A much-misunderstood concept for the layperson, or less experienced entrepreneur, is the notion of net proceeds.
In this article we’ll walk you through the term, what it means, how it’s calculated and why it’s a vital concept for any business to focus upon. We’ll also examine net proceeds vs gross proceeds, and what sets these terms apart.
What are Net proceeds? – An example
What does net proceeds mean? Net proceeds are the amount the seller receives following the sale of an asset after all costs and expenses are deducted from the gross proceeds.
Gross proceeds are simply the full monetary sum levied by the seller. Imagine you’re selling a car. In order to do so, you have to make some repairs, arrange for a Department of Transport Inspection Report, obtain an odometer disclosure witnessed by a notary, fill up the gas tank and advertise for buyers.
Let’s say you sell your vehicle for $10,000. However, you have the following costs:
- Repair and DoT documentation: $1150
- Odometer Disclosure (notary public): $50
- Tank of Gas: $80
- Advertising costs: $40
This means your gross proceeds were $10,000 but your costs and expenses were $1320, leaving you $8680 in net proceeds.
Note that the above calculation does not make any reference to the average market value of the vehicle, or the money you spent buying it in the first place. That’s because net proceeds refer to the value created by a particular transaction. In this example, that’s the sale of the automobile. Your original purchase happened at an earlier time and is not factored in, for the purposes of this example.
The above example also assumes you are selling your vehicle at a loss. If you made a profit, in relation to the original purchase price, and allowing for the costs of any non-standard repairs, you would be liable to pay capital gains tax on any profits made. That tax would then further reduce your money in hand. For most used car sales, this is not a common scenario.
What is the difference between proceeds and net proceeds?
Proceeds is a general term referring to monies received by a seller in a transaction. If this term is used, it’s important to ask for clarification. Does this term include costs and expenses (net proceeds) or not?
In other words, “proceeds” is not a useful term to use because it doesn’t indicate whether the sale was profitable or not.
What is the difference between net and gross proceeds?
Net and gross proceeds are very different concepts. In the car sale example given above, the net proceeds were $8680, whereas the gross proceeds were $10,000. Net proceeds are of utmost importance to entrepreneurs and business owners because they give an accurate picture of the profitability of a venture.
The formula for Net Proceeds can be understood as:
Gross Proceeds from Sale – Costs – Expenses
where:
Costs = direct costs of conducting a sale (including marketing, distribution, etc.)
Expenses = ancillary costs (the tank of gas, inspection report and odometer statement)
Do Net Proceeds Include Tax?
No. Tax is applied to net proceeds, rather than gross proceeds. Let’s look at a different car sales example, where your business is buying, renovating, and selling classic cars.
Imagine you purchase a classic 1969 Corvette which has been falling apart in the seller’s garage. You pay $4000 for the car and spend $9400 transporting, repairing, and respraying it. You then have it insured and inspected (a further $500).
Finally, you fill the gas tank and advertise to sell the vehicle for $28,000. A collector talks you down to $26,000 but you’re still happy with the sale. Let’s run the numbers.
Cost of Car Purchase: $4000
Cost of Repairs: $9000
Cost of Respray: $400
Cost of Vehicle Inspection / Odometer / Insurance: $500
Advertising Cost: $50
Tank of Gas: $60
Total Costs and Expenses: $14,010
Gross Proceeds: $26,000
Net Proceeds (Gross Proceeds – Cost and Expenses): $11,990
You would then be liable to pay capital gains tax on the $11,990 net proceeds because these exceed the initial purchase price ($4000). You would have made an absolute profit on the transaction, which includes the cost of buying the car.
Therefore, when factoring whether net proceeds will compensate you adequately, it’s important to factor in any potential capital gains tax. Neither of the above examples consider your time and effort as part of the valuation. If your net proceeds prove inadequate, you may consider the transaction not worth doing.
We hope this article has adequately explained the difference between proceeds, net proceeds, and gross proceeds.
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