What should a split be for a silent partner?

[TonyP]

I need some help in structuring the split on a new business.

I'm new to all of this but from what I can gather from reading through the archives I have an idea of how to do this but I would like you guys opinion on this.

The business will be a new franchise which I will be running. The franchise model allows for a semi absentee ownership but I'm realistic in regards that I'll be putting in alot of hours in learning the business. As the business normalizes I am expecting to put in about 20 hours a week. The total investment is projected to be about $200,000. My projections are and these are conservative:

1st year - break even to negative $20,000
2nd year - $30,000 profit
3rd year - $60,000 profit
4th year - $70,000 profit

I will be taking out a small business loan of about 65% or $130,000 which I will be personally guaranteeing. As for the remaining balance of $70,000 I am looking at bringing in a silent partner.

My partner which I have invested with before in the pass (on real estate deals) is only looking for cash flow. He does not want to be involved in the business. If he was to invest $70,000, would a 50/50 split of the profit until he gets his initial investment back and then a 80/20 split afterwards where he gets the 20% be good? I am also looking at having an opportunity to buy him out after 5 years. Does this seem to be right? Or am I giving up too much or too little? I want to be fair. I have not factor in paying myself but I don't know if I should. And if I do how much should I pay myself?

Also what should his equity share be? I'm assuming if he's investing $70,000 that's 35% of the total investment so should he get 35% equity or should he get 50% because he's investing all the equity up front? Can the share be scalable as well?

Sorry for all the questions but all this is new to me. Thank you for being patent and answering my questions.

[ArcSine]

Your preliminary thoughts form the basis for what sounds like a reasonable deal. The numbers and percentages may change as you continue to fine-tune your projections, and as a result of negotiations, but the general idea of giving him an accelerated return until some trigger point (he's gotten back some X% of his investment), then scaling back to a lower %-age thereafter is a common structure concept.

If his 20% share (or whatever the final % ends up at) doesn't automatically terminate at some point by its own terms, then your holding a buyout option (as you've mentioned) is very important. Not only could an open-ended 20% cut from the pie prove to be VERY expensive to you down the road, but for various tax-administration and bookkeeping reasons it's expensive to have a minority equity interest hanging around on the books long beyond the usefulness of their initial investment.

As an alternative to the buyout option you might consider having the 20% share self-terminate. Similar to the way a loan is eventually paid off, the equity interest is deemed liquidated after it has received some defined ROI on top of its capital return. With this alternative you can still set the terms in such a way that he's taken out only after he's received some fair overall, start-to-finish rate of return on his investment.

The mechanism whereby he gets 50% (or some other %-age) only until some trigger point, then significantly scales back, effectively mitigates your stated concern of "giving away too much". Then layering on either a buyout option, or a self-liquidating provision in his residual equity interest, adds a second tier of protection for you.

His "equity share", which you asked about, is simply whatever it is, as defined in your final agreement. Arrangements (such as the one you're contemplating) which involve varying payout percentages at different times and under different scenarios really can't be described with a single %-age number. It's human nature to want to say, "Bill is a 40% equity partner", rather than, "Bill gets 40% of current cash flow surplus after deducting Items (2) - (11) of Section IV.B of the partnership agreement; 37.2% of any net asset liquidation proceeds in excess of $1,250,000; and has 7 ½ voting rights units on all partnership matters described in Section III of the agreement." The simpler version is really meaningless without considering the background context.

My point is that you don't have to worry about what his "equity share" would be described as. Once you've defined his cash flow share and terms, any buyout options, any veto or approval rights he might be given under certain conditions, then you've fully defined his "equity share" thereby.

[huggytree]

because he invested $70k he should get 20% for life?

i dont deal in the world of investors, but it seems crazy high.....yes the 50/50 thing sounds great until he's paid back, but does he deserve $10k-20k a YEAR for the rest of his life for it???

not a deal id do

i wouldnt look for a silent partner...id just look for a investor...give him 100% interest.....but not 20% forever

i doubt you'll find someone on this forum who can give you the professional advice you need....but you'll get some opinions like mine

[Freelancier]

So flip the situation: you're investing your hard-earned $70K in a business. You're really investing in the business' owner unless that money is funding a piece of capital equipment you can re-sell. So... how good is that business owner? What's his/her track record?

What is a reasonable return of an unsecured $70K investment? What's the desired timeframe to getting your money back? At what point -- if the business isn't returning your investment -- before you move to take control? Can you take control?

I can get 8% per-year without a high level of risk in this market. Unsecured credit card debt gets 13-25% per year, but a business owner is not likely to get $70K that way. I'd want minimum 20% direct return per year + an ownership stake that automatically moves to 51% ownership if those 20% payments aren't up to date after 2 years. But that's me.

[cobase]

On the equity piece, it can be whatever you want. Keep in mind that most of the value is not going to come from the up-front investment, but rather from the work that you put in. So I would personally take 35% equity as the top end of what that investor would receive. That's basically saying they will get 35% of profits *forever*.

Are you suggesting they would get 50% of the profits for the first 4 years (based on your projections), and then the other 50% would accumulate to the business (of which they would own 35%)? So, you would be putting in literally all the work and twice as much capital, yet this investor would get 68% (50% + 50%*35%) of the profit for 4 years? That is not anywhere near a good deal in my book.

This sounds like a terrible deal to me. Do you know this person or are they trying to sell you something?