a big deal to investors.

So you really understand why it’s very important, I want you to understand the concept from its very roots.

There are actually 3 types of profit

Yes, there are actually 3 types of profit investors will be looking for in your pitch or business plan.

The first is Gross profit.

This is the profit your business makes after you remove the DIRECT costs of making or buying the product from the sales price.

Let’s say your business sells smartphones for $400 each. That’s your sales price.

You buy the phones from your supplier for $250, and the cost of shipping each phone to your shop is $50, giving a total direct cost of $300.

As a result, your gross profit for each phone is $100 (400-300), and the gross margin is 25% (100/400).

The second type of profit is Operating profit (or EBIT).

This is the profit your business makes after you remove the INDIRECT costs of running your business from the gross profit.

Note: Indirect costs are also known as “overhead” costs.

Using the same example, let’s say the total overhead costs of running your business (electricity, staff salaries, internet, shop rent, etc.) comes to $25,000.

And during the year, you sold 1,000 phones. So, the overhead cost per phone comes to $25.

When you subtract this overhead from the gross profit of $100 per phone, that gives us an Operating profit of $75, or an operating profit margin of 18.75% (75/400).
The third type of profit is Net profit.

This is also known as Earnings after Tax (EAT) or Profit after Tax (PAT).

As the name implies, it’s the profit that remains for the business and its investors after the business has paid its taxes.

I won’t worry about this calculation here because tax rates and rules vary across different countries.

So, why do investors focus on EBIT (Operating profit)?

As any accountant will tell you, tax rules are flexible and there are several legal ways to reduce the amount of tax a business pays.

That’s why investors focus on the operating profit.

If the business is not making any operating profit, there won’t be any taxes to pay.

Also, if the business is making high gross profits, but the operating profit is low, then it means the business is carrying large overheads.

But if the gross profit is the problem, then it means the business cannot be profitable no matter what you do to the overheads.

If gross profit is low, you can either increase your sales prices, or cut down your direct costs.

But here’s the interesting part

At the startup stage of a business, the operating profit is usually low for most types of businesses.

In fact, for many startups, the operating profit (EBIT) is usually negative (below zero).

You know why?

At the startup stage, most businesses experience very low sales. That’s why it’s a startup: the market doesn’t yet know you.

And to increase sales and survive, startups have to incur several costs.

They have to invest in sales and marketing, invest in inventory, and buy equipment to make the product or prototype.

On top of that, the startup has to pay rent, hire staff, and pay other important bills like legal, utility and other setup costs.

As a result, most businesses spend more money than they make in sales to support the business in the startup stage.

That’s why the operating profit (EBIT) is usually low or negative for most startups.

And if you’re in the prototype stage (which means there’s no product to sell yet), it’s very likely your EBIT will be less than zero.

Too good to be true

So, when an investor sees an EBIT that’s as high as 74% for the first year of business of a prototype-stage company, guess what they’re thinking?

These numbers are too good to be true.

If all you have is a prototype and there’s no sales coming through the door, how can you possibly have an EBIT that high?

Maybe in your financial projections those EBIT numbers could be possible in the 3rd, 4th, or 5th year.

But in the first year (as a prototype), investors are likely to *cough*

So, here’s what you need to do:

There is no good or bad EBIT.

It all depends on your kind of business.

A startup service business, like a consultant working out of her house, is likely to have a higher EBIT because her overheads are much lower than a manufacturing or retail business that has to make or buy products to sell.

Also, the level of sales determines the size of the EBIT.

If your sales are much higher than your costs, the EBIT will be high, and vice-versa.

That’s why the EBIT of a business in the growth or maturity stage is likely to be much higher than that of a business in the startup or idea stage.