An anecdote illustrating the importance of distinguishing the firm from its owner

I once had a business in publishing and I was renting from a landlord who also had a publishing house, "Les Editions Entente", in the same building on the floor beneath my offices. He wanted to sell his business, and thought of me. He asked me whether I was interested in buying "Les Editions Entente". I said: "Why not? Can I see the accounting documents?" He gave them to me. They showed a turnover of 2 million French Francs, and a profit of 300 000 French Francs. A pretty good performance!

I looked more closely at the accounts but couldn't see rent. I asked: "Your firm doesn't pay rent?
- No, the building belongs to me.
- Well but there should be a rent. In fact the figure would be about 300 000 French francs. So in truth your profit is 0."

He looked at me with eyes like table plates.

To try and make him understand that he was giving 300 000 French Francs per year to his firm - which explained the profit -, I asked him: "If I purchased the firm from you, would there still be no rent?
- Oh no, in that case you would owe me 300 000 French Francs per year."

He was mixing up the accounts of his firm and his own personal accounts. He thought that he was selling a highly profitable firm (therefore worth a lot of money) when he was actually selling an unprofitable one. A firm making no profit, in the most usual cases, to any buyer, is worth about nothing*. Someone could argue: "But it can pay you a salary!" Yes but you don't need to purchase the whole firm in order to sell your work. In fact this is an interesting question in the economics of work markets that we shall not address here.

When we say that Joe puts 10 000 euros into his firm this means that afterwards Joe has 10 000 euros less in his pocket, and his firm owns 10 000 euros. And from now on what we are interested in is what the firm does with its money. We are no longer interested in Joe's personal accounts. When we sometimes say casually "Joe purchases a van", it is a slightly abusive way of speaking: it is Joe's firm which purchases a van.

In small businesses the owner usually is also employed by his firm, so the boss may receive a salary for his work. In the toy example the owner receives a salary at the end of each month. This salary is paid to the owner because he works in the firm. You don't pay salaries to shareholders, you pay salaries to workers in the firm, that is to people who sell their work to the firm.

* We shall see later how we approach valueing a firm. It may have different values for different buyers, being worth nothing to some but being worth a lot to others, because the value of a firm depends not only on the firm itself, but also on the buyer's other activities. (A bow is worth very little to me, but is worth a lot to a violin player who happens to have no bow. Of course I could buy the bow in order to sell it to the violin player...)