what does it mean to sell a percentage of a business

Discussion in 'Growing and Managing a Business' started by dsdsdsdsd, Apr 5, 2011.

  1. dsdsdsdsd

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    Apr 5, 2011
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    I am not in a position to create a business structure that is qualified to sell proper shares: I'm a web developer, not a business administrator ... to create/administer a limited liability coorp is beyond me.

    However, I would like to raise money from family/friends for further developing my prototype to a commercial-ready product.

    Ideally, I would like to offer a percentage of my non-existing business in return for an investment: maybe .25% for $1000, up to $25000.

    But what does this mean? Would Aunt Mildred receive .25% of revenue every month?

    I suppose that in the future these percentages could be converted to actual shares? How does a company equate percentages with shares?

  2. ArcSine

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    Jun 2, 2010
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    Shannon, those percentages generally refer to a % of some number associated with your cash flows or your book profits. What that number is, and how it's to be defined, is determined on a case-by-case basis. You and your investors have a lot of leeway in defining your deal terms, so don't feel that "percentage of a business" means one and only one thing.

    You could, for example, offer each investor a % of your net cash flow (cash revenues received, minus all cash expenses paid). Alternatively, you could offer a % of the "top line" (your revenues; so named because Sales / Revenues are traditionally the top line of an income statement; contrast to "bottom line" which is net profit after deducting all expenses).

    For an investor who is getting X% of the bottom line, her return is affected by each and every expense your business incurs. Hence your deal with the investor will include restrictions of some sort on your ability to incur expenses. At the very least, the investors will put a cap on how much salary you can extract for yourself. Closely related will be limits (or outright prohibitions) on certain "perk" type expenses, which you could theoretically use to feather your own nest, while simultaneously reducing the company's profits down to nothing, leaving the investors with X% of zero.

    What you suggested---giving a piece of the top line---is frequently an attractive alternative. An investor who's getting a % of your revenues no longer cares about your expenses, thereby freeing you from any restrictions they might impose on your ability to manage the company as you see fit.

    A common solution residing somewhere between these two is to give your investor a percentage of modified profits, defined as Revenues less certain expenses, but before deducting your salary and other "perk"-type expenses.

    The point is that you and your investor(s) can define and structure your deal in whatever way is mutually agreeable. Then it's just a numbers exercise. Suppose for example your investor is putting up $10K, and you both agree that a 20% return ($2,000 per year) is acceptable. If you forecast your revenues and your net profit to be $100,000 and $25,000 per year, respectively, then you could offer her either 2% of Revenues, or 8% of the net. Of course, as your revenues and your net deviate from the forecast---and they will---her actual realized return will deviate from the $2K each year.

    Alternatively, of course, you could just offer her a fixed dollar return per year, for a set number of years. In other words, treat her investment as a business loan. For example, monthly payments to her of $187.40 for 7 years would fully repay a $10K loan, and give her a 14% return. (Why'd I use 14%, if we said that a 20% return is proper for this deal? A loan is safer for the investor, than getting X% of some profits or revenues that may or may not materialize; with a loan she gets her monthly check regardless. So if a 20% return is proper compensation for the risk of a %-of-profits deal, then she may be happy getting 14% in the relatively safer loan-type deal.)

    Down the road, if you want to formalize the investments by issuing shares, again it's just a simple arithmetic exercise. You might, for example, create a class of shares and in the defining documents, specify that each share is entitled to 1% of the net. Then to an investor who's to get 5% of the net in exchange for an investment, you'd issue 5 shares.

    Good luck with it, Shannon, and say "hi" to Aunt Mildred for me.
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  3. smith360

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    Mar 28, 2011
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    If it is beyond you then you should take advice on setting up a limited company and issuing shares from an accountant.

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