Struggling to compare an equity stake in a business to index funds

[MrGreen]

I have 50k that I'm considering investing into a business. I've seen the business plan and pro forma and we're currently discussing how much of an ownership stake this capital would convey. I've been trying to wrap my head around how this compares to what this money would do for me sitting in index funds, because that's where it'd be otherwise.

I fully understand the business could fail and if I proceed with the investment I will treat it like the money is gone. However, the business plan is solid. A bank is ready to close a ~250k loan (just under 80% of the startup capital) to the LLC, with no collateral, amortized over 10 years. So we're not talking about a moon shot here.

We're FIRE, using a 4% withdrawal rate so I would expect to draw 2k in income from that 50k investment if it were sitting in VTSAX. Of course, historical performance shows me that I have a good chance of significant appreciation of 50k over 20-30 years, even after drawing 2k yearly.

If invested in the business, all of my investment is at risk, and that risk is more immediate than the risk associated with index funds so it would make sense to expect a greater return. But how much greater? Have other mustachians invested in businesses before and if you've made this kind of comparison, how did you go about it?

[MustacheAndaHalf]

If this deal goes ugly (not just failing, but ugly) will your friendship with someone suffer as a result?  How important are the relationships that lead to this possible deal?
If you're set for FIRE, shouldn't your appetite for risk be lower?  If this deal succeeds, won't you pile more money in into similar deals?

On the contrary side, CAPE has a 0.4 correlation with future stock performance, and right now it predicts very low returns.  The correlation isn't strong enough to state as fact - it's a tendency that may play out differently.  If the overall market does poorly, how will this business do?  Is it a staple that people need, or something people tend to go without during a downturn?

Note that investing in companies like Apple is hard to compare to companies with no assets and $300k of debt.  At best, you might compare this to a micro-cap ETF (smaller than "small cap") like IWC (iShares Microcap ETF).  Currently that fund under-performs the total stock market significantly (-5% to -10% per year, depending on time frame).

If the company will do well during downturns, and this isn't money you'll miss, then it might be worth the risk.  But also consider the additional addiction risk: that you might push more money behind this idea until it doesn't work anymore.

[Chris Pascale]

Can you (and would you want to) work in the business, even in a small, low-level role?

Is this something you'd always wanted to do?

If yes to both, then definitely, yes.

I personally would be very interested if it's a business I like, and if I could just say goodbye to the money.

What's your stake going to be?

[MrGreen]

If this deal goes ugly (not just failing, but ugly) will your friendship with someone suffer as a result?  How important are the relationships that lead to this possible deal?
If you're set for FIRE, shouldn't your appetite for risk be lower?  If this deal succeeds, won't you pile more money in into similar deals?

On the contrary side, CAPE has a 0.4 correlation with future stock performance, and right now it predicts very low returns.  The correlation isn't strong enough to state as fact - it's a tendency that may play out differently.  If the overall market does poorly, how will this business do?  Is it a staple that people need, or something people tend to go without during a downturn?

Note that investing in companies like Apple is hard to compare to companies with no assets and $300k of debt.  At best, you might compare this to a micro-cap ETF (smaller than "small cap") like IWC (iShares Microcap ETF).  Currently that fund under-performs the total stock market significantly (-5% to -10% per year, depending on time frame).

If the company will do well during downturns, and this isn't money you'll miss, then it might be worth the risk.  But also consider the additional addiction risk: that you might push more money behind this idea until it doesn't work anymore.

A bankrupt business is as ugly as it gets in my book. If I follow through with the investment I consider the money gone. That's the only way you avoid hard feelings if it doesn't pan out. Earning a couple extra bucks isn't worth losing friendships, especially since we've already won the game.

We're so far beyond our FIRE target number that my risk appetite is higher for the small amount of funds I don't consider necessary to sustain our portfolio. We wanted $1 million liquid and we're almost at $1.4 million now, and that doesn't include a couple real estate holdings. However, I don't have unlimited money to play with because we're more or less in the sweet spot between taxable and pre-tax accounts. But we have more than enough to cover our first 5 years of FIRE while we're starting the Roth conversion train, even taking a recession into consideration. I've been actively looking for something to invest in with 50k or so because I consider that to be expendable cash, above and beyond the most ultraconservative estimates of what we need for FIRE.

