New Business - how much do I give to my backer?

Discussion in 'Starting a Business' started by user name, Feb 5, 2012.

  1. user name

    user name
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    Hi there,
    I am starting a new HR firm in a niche industry out of Canada, service is global in scope. Have worked in Corporate Finance and with start-ups in the past but someone was never invited to that session on 'how much of my new business do I give up to backers.' Wondering if anyone might be able to give some advice? The dollar value is very low - under $20K to get off the ground with more to come later as I inch into this full-on... thanks in advance.
    K
     
  2. ArcSine

    ArcSine
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    Unfortunately, that ubiquitous question doesn't have a simple one-size-fits-all answer. However, you could take the following approach which puts you into the investor's shoes, and gives the very basic fundamentals an investor would apply in arriving at an answer. Knowing how an investor is likely to come at it gives you a head start in deciding how best to structure your arrangement.

    An investor wants to get a certain %-age return on his bet...ah, investment. That percentage varies across a broad range, but in general it's highly dependent on the level of risk and uncertainty he perceives in your potential cash flows. If your biz promises to generate a steady, predicable, and rather reliable cash flow stream, the investor might be satisfied with, say, 10%. On the other hand, if you're setting up some highly speculative operation, this same investor might require a 35% return (again, just making up numbers here).

    Obviously where your business lies on this spectrum is very situation-specific. The track record of the management team you'll have on board; the economic outlook for your particular industry; how well-capitalized you intend to be (to be able to weather the tough times); the quality of the assets your biz might have on its balance sheet; where in the capital structure you intend for this investor to be (e.g., if this investor is buying some form of "senior" equity which will have a layer of "junior" equity beneath it as a safety net of sorts, that would help to diminish his risk perception a tad, at least);...ad infinitum.

    Having determined an appropriate rate of return, the investor will look at your likely cash flow pattern* and from that will estimate what kind of percentage ownership he'll need in order to realize his required return rate. Just as a highly simplified example, suppose that he's investing 1,000 and requires a return of 350 per year for 5 years (equivalent to about a 22.11% rate of return). If he believes your biz can generate net cash flow of 1,400 per year for at least the first 5 years, then he'd need 25% ownership. (Of course, this assumes this deal is structured such that after he's received his final payout, he is "taken out" and full ownership returns to your hands.)

    *(For this matter he will likely take the forecasts and projections you provide, and then adjust the assumptions they're built on to reflect a more conservative set of estimations.)

    As you're already realizing, there are a truckload of variables that'll affect the answer, in any given situation. How quickly he needs to realize his return (3 years or 8 years?); how much of a say-so in the day-to-day management he'll have prior to his take-out (more control = greater safety in his eyes, as he feels he'll be able to take steps to protect his investment if he sees things going awry); and so on.

    That's quite far from the quick and direct answer you wanted, I'm sure. But if someone tries to sell you the idea that simple answers and easy rules of thumb exist, smile politely and tune 'em out, 'cause they'll cost you in the end. On the other hand, if you approach it with the investor's mindset already in hand, it'll likely help a lot during the planning and negotiations.

    Best of success with your plans!
     
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  3. user name

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    ArcSine - this is exactly what I was hoping for, actually; thank you. My background is in business, but never on this end of things. I do realize it has to be a risk-reward strategic balance and as my industry is basically non-existent in my country, it's very hard to figure out the projections up front. My backer seems to realize that although does not know the industry well; he'll likely stay out of a control position. His only interest will be to get me everything I need in order to operate. As for years to get a return, this is luckily flexible as I'm working elsewhere and unwilling to jump out of this into the unknown - not within my comfort level and leaves me with nothing to fall back on. I guess I will reread what you've written, look at my projections, and come up with a figure.. although I must say I feel a certain comfort in that you've helped me feel comfortable with a figure range already.. :)
    What are your thoughts about building a buy-out clause in to a contract? Something I wish to do as well - I realize this may be floating and have to wait to see what predictions versus reality are, yearly..there may be more than just the start-up capital involved (like the use of his lawyer/highly successful friends for mentor-ship, etc.) So many variables!
    Thank you again.
    K
     
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  4. ArcSine

    ArcSine
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    I'm glad it helped a bit, K. Buy-out provisions are a standard component of most private investment deals. Very few financiers of small businesses have any desire to have their money tied up inside of any one company for a long-term haul. They typically want to see their money grow by a certain multiple within a certain time frame (or equivalently, to earn a certain percentage return on their capital), and then cash out.

    There are exceptions, of course---it's an individual thing---but more often than not the backer's objective is to get out relatively soon, having earned an attractive return or multiple.

    Also, in my earlier post I didn't intend to imply that every private equity deal necessarily involves the backer getting his money back in the form of a level-payment annuity stream (i.e., the same amount of cash each year, like a loan payment). I just used some over-simplified numbers for an illustration. It'd be just as typical for a deal to call for an investor to put up X dollars today, and then get back Y dollars 4 years later (say), where Y is a sufficient multiple of X to represent an attractive return. The actual cash return pattern to the investor depends on the cash flow pattern of the business itself. Some start-ups, by their nature, begin generating positive flow right out of the starting gate. If so, some "early" take-out cash can be directed to the investor in order to reduce his investment level. Other companies don't go cash-positive until sometime later.

    Usually, private investor money is expensive, and so you'll probably want to structure the take-out so as to get the investor repaid as soon as possible (but not at the cost of cash-starving your new biz just when cash is so critical to its long-run survival, of course).

    Cheers!
     
  5. kundansingh

    kundansingh
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    thats really tough part , but you should take the decision after thinking twice:)
     
  6. jcworlditsme

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    This would depend on what type of business you wanted to create.
     

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