How much of the business should go to the investor?

As a cashflow lender to small business, I am occasionally asked for a large chunk of money and offered absolutely no security in return. Unfortunately (!), unsecured lending for start-up enterprises and business acquisitions does not exist in Australia. What does exist is equity finance.

So after your client comes to the realisation that they will not be able to raise the funds they need via an unsecured loan (for their business start-up/ acquisition/ expansion), how much of their business are they going to have to relinquish to an in-coming equity investor/ business partner? Say for example the client needs $500,000 to start-up a widget making business. How much of the new enterprise should the money-partner (investor) get to own?

A simple three step calculation can provide the answer to this question.

Step one is to calculate the value of the business in five years time (the normal investment horizon for equity investors). How do you calculate the valuation? See my blog posting from two weeks ago for a detailed explanation, but the short answer is that you multiply the projected EBITDA (Earnings before Interest, Tax and Depreciation Allowance) by the relevant earnings multiple. Lets say in our example the projected EBITDA will be $1M, and the multiple is five times. The business in five years will be worth $5M.

Step two is to calculate the "present value" of the projected business valuation. To do this, you will firstly need to apply a "discount rate". The riskier the business, the higher the discount rate, but lets say in our case we are going to apply a discount rate of 30%. We now divide our projected business valuation by 130% (or 1.3) five times. In our case here, that gives us $1.35M.
Step three is to calculate now how much of the business the investor should receive. In our case, the investor is putting in $500,000. This is 37% of $1.35M, so the investor should receive 37% of the shares.

The variables here - all of them open to vigorous debate in any negotiations between investor and investee, will be the projected EBITDA, the earnings multiple applicable in five years, and the discount rate.

Investors will argue to business owners that owning 63% of something is better than owning 100% of nothing!

However most small business owners are simply unwilling to sacrifice such a large stake in their business for what they believe is such a small amount of money - which is why debt finance is usually more attractive - even if it does mean that security will have to be (begrudgingly) put on the table, and regardless of interest rates (within reason). Risking the family home, and paying a premium for the money is usually seen as a reasonable trade-off for retaining 100% of the business, and 100% of the pay-off for all the hard-work!