I am looking to invest in a small business, they need let's say 20k to take the company to the next level.

The company is currently a pretty much one man band, wanting to expand to employing several staff. It is about 5 years old, has several ongoing customers and is profitable.

FWIW The company is an IT services company (networking, phones, OS installs etc).

I have the cash available, the business plan sounds good, have done diligence etc. So I want to know for my $20k what would be a fair percentage ownership once the deal is done.

So to generalize the question:

When investing in a small business (for equity), what kind of things should be considered, to work out what would be a fair percentage stake, for a given $ of investment?

  • Somewhere between 1 and 100%. This question should be closed. – Pete B. Jul 24 '17 at 11:27
  • @PeteB. That is a very elegant answer; sadly it doesn't answer the actual question asked. Paraphrased: What to consider to work out the percentage (NOT the final percentage). So since that is a different question I don't think it should be closed. Suggestions on how to clarify, phrasing the question, is more than welcome though. – DarcyThomas Jul 24 '17 at 22:29

There is nothing fair / unfair in such deals. It is an art than a science.

what kind of things should be considered, to work out what would be a fair percentage stake

A true fair value is; take the current valuation of the company [This can be difficult if it is small and does not maintain proper records]. Divide by number of shares, that is the value of share and you should 20K worth of such shares.

But then there is risk premium. You are taking a risk that an small start-up may do exceedingly well ... or it may close off. This risk premium is what is negotiated. It depends on how desperate the owner of the small company is; who all are interested in this specific deal ... if you want 30% share; someone else is ready to offer 20K for 15% of share. Or there is no one willing to lend 20K as they don't believe it will make money ... and the owner is desperate, you may even get 50%.

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  • Adding onto this. Say if the company is mutually valued at 100K. Someone investing 20K gets 16.66% of shares outstanding (this can be done by issuing new shares). I often see people miscalculate this (conflating an investment with buying shares) – Lan Jul 24 '17 at 17:24

It should be pretty obvious that without knowing what sort of assets the company owns, and what sort of net earnings are being generated it's impossible to say what a $20k equity investment should get you in terms of ownership percentage.

With that said, you want to look at a few to several years of books, look for trends. Some things to understand that might be subtle red flags:

  • Who are the clients?
  • What percent of revenue are the top 5 clients?
    • Assuming there are more than 5 clients.
  • Is the revenue cyclical?
  • How much has the owner invested?
  • Are there other investors?
  • Does the business have any debt?
  • What will this $20k accomplish?
    • Is this will be for new hires, how will that person be found? What are they going to do? What will they be paid?
    • Is this for equipment?
    • Is this money simply going in to the owner's pocket in exchange for some percentage of future cash flow?
  • Is this business a "real" business?
    • Business license, business tax returns, bonded, insured, etc.

It's extremely common for early stage investors to essentially make loans rather than strictly buying shares. In the worst case scenario creditors get to participate in liquidation proceedings before shareholders do. You may be better off investing in this business via a loan that's convertible to equity at your discretion.

Single owner service companies are difficult because all of the net earnings go to the proprietor and that person maintains all of the relationships. So taking something like 5 years of net earnings as the value of the company doesn't make much sense because you (or someone else) couldn't just step in and replace the owner. Granted, you aren't contemplating taking over the business, but it negates using an X years of net earnings valuation method. When you read about valuation there is a sort of overriding assumption that no single person could topple the operation which couldn't be farther from the truth in single employee service companies. Additionally, understand that your investment in a single owner company hinges completely on one person's ability and willingness to work.

It's really vital to understand the purpose of the funds. Someone will be hired? $20,000 couldn't be even six months of wages... Put things in to perspective with a pad, pen and calculator. Don't invest in the pipe dream of a friend of yours, and DEFINITELY don't hand this person the downpayment for their new house. The first rule of investing is "don't lose money," this isn't emotional, this is a dollars and cents pragmatic process.

Why does the business need this money? How will you be paid back?

Personally, I think it would be more gratifying to put $20k in a blender and watch it blend, this is probably a horrible investment. The risk should just be left to credit card companies.

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