It's hard to say how the company would do during a downturn. It definitely targets middle class and upper middle class families. A downturn doesn't necessarily mean loss of jobs, but it can. However, we also live in one of the fastest growing areas in the country. People from HCOL locations are flocking here for the weather and the cheaper COL. The next decade is poised to see tremendous growth, provided a hurricane doesn't wipe the area out (you never know). So the demographic trend favors the business.

Can you (and would you want to) work in the business, even in a small, low-level role?

Is this something you'd always wanted to do?

If yes to both, then definitely, yes.

I personally would be very interested if it's a business I like, and if I could just say goodbye to the money.

What's your stake going to be?

We probably won't work in the business, though it's not out of the realm of possibility. We're FIREd though and, quite frankly, it would probably cramp our lifestyle. We just took a three month trip around the country and may want to do it again next year. The business is not something I've always wanted to do. It's mainly a financial play for me, a chance to earn a significantly higher return on 50k than a 4% safe withdrawal rate. Our stake will probably be between 10-20%, and the return on that based on the business plan projections would likely be 10-20k per year after the first couple years. The first year return will likely be 0-7k, and the second year return about 10k. Just depends on how fast it grows. The area will support 4 or 5 locations within an hour of the city. Taken to that scale it would probably pay even more. Or the majority owners might reach the sweet spot and take their foot of the gas so they can enjoy life a bit more.

The majority owners are our best friends so we know well the caliber of the people running the business. Because of that relationship, we've had a much closer perspective on the details. Not quite the same as being handed a business plan with no knowledge of who will operate the company and what that operation looks like. This is also why it's paramount that the investment only happen if I approach it the same way as lighting the money on fire. Obviously, I don't want to light the money on fire, but if it goes away it doesn't jeopardize our financial position at all. I'm pretty cold-hearted when it comes to our portfolio. The idea of investing in a friend's venture just because they're my friend is laughable to me. It has to make money to make sense.

[FIPurpose]

If this deal goes ugly (not just failing, but ugly) will your friendship with someone suffer as a result?  How important are the relationships that lead to this possible deal?
If you're set for FIRE, shouldn't your appetite for risk be lower?  If this deal succeeds, won't you pile more money in into similar deals?

On the contrary side, CAPE has a 0.4 correlation with future stock performance, and right now it predicts very low returns.  The correlation isn't strong enough to state as fact - it's a tendency that may play out differently.  If the overall market does poorly, how will this business do?  Is it a staple that people need, or something people tend to go without during a downturn?

Note that investing in companies like Apple is hard to compare to companies with no assets and $300k of debt.  At best, you might compare this to a micro-cap ETF (smaller than "small cap") like IWC (iShares Microcap ETF).  Currently that fund under-performs the total stock market significantly (-5% to -10% per year, depending on time frame).

If the company will do well during downturns, and this isn't money you'll miss, then it might be worth the risk.  But also consider the additional addiction risk: that you might push more money behind this idea until it doesn't work anymore.

A bankrupt business is as ugly as it gets in my book. If I follow through with the investment I consider the money gone. That's the only way you avoid hard feelings if it doesn't pan out. Earning a couple extra bucks isn't worth losing friendships, especially since we've already won the game.

We're so far beyond our FIRE target number that my risk appetite is higher for the small amount of funds I don't consider necessary to sustain our portfolio. We wanted $1 million liquid and we're almost at $1.4 million now, and that doesn't include a couple real estate holdings. However, I don't have unlimited money to play with because we're more or less in the sweet spot between taxable and pre-tax accounts. But we have more than enough to cover our first 5 years of FIRE while we're starting the Roth conversion train, even taking a recession into consideration. I've been actively looking for something to invest in with 50k or so because I consider that to be expendable cash, above and beyond the most ultraconservative estimates of what we need for FIRE.

It's hard to say how the company would do during a downturn. It definitely targets middle class and upper middle class families. A downturn doesn't necessarily mean loss of jobs, but it can. However, we also live in one of the fastest growing areas in the country. People from HCOL locations are flocking here for the weather and the cheaper COL. The next decade is poised to see tremendous growth, provided a hurricane doesn't wipe the area out (you never know). So the demographic trend favors the business.

Can you (and would you want to) work in the business, even in a small, low-level role?

Is this something you'd always wanted to do?

If yes to both, then definitely, yes.

I personally would be very interested if it's a business I like, and if I could just say goodbye to the money.

What's your stake going to be?

