How can I calculate investment vs equity share in a company?

[AcidReflux]

As a PH member I'm always looking to increase the number of company directorships I hold. And another opportunity has come up to join a company as an equity director. I've never bought into a company before so I don't know how this works. Here's my guess:

Company turns over about £1m. Net profit average say £170k
If I've got the opportunity to invest £50k is it reasonable to expect to get that back in three years?
If so, I need £17k per year, which is 10% of the profit. So my £50k would need to buy 10% of the company, valuing it at £500k.

Am I on the right lines? Or anywhere near them? I've got the first cards-on-the-table meeting with the MD later this week and it'd be nice to have a rough idea of how this works, but I don't have much time to research this between now and then. If anybody can point me towards some helpful plain-English websites on this subject then I'd be most grateful. Most of the ones I've found seem to be geared towards stockmarket investors.

[Dr Jekyll]

Sounds the wrong way round to me.

If 10% profit is reasonable bearing in mind risk, then 170K profit implies a valuation of 1.7 Million. So 50K gets you 3% of the company, so 3% of the profit.

[AcidReflux]

Dr Jekyll said:

50K gets you 3% of the company, so 3% of the profit.

Thanks for the reply. 3% of the profit (£170k) is £5k, meaning it'd take ten years to get my £50k investment back. Is that a reasonable/normal expectation?

[The Ferret]

AcidReflux said:

Thanks for the reply. 3% of the profit (£170k) is £5k, meaning it'd take ten years to get my £50k investment back. Is that a reasonable/normal expectation?

You're assuming the company pays all of its profits out to shareholders ever year. If that is the case then yes it is reasonable, but companies tend to want to reinvest so that they can grow/diversify/etc...and present a picture to the outside world that it is adding value rather than just stripping out profit.

Edited by The Ferret on Tuesday 20th September 09:10

[anonymous-user]

If you invest £50k and get £17k a year back in dividends, that is a 34% ROI

Remember that as well as getting £50k back in dividends, you would also still have whatever shares you get for your £50k in the company - potentially a future dividend stream or a payout (maybe at a multiple / premium) on exit.

For a small company making £170k a year, a sensible valuation would be somewhere from 1x - 7x annual profits so your £50k would represent something from to 4.2% to 29% of the value of the company. Aim for the highest you can get!

[AcidReflux]

Is it impossible to say what's "normal" in these circumstances because it's too variable depending on the type of business, its growth history and forecast, its balance sheet etc.? How do people normally work out what to expect from a deal like this? How do the five on Dragons' Den work it out, for example?

[The Ferret]

AcidReflux said:

Is it impossible to say what's "normal" in these circumstances because it's too variable depending on the type of business, its growth history and forecast, its balance sheet etc.? How do people normally work out what to expect from a deal like this? How do the five on Dragons' Den work it out, for example?

They ask the major questions on the spot, such as revenue/profits/orders/salaries/debt and along with their knowledge of business (often in the specific sector in question)and whether they see the service/product attractive, they make their decision.

What then goes on behind the scenes is unknown to us, but you can bet that a huge due diligence is undertaken to make sure nothing nasty is lurking which they were not made aware of which would have altered their decision had they been aware.

You need to do that type of exercise yourself. You need to know a fair bit about the market they operate in, its competition, sustainability etc, then get to the bottom of what is going on in the company itself. A lot of work but well worth it in the long run. If you cant get that sort of info or simply dont have the time I would be asking an advisor for some help.

Once you've worked out whether its worth investing in then you can look at the return. You may find its really not all that special, and not worth investing 50p let alone 50 grand. Then again it could be a very good long term investment, and you may be happy to get a lower rate of return than if its were a more risky investment.

So many variables make it a difficult job, but the more questions you ask and the more info you get make the job a lot easier.

Edited by The Ferret on Tuesday 20th September 14:17

[AcidReflux]

Thanks Ferret for your lengthy reply. I appreciate it.

Coincidentally, I've just come off the phone with my accountant and he's going to pull out enough research about the company to help me make an informed decision. This thread is enough of a clue that there's no standard way in which this works but last night I thought I'd ask the question anyway in case the answer was straightforward.

[mx stu]

JPJPJP said:

For a small company making £170k a year

You need to make sure the £170k net profit is the real profit. Try (or get your accountant to try) and identify non commercial rate transactions (i.e. management not taking market rate salaries, the business leasing cheap offices/ factories from directors or any other similar transactions).

If you invest on the basis of £170k net profit then they turn around and wipe that profit out by paying themselves market rate rent/ salaries then you've made an expensive mistake.

[Beardy10]

I'd be amazed if a small company that is looking to raise additional capital by diluting exisitng shareholders is paying out dividends. If it's paying out dividends it implies that the company has no need for the capital. You should be investing in a company like this thinking about capital growth not a dividend yield....if nothing else the tax treatment is much better.

[The Ferret]

Beardy10 said:

I'd be amazed if a small company that is looking to raise additional capital by diluting exisitng shareholders is paying out dividends. If it's paying out dividends it implies that the company has no need for the capital. You should be investing in a company like this thinking about capital growth not a dividend yield....if nothing else the tax treatment is much better.

