Taking on investment - advice needed

[Joe Shepherd]

Hi everyone - i am after some clarification as i am approaching a T junction in my business journey and want to get a clear head on a couple of things;

I have somebody interested in investing in my business. We are early stages but the ballpark figures mentioned are 500k for 25% equity.

The 2m valuation is based on 5 x net profit (standard multiplier in my industry) of 400k. My question is firstly, how does this work logistically. I own 100% of the business, so does he pay me 500k for 25% and then i invest the funds into the business as a directors loan?

Or does he pay the business the 500k as an investment (non repayable) in return for 25% equity. If he does it this way, as 25% owner surely 25% of that 500k investment is his immediately (on paper) and therefore his investment is only really 375k valuing the business at 1.5m, 3.75x earnings?

Any advice is appreciated,

Joe

 

[STDFR33]

There a different ways to invest, and despite what you say, there are different ways to value the business.

Would you let them take 25% for £500k if the company owned a £10m property with no mortgage, for example?

If the sums you talk about are realistic, then you need to get a professional on board.

@Clinton may be able to offer some further advice.

 

[Clinton]

Thanks @The Accountancy Lab

Joe, what you've rightly recognised is that there's a difference between what's known as pre-money valuation and post-money valuation. You'll find extensive discussion of these concepts on various investment, VC and startup websites and blogs.

Whether the investor's valuation was pre or post money is something you'll have to ask him, not us. And bear in mind that there's no such thing as "standard multiplier in my industry"! This is one of the valuation myths I cover here. There may be aspects to your business that command a premium to what other businesses in your industry have sold for recently. As @The Accountancy Lab points out there may be a valuable property. I'll add that the valuable assets could be intangible - they could be your brand, software you've developed, other intellectual property you own etc., all of which won't appear on your balance sheet but could be worth a lot of money.

You need proper advice on this before just jumping into a £500K deal!

In one of your options you mentioned the possibility of him paying the money to you. If he does then he's buying 25% of your shares (at a £2m valuation). You'd be under no obligation to then loan that money to the company. Be aware though that, whatever you do with the money, this is a capital gains position for you personally.

However, these transactions are never as simple as they look from the outside. Any sophisticated investor would impose a million clauses and caveats to his investment. They'll usually want to protect their interests via anti-dilution clauses, getting a seat on the board, having a proper shareholders' agreement drawn up, introducing penalty clauses to protect against key-person (you?) running away etc etc.

You really do need professional advice to best protect your interests on various issues from valuation to the matter of giving someone a lot of power over your business (33% shareholders can be quite a pain in the ass if your relationship breaks down. And 24.9% is a lot, lot different to 25.1% in terms of shareholder power). And, of course, you need a good lawyer to draw up all the legal docs later.

 

[The Byre]

The 2m valuation is based on 5 x net profit (standard multiplier in my industry) of 400k.

There is no such thing as a standard multiplier for any industry. The true multiplier is what an investor believes that company will be worth when the time comes to cash-out, minus what it will cost to get the company to that valuation.

The key word here is 'believe'!

I believe house prices will stagnate. Others believe house prices will rise. So I believe that any one given house is worth somewhat less than the price put on that house by some other potential purchaser. Back in 2000, I 'believed' that property prices were too low and paid 20% over the asking price to secure a deal.

Another key idea here is 'cash-out'.

Never forget that any investor is not handing over £500,000 or any other sum, because he or she likes you, or likes what you are doing. One day (as the song goes) 'not too far away' they will want their money! In countries like Germany and Japan, that day may be 100 years hence. In the UK, it is often just a few years, five to ten is typical! The structure of the company and the investment has to be ready for that day.

Any sophisticated investor would impose a million clauses and caveats to his investment. They'll usually want to protect their interests via anti-dilution clauses, getting a seat on the board, having a proper shareholders' agreement drawn up, introducing penalty clauses to protect against key-person (you?) running away etc etc.

AKA covenants! Buying bits of a company is usually a fairly complex arrangement. Buying £500k in shares involves no paperwork and one telephone call. Buying a house for that sum involves conveyancing docs and letters of conditions, such as "subject to leaving the kitchen fittings intact!" Buying a piece of a company involves all kinds of contracts and negotiations, covering anything and everything from what is to be done with the money, who decides what, who sits on the board, who has rights of veto on senior staff appointments or major decisions and what happens when that cash-out is required!

So, as @Clinton states, you need someone on your side who knows their way around buying and selling bits of SMEs - and no, that is not your High Street lawyer or an accountant (though involving a Beagle and Beans is a good idea) but somebody who specialises in understanding all the issues involved in buying/selling shares in SMEs.

Unfortunately, the market for sales agents for companies is lousy with representatives of the partnership 'Dowee, Cheatem & Howe'. These types of business brokerages will tell you (a) that the sun shines out of your butt-hole (something you knew already!) and (b) that your company is worth "considerably more than the sum you have in mind!" (This may be of course "considerably less" depending on which game they are playing!)

I would have a read through all the blogs and articles on @Clinton's website, take a deep breath and think seriously about getting professional help and adult supervision!

Good luck!

 

[Joe Shepherd]

There a different ways to invest, and despite what you say, there are different ways to value the business.

Would you let them take 25% for £500k if the company owned a £10m property with no mortgage, for example?

If the sums you talk about are realistic, then you need to get a professional on board.

@Clinton may be able to offer some further advice.

We do own property in the business but these will be transferred to me personally prior to investment and therefore won't form part of the deal. The deal is for the trading business and cash in reserves as well as company assets will be added to the valuation.

 

[Joe Shepherd]

Thank you all for your very useful advice - i'll read the articles you have suggested and of course i will be well looked after in terms of appointing the appropriate business' / individuals to look out for my best interests.

 

[billmccallum1957]

Aside from the issue of having the right advice, one would question why anyone would sell 25% of a business generating £400K in net profit P.A. for £500K??????

Just wait 15 months and you have £500K without giving up any equity.... or does this new person bring something new to the business that justifies such a generous offer?

 

[Clinton]

Just wait 15 months and you have £500K without giving up any equity....

Er, something got lost in your calculation

The 25% he is selling only earns 100K a year, so in 15 months that 25% would have earned £125K, not £500K.

On a different matter, business owners often think their business is worth 10x or 20x or 100x their annual profit. The reality is very different. Small businesses are far more risky than buying shares in a listed company. As such they attract far lower multiples.

If you think 5x is too cheap, remortgage your house to raise some dosh and contact me by DM, I've got some great deals for you.

 

[billmccallum1957]

Er, something got lost in your calculation

The 25% he is selling only earns 100K a year, so in 15 months that 25% would have earned £125K, not £500K.

On a different matter, business owners often think their business is worth 10x or 20x or 100x their annual profit. The reality is very different. Small businesses are far more risky than buying shares in a listed company. As such they attract far lower multiples.

If you think 5x is too cheap, remortgage your house to raise some dosh and contact me by DM, I've got some great deals for you.

oops

 

[qul]

If they're investing, then the normal process would be to issue new shares, rather than selling some of your existing shares or doing anything with loans.

eg if you have 100 shares and £500k for 25% is post money, issue them with approx 33 shares. So they'll hold 33 out of 133 shares, ie 25%.

I think I saw capital gains tax mentioned above, but this wouldn't be the case if you issue new shares.

 

[Energise Accounting]

I agree with @qul from an accounts point you just issue some new shares.

Although you do need to get a proper valuation of your company and a decent solicitor.