We probably won't work in the business, though it's not out of the realm of possibility. We're FIREd though and, quite frankly, it would probably cramp our lifestyle. We just took a three month trip around the country and may want to do it again next year. The business is not something I've always wanted to do. It's mainly a financial play for me, a chance to earn a significantly higher return on 50k than a 4% safe withdrawal rate. Our stake will probably be between 10-20%, and the return on that based on the business plan projections would likely be 10-20k per year after the first couple years. The first year return will likely be 0-7k, and the second year return about 10k. Just depends on how fast it grows. The area will support 4 or 5 locations within an hour of the city. Taken to that scale it would probably pay even more. Or the majority owners might reach the sweet spot and take their foot of the gas so they can enjoy life a bit more.

The majority owners are our best friends so we know well the caliber of the people running the business. This is also why it's paramount that the investment only happen if I approach it the same way as lighting the money on fire. Obviously, I don't want to light the money on fire, but if it goes away it doesn't jeopardize our financial position at all.

Based on Empire Builders a small business can sell around 2x annual profits.
I've seen solid local businesses try and sell for about 8x annual profits.
Compare that to the open market where the best business sell for 12-20x profits.

For people that run their own business, they too often to count their time against the profits so you'd have to subtract a bit. But if it were me, I'd want to see a growth trajectory that gets me to at minimum 25-50% CAGR over the entire course of the business. As far as what your 50k investment should represent? There are no hard and fast rules. Do the people who will actually be working the business be getting a full pay check or do they want part equity for their labor?

You are providing about 15% of the upfront capital. Sounds like a 10% hands-off investment or 15-20% hands-on for back of the napkin math.

Sounds like though since you'll be a minority owner, it won't be too tough to eventually sell your part to the majority owners. I actually think more people should put 5-10% of their money into high-risk (but smart) investments. Good job on finding an opportunity that you feel comfortable sitting back and watching!

[Andy R]

If you have real reasons it will outperform the market, then it may be an option worth investigating.
If not, you are just gambling.

Let me explain what I mean.

You can outperform by picking a single company, the problem is that if you can't know in advance if it will outperform, you are not increasing your expected return. What you are doing is increasing the range of possible outcomes (which is the definition of risk) without increasing expected return, which is the definition of gambling.

Imagine a game of roulette. 1 in 37 times you get 37 times your original bet, which sounds amazing, but the other 36 times you get nothing, so your expected return is (37 x bet + 36 x 0)/37 = your original bet. Your expected return equals your original bet, but you are hoping that it will land in the higher end of that larger range of outcomes, but hope is not an investment strategy. This is the difference between gambling and investing.

So the question boils down to - is there some actual reason you think it could outperform the market, or is it just because you or someone you know happens to be involved in the business?

[MrGreen]

If you have real reasons it will outperform the market, then it may be an option worth investigating.
If not, you are just gambling.

Let me explain what I mean.

You can outperform by picking a single company, the problem is that if you can't know in advance if it will outperform, you are not increasing your expected return. What you are doing is increasing the range of possible outcomes (which is the definition of risk) without increasing expected return, which is the definition of gambling.

Imagine a game of roulette. 1 in 37 times you get 37 times your original bet, which sounds amazing, but the other 36 times you get nothing, so your expected return is (37 x bet + 36 x 0)/37 = your original bet. Your expected return equals your original bet, but you are hoping that it will land in the higher end of that larger range of outcomes, but hope is not an investment strategy. This is the difference between gambling and investing.

So the question boils down to - is there some actual reason you think it could outperform the market, or is it just because you or someone you know happens to be involved in the business?

I definitely get what you're saying, and it is expanding the range of possible outcomes. In this case, the business failing before I see the first penny in profits is the worst case scenario. Though it would seem to be a very low possibility. Banks don't loan money to just anyone, and being willing to close a 250k loan, with no collateral, and an amortization schedule of 10 years tells me that the bank thinks this is a pretty good investment. And they're making that decision based on the business plan alone.

The returns for the business could definitely beat the long term market average. As I mentioned previously, some of that will depend on how aggressively the majority owners want to grow it. They are sufficiently incentivized to grow it to the point where is replaces their current W-2 incomes, which should be enough for me to make a tidy sum on my 50k investment. If I saw 10k a year for the next 30-50 years of my life, that would easily outstrip any earnings I would get in VTSAX. We're all in our mid-30's, and this will become the "family business" for them. They're in it for the long haul, not just to build it up a little bit and then look for a buyer.

