Buying into a Start-Up Company and Valuing the Percentage Stake

[mtgray]

Hello to All!

I've been approached by a small group looking to start up a business locally and presented with an offer to "buy-in" to the company in return for capital. The group has put together a business plan based on similar business models already existing in the area and prior experience. The plan contains all of the necessary info. for valuing a business and projects the cash flow out to Year 5. The numbers, although quite rough, do present what I feel is an accurate projection for the business. Since the business is retail based, some uncertainty (due to sales and material costs) is accounted for in the projections. The group already consists of 3 partners, I would be the 4th. I would contribute minimal hours (15 hours or less) per week to the business in order to help with start-up related activities, however this would likely increase.

The offer:

$30,000 USD investment in return for 3% ownership in year(s) 1-3 and then adding an additional 2% stake by Year 5 (for a total of 5%). After Year 5, an additional 2% stake would be made available for purchase to bring my total share up to 7%.

Without going into great detail, the initial evaluation (cost) of the business that includes construction, equipment, and start-up costs is $590,000. The annual revenue for Year 1 is estimated to be $438,000 and is projected to increase by 25% for Year 2 (due to sales) and then projected to increase by 15% in growth for Year(s) 3,4,5.


I would appreciate if some successful business gurus could help me:

1. Understand if you would consider this a "fair" offering for this type of scenario;

2. Value the ownership stake offered (whether or not the stake offered is reasonable for the $30,000);

3. How should I determine how to value the additional offerings after Year 5. Should I put some sort of clause into the agreement to determine how the additional 2% will be priced or distributed?



Thanks to everyone in advance!

[Fulcrum]

I wouldn't put too much faith in projected income values as there is currently no basis for them (you've got what the other guys are doing but not what this guy does). Yes, you do need to have some projections but never forget that that is all they are.

How much cash are the other 3 partners putting up? Sure, all 4 of you are taking on almost $600k worth of debt combined, but what is the cash being put at risk? This is what should determine each partner's equity going in. If you're putting up $30K and the other 3 partners are only putting up $10K each than you should be getting 50% of the equity (slightly less if you are held free from any debts).

Also, 3% ownership for $30k tells me that this business is being seen as being worth $1,000,000 and not a single sale has been made yet. In my opinion, you need to be getting a lot more than 3% right now.

[turboguy]

I agree with Brad that 3% isn't enough. Are there contingencies concerning the additional 2% that takes you up to 5%. Assuming the start up costs are the $ 590,000.00 you mention then 5% would be more appropriate. Is there any pay for the 15 hours or less you will be putting in? How about for the other partners for the time they put in?

Forecasts for a business that is only in the planning stages are about as useful as a weather forecast for November 16th 2018. For some reason we never erased a whiteboard in our office where around Sept 1st of 2014 we all took a guess as to our sales for that year in total. With only 4 months left our guesses missed the mark by a mile and our closest guess which was mine missed by nearly 25%. This is for a business that had been in operation for 24 years at the time. Probably only 40% of start up businesses make it to year 5 at all so don't put a lot of faith in the projections.

[PZagotti@ZnBcpa.com]

First Brad is correct based on what they want you to pay for 3% they are going for a 1 million dollar valuation.
If top line is coming in at roughly 438K then you are purchasing at over 2X topline.

So now let me break out my Mr. Wonderful impression... "Really 1 million valuation on a business that has not even opened its doors. And I am spending my money on a business that might make 438K in the first year if eeeeverything goes right? I mean is sounds like everything has to go right for me to breakeven on this deal for years to come and when I invest money I invest money to make more money. And you have to work for them too???? So show me where the upside is in this thing."
If you do not know who Mr. Wonderful is go watch shark tank and you will understand the above statement.

You see when you are an initial investor you have to price risk into the model and as a result you must pay much less then expected fair value. So as an investor right now I am not loving it.

My question is what is projected net profit for the years in question?

So 30K is so small in comparison to the cost to purchase inventory and open opening a bricks and mortar location. Why are they asking you for the money?
What are they going to spend the money on?

What kind of entity is this?
If they are bringing you in as a general partner in a partnership then you could be personally responsible for the liabilities of the company.
Many times operating agreements have a cash call clause and if you do not bring extra cash to the table when an official call is made you can be diluted out of your ownership of the company. Are you willing to / do you have the money to throw more money after this thing just to keep the 3% interest?

There are so many other questions I could throw your way but this is not really the forum to get a good answer. You really need to find a CPA and attorney in you area that has M&A experience to have them go over the deal with you.

One last question, what would be your exit strategy?
When you make an investment you should know at what point you are getting out.
You would be a minority interest in an illiquid entity with few other buyers.

Here is my advise, if they need the money then make them a loan and take a collateral interest in their inventory and a 3% profit interest in the company. As they pay off the interest bearing note you reduce you collateral interest in the inventory on hand and you will return the 3% profit interest at the end of the year the loan is paid off in full.
So you get an interest rate on the money you loaned them and 3% of the profits for each year the loan is outstanding.

You will want to have an attorney write the agreement up and perfect your lean at the court house just to protect your interest.

[Clarkempire]

Short and sweet.

I would never go in on a business with that small a share based on projected income.

[Harold Mansfield]

I agree that I wouldn't invest in anything, especially retail, for that little a share. And also be required to work the business for a min 15 hours a week? Estimates and projects are guesswork. It's what you want and plan on making if everything goes exactly right. People usually take their expenses, some general number of the entire industry, and then "project" a percentage of it all as what they're going to do.

No matter how they come up with the numbers, they are still goals/wants. Not certainties. It could also be zero or a loss the first year, or longer.

You're there and seeing it first hand. You are speaking with the others involved and can get a feel for whether or not they know what they're doing, and if have a solid plan that makes sense. Without the benefit of all of that important, additional information it doesn't sound like a good deal on the outside looking in to me. I can think of better things to do with $30k and not have any partners.

JMO of course.

[Kg3000]

So i am not sure if you did this deal yet, but I would be very careful. Whenever I am approached to do a deal I look at things and see what do they really need me for. Sometimes its money, other times its for expertise.

Not sure if this was answered but where is the 590k coming from? Are the other partners bringing in that much money on their own and if they are why do they need your 30k? or do they need the 30k for financing on a larger loan as a down payment, (I would think they need closer to about 100k-120k for a down payment.) That is probably where I would start when calculating the equity, if they really are only doing it as a down payment and need about 100k-150k, 30k of which you will supply then they should be giving you about 20-30% of the business. Seems high but remember in this scenario you would be bringing in a lot of the money and working on top of that.

Another thing is if they are just self financing they you need to see what they need from you. The 30k at that point is meaningless, you could probably cut a deal where you work the 15 hours and get 3% with the option of 5% later on just with the sweat equity. This is assuming that you are coming in as an expert in whatever the business is.

Either way I would do some due diligence, make sure to run background checks on everyone and look at any past business deals good or bad that they have been involved in.

Good Luck!!