Have to agree it all sounds a bit too good to be true, but without knowing the background behind the offer to the OP its difficult to tell what is going on. If he knows the existing shareholders well and his money is wanted for the right reasons then great. How did the opportunity come about?

One other thing worth thinking about is the type of work/service they offer and the risk of defects/problems relating to prior years revenue. Can I ask what type of business it is?

[AcidReflux]

Essentially it's a job offer. There are people that the company could employ instead of me, and the salary the MD is offering is not spectacular (no more than I currently earn, for example), but I've been a supplier to this company for a decade and we work very well together. The MD wants me to join because he knows it would be an easy fit, and I think the offer of equity is a sweetener and wouldn't necessarily be offered to other candidates. There are no other shareholders involved so it's quite a big leap for him to offer a chunk of his company to a third party. As far as I can tell, the company doesn't need my cash.

Ferret - the company is in the media industry. Fewer than ten employees. Husband/wife shareholders. Chance of liabilities against previous years' revenues is very low.

[anonymous-user]

I would be surprised if the MD is thinking of offering anything like 30% of the company

5% tops is my thought

[AcidReflux]

JPJPJP said:

I would be surprised if the MD is thinking of offering anything like 30% of the company

5% tops is my thought

You could be right. I just don't know how much investment he'll expect in order to hand over that amount. If he values his company at £1m then 5% will cost me £50k. But it'd take quite a while to get that £50k back, by the looks of things.

[Beardy10]

You need to be very careful. Too many people go into deals like this only thinking of the positives.....you need to think about what happens if it goes wrong too.

Being a minority shareholder gives you absolutely zero power....i.e. they can still run the company as they want. They can give themselves pay rises to get money out of the company rather than paying dividends...so can effectively cut you out of any profit share. Minority shareholders do have some rights but basically it will give you no say in how the company is run and make it harder for you to leave....and it sounds like you are being paid a fair if not stunning salary. You will obviously share in the success should the company be sold but you will have no say over that.

If you are getting only an average salary and you are bringing something to the company they should be giving you equity rather than you paying for it. As it stands they are potentially hiring someone who brings massive added value to the company and he's also putting money in the bank........

[AcidReflux]

Beardy10 said:

you need to think about what happens if it goes wrong too.

I hoped the shareholder agreement would cover enough of the variables to offer some protection, wouldn't it? Or am I overestimating its importance?

Beardy10 said:

If you are getting only an average salary and you are bringing something to the company they should be giving you equity rather than you paying for it. As it stands they are potentially hiring someone who brings massive added value to the company and he's also putting money in the bank........

I would hope I'd bring value to the company anyway but as I mentioned before the most important asset I have that other candidates perhaps wouldn't is a track record with their team and their clients. This is valuable to a small company like this. On the other hand, if I don't sign up to a deal, the MD will be forced to hire someone else and I'll lose about a third of my income. The MD probably feels that he doesn't need to offer an over-generous deal because of this, but I don't know how much importance he places on my track record.

I don't think the salary he's offering is taking the piss, but it ain't great. It's a small company though and he needs to keep a close eye on his monthly salary outgoings.

Thanks for the advice, Beardy10.

[Beardy10]

AcidReflux said:

Beardy10 said:

you need to think about what happens if it goes wrong too.

I hoped the shareholder agreement would cover enough of the variables to offer some protection, wouldn't it? Or am I overestimating its importance?

Beardy10 said:

If you are getting only an average salary and you are bringing something to the company they should be giving you equity rather than you paying for it. As it stands they are potentially hiring someone who brings massive added value to the company and he's also putting money in the bank........

I would hope I'd bring value to the company anyway but as I mentioned before the most important asset I have that other candidates perhaps wouldn't is a track record with their team and their clients. This is valuable to a small company like this. On the other hand, if I don't sign up to a deal, the MD will be forced to hire someone else and I'll lose about a third of my income. The MD probably feels that he doesn't need to offer an over-generous deal because of this, but I don't know how much importance he places on my track record.

I don't think the salary he's offering is taking the piss, but it ain't great. It's a small company though and he needs to keep a close eye on his monthly salary outgoings.

Thanks for the advice, Beardy10.

A shareholder agreement won't really protect you that much to be honest....you need to read it carefully obviously as it will have been written from their perspective.

You definitely need to think about what happens if your circumstances change and should you want to get your money out. Maybe some kind of good leaver clause ?

The only way you can really have protection as a minority shareholder is to also be a director and have certain things needing a unanimous board vote like remuneration, major capex etc. That's very hard to get and a very hard conversation to have in your situation though....

[walm]

Really quickly on this - you have to be very careful to assess TWO very different questions.

1. What is the company worth as a pure investment?
2. What is the opportunity for me to work there worth?

For a rock solid, boring, not growing much business with £170k STABLE in TRUE net income then a 10% return each year isn't bad.
So that would value the company at £1.7m (£170k divided by 10%).

If it is growing - how fast, why and how much capital does it need. What do the cash flows look like.

REMEMBER do all that math assuming that he employs someone OTHER THAN YOU so that you have a pure INVESTMENT and don't ignore or double count your own contribution to the profits/costs.

Then ask yourself whether you want to work their for 1/3 of your time. That's question 2.