I don't expect anything totally ridiculous. It's highly unlikely I'll ever make 50k in one year on my investment. Though if they knock it out of the park, with 4 or 5 locations in the next decade, and a premier reputation for service, it's not impossible that I could see a 20-30k per year return. I wouldn't make the investment thinking that'll happen though.

[SeattleCPA]

I think small businesses can easily outperform the index. (Suggestion: Use Portfolio Visualizer to look at total stock market.. and then small cap... and then microcap sectors.)

However, while I am a total booster of small business ownership and entrepreneurship, I really agree with comments others have shared about the risks.

I am convinced the "Anna Karenina" principle applies not just to marriages and families but also to small business successes. Lots of issues could cause an investment to fail.

BTW: I personally would only invest in a small business venture I controlled (and I've done this multiple times over the decades) or one where I really, really, really knew the lead dog entrepreneur well.

[J Boogie]

I think small businesses can easily outperform the index. (Suggestion: Use Portfolio Visualizer to look at total stock market.. and then small cap... and then microcap sectors.)

However, while I am a total booster of small business ownership and entrepreneurship, I really agree with comments others have shared about the risks.

I am convinced the "Anna Karenina" principle applies not just to marriages and families but also to small business successes. Lots of issues could cause an investment to fail.

BTW: I personally would only invest in a small business venture I controlled (and I've done this multiple times over the decades) or one where I really, really, really knew the lead dog entrepreneur well.

Interesting you mention that - I listen to a lot of Peter Thiel's talks and interviews and he frequently mentions the inverse of the Anna K principle.

“All happy families are alike; each unhappy family is unhappy in its own way.” Business is the opposite. All happy companies are different: each one earns a monopoly by solving a unique problem. All failed companies are the same: they failed to escape competition.”

But I believe that you are correct in a general management and execution sense. Thiel is offering this advice to smart, competent people and the assumption is that they seek his advice for starting a transformational business and wouldn't be likely to make basic management errors.

[BicycleB]

I invested in a friend's business and lost every penny. But I was younger, the friend had less experience, and the business proposal was not worthy of a bank loan. This deal sounds plausible and your personal situation for making the investment sounds excellent. In your shoes, I'd do it for any price we both thought was reasonable, just as you're suggesting. So - what price? Spitballing follows fwiw...

Because the investment is illiquid, it should bring a higher return than the stock market. Similarly, because it has higher risk being a small business, a higher return.

My guess is that each of those factors should be worth 20% to 30% in a decade for the situation you describe. Multiplying, I'd like to see about 1.6x value after a decade compared to a decent stock/bond mix. Using 5% net of inflation as the benchmark, or roughly 1.625x gain by the benchmark, a target value of roughly 2.6x.

Based on your projections, and assuming all numbers in the projection are net of inflation, then: using 10k/year  in years 2-10 as typical return plus 5% compounding of proceeds, presumed distributions would have cumulative value of maybe 110k or a bit more. If the value of the business at that point is also 2x of earnings, total return of 130k. Roughly 2.6x your investment, and I used the low end of your projection. So it seems viable to seek a % that would produce the results you describe.

I'd seek the high end of your proposed 10-20% stake if I could, and figure 15% would be healthy. Keep us posted!

PS. My remarks assume your LLC will be structured so that you can have the hands-off experience you hope for. I'm assuming that's some sort of arrangement where you are essentially a limited partner. If your whole stash is at risk for their business decisions, not just your investment, you would need to be at the high end...and I'd still hesitate, or rather seek revision of the proposed ownership terms. I'd consider a lawyer fee to be part of my investment, to make sure the investment has the limited risk profile that I thought. When my friend went de facto bankrupt, I was glad that I had only loaned money, not taken an equity position.

[soccerluvof4]

I think small businesses can easily outperform the index. (Suggestion: Use Portfolio Visualizer to look at total stock market.. and then small cap... and then microcap sectors.)

However, while I am a total booster of small business ownership and entrepreneurship, I really agree with comments others have shared about the risks.

I am convinced the "Anna Karenina" principle applies not just to marriages and families but also to small business successes. Lots of issues could cause an investment to fail.

BTW: I personally would only invest in a small business venture I controlled (and I've done this multiple times over the decades) or one where I really, really, really knew the lead dog entrepreneur well.

I agree more along these lines. Having owned several small businesses I would not invest in someone elses small business but instead look to create my own. Headaches of partnerships, uggh... better of staying in your funds imo.

[SeattleCPA]

I am convinced the "Anna Karenina" principle applies not just to marriages and families but also to small business successes. Lots of issues could cause an investment to fail.

Interesting you mention that - I listen to a lot of Peter Thiel's talks and interviews and he frequently mentions the inverse of the Anna K principle.

“All happy families are alike; each unhappy family is unhappy in its own way.” Business is the opposite. All happy companies are different: each one earns a monopoly by solving a unique problem. All failed companies are the same: they failed to escape competition.”

But I believe that you are correct in a general management and execution sense. Thiel is offering this advice to smart, competent people and the assumption is that they seek his advice for starting a transformational business and wouldn't be likely to make basic management errors.

Thiel is obviously a smart guy. But the Paypal and VC experiences, I would guess, scramble his perception of the odds.

If you like Thiel's thinking, you might (might) be be interested in my book review of "From Zero to One": How Not to Be A Billionaire. My basic criticism of his thinking? Sure, it applies to venture capital but not small business.

Thiel's thinking, btw, isn't unique. Entrepreneurship professor Scott Shane's "Illusions of Entrepreneurs" covers similar ground as I discuss in another book review Illusions of Entrepreneurship Professors.

I would argue the general problem with both Shane's and Thiel's thinking is the odds don't work for the entrepreneur to go for the venture that massively scales.

Final comment about this: The odds do work for the venture capitalist if they're either lucky or good...But they're investing in dozens of companies and only need one to work.

P.S. I may as well share here that after I left Arthur Andersen & Co many years ago, my first job in industry was to go to work for a really hot VC-funded tech startup. My experience soured me on the venture capital profession.

[MrGreen]

I invested in a friend's business and lost every penny. But I was younger, the friend had less experience, and the business proposal was not worthy of a bank loan. This deal sounds plausible and your personal situation for making the investment sounds excellent. In your shoes, I'd do it for any price we both thought was reasonable, just as you're suggesting. So - what price? Spitballing follows fwiw...

Because the investment is illiquid, it should bring a higher return than the stock market. Similarly, because it has higher risk being a small business, a higher return.

My guess is that each of those factors should be worth 20% to 30% in a decade for the situation you describe. Multiplying, I'd like to see about 1.6x value after a decade compared to a decent stock/bond mix. Using 5% net of inflation as the benchmark, or roughly 1.625x gain by the benchmark, a target value of roughly 2.6x.

Based on your projections, and assuming all numbers in the projection are net of inflation, then: using 10k/year  in years 2-10 as typical return plus 5% compounding of proceeds, presumed distributions would have cumulative value of maybe 110k or a bit more. If the value of the business at that point is also 2x of earnings, total return of 130k. Roughly 2.6x your investment, and I used the low end of your projection. So it seems viable to seek a % that would produce the results you describe.

I'd seek the high end of your proposed 10-20% stake if I could, and figure 15% would be healthy. Keep us posted!

PS. My remarks assume your LLC will be structured so that you can have the hands-off experience you hope for. I'm assuming that's some sort of arrangement where you are essentially a limited partner. If your whole stash is at risk for their business decisions, not just your investment, you would need to be at the high end...and I'd still hesitate, or rather seek revision of the proposed ownership terms. I'd consider a lawyer fee to be part of my investment, to make sure the investment has the limited risk profile that I thought. When my friend went de facto bankrupt, I was glad that I had only loaned money, not taken an equity position.

That sucks going through a business failure. One thing I forgot to mention is that this business will be a new location for a franchise that's been around for 30 years. They have hundreds of locations now. So it helps to know that the owners, my friends, will have an experienced entity behind them, providing training, advice, and guidance in exchange for a small percentage of their revenue.

The LLC would be set up so that I'm a member with a minority ownership stake in the business. One of the things we're looking at now is ensuring that an operating agreement will provide the necessary language to protect the percentage of profit I'm supposed to receive from the business, limit the majority owner's ability to change unilaterally change anything that would negatively impact my position, but also allow the majority owner the freedom to execute all the day-to-day business decisions. I spoke with another friend of mine to has an LLC (partnership) with several others and he said we should be able to have all the appropriate language in the operating agreement.

I think small businesses can easily outperform the index. (Suggestion: Use Portfolio Visualizer to look at total stock market.. and then small cap... and then microcap sectors.)

However, while I am a total booster of small business ownership and entrepreneurship, I really agree with comments others have shared about the risks.

I am convinced the "Anna Karenina" principle applies not just to marriages and families but also to small business successes. Lots of issues could cause an investment to fail.

BTW: I personally would only invest in a small business venture I controlled (and I've done this multiple times over the decades) or one where I really, really, really knew the lead dog entrepreneur well.

Our situation is definitely a unique one. We've known the couple starting the business for 15 years, since college. They are arguably our closest friends, so I know their character well. Because of that relationship, we've had an inside view of the process since the conception of the idea. The topic of investing in the business came up more casually over a year ago at a time when they thought all their starting capital would come from partners. At that point I had very little interest because it isn't a business that excites me and there was no specific financial data yet, only the knowledge that it is a successful franchise. Now that there is solid, specific financial data for their location it looks pretty appealing to me, compared to index investing. I'm still uncertain about it because I do understand there is risk. My parents' business went bankrupt when I was 11 and it cost them everything. This is different because the business is a separate LLC with no collateral, but that experience does shade the lenses through which I view life. This is the reason I wouldn't proceed with an investment unless failure was an acceptable end result.

The part of me that does want to invest sees this as a great way to diversify our income. We've FIREd so I have zero interest in starting a business myself. I'm too busy enjoying my freedom. We have some real estate exposure, but not a lot. Our net worth is about 75% liquid assets/25% real estate. Adding an ownership stake in a business that kicks of a nice return every year feels like a nice diversification under the right circumstances. However, it could be that I'm too close to this one and it makes me think more favorably about the business than I really should. I guess some folks would view my closeness to the situation as a bad thing because of the risk to the friendship. I suppose I view it as a good thing, because I've been standing behind the curtain this whole time, and I know the man well, so I have a better view to see what flaws there may be.

[Villanelle]

You are mentioning more locations and increased profits if/when that happens.  But more locations seems like it would require more capital at least initially. Unless those locations would be paid for using profits alone (in which case I would think your pay out would all but disappear for a while), are you going to maintain the same % of ownership after the majority owners sink more money in?  That seems odd.

Also, would you have a say in whether they can reinvest profits rather than paying you out? 

[Mustache ride]

Wouldn’t this be just a simple CAPM equation?

[MrGreen]

You are mentioning more locations and increased profits if/when that happens.  But more locations seems like it would require more capital at least initially. Unless those locations would be paid for using profits alone (in which case I would think your pay out would all but disappear for a while), are you going to maintain the same % of ownership after the majority owners sink more money in?  That seems odd.

Also, would you have a say in whether they can reinvest profits rather than paying you out?

New locations would be paid for with profit, not raising additional capital. Also, all locations would fall under the umbrella of this LLC so I would maintain the same ownership % in all locations. The relationship is more like additional locations would be satellites of the main one, vs. each location being a separate entity.

As to the question of reinvesting profits vs. paying out, that would depend on the language in the operating agreement, and is definitely something we'll be discussing. If I don't have a say, in theory, they could continually expand, thereby limiting my ability to take profit. But if I do have a say, that gives me the ability to block expansion, which may or may not be in the best interest of the business. We'll need to work through the pros and cons of those kinds of things.

There is a cap though. There feasibly can't be more than 5 or 6 locations in the area and if they successfully expanded that far, it inevitably means that when my payouts do come in they would be significantly larger. If I saw no profits for almost a decade but then every year after that it was 50k+ (which it very well could be) that wouldn't necessarily be a bad thing. Hell that investment alone would fund our FIRE lifestyle indefinitely.

Wouldn’t this be just a simple CAPM equation?

I am unfamiliar with this. Will research more.

[Villanelle]

You are mentioning more locations and increased profits if/when that happens.  But more locations seems like it would require more capital at least initially. Unless those locations would be paid for using profits alone (in which case I would think your pay out would all but disappear for a while), are you going to maintain the same % of ownership after the majority owners sink more money in?  That seems odd.

Also, would you have a say in whether they can reinvest profits rather than paying you out?

New locations would be paid for with profit, not raising additional capital. Also, all locations would fall under the umbrella of this LLC so I would maintain the same ownership % in all locations. The relationship is more like additional locations would be satellites of the main one, vs. each location being a separate entity.

As to the question of reinvesting profits vs. paying out, that would depend on the language in the operating agreement, and is definitely something we'll be discussing. If I don't have a say, in theory, they could continually expand, thereby limiting my ability to take profit. But if I do have a say, that gives me the ability to block expansion, which may or may not be in the best interest of the business. We'll need to work through the pros and cons of those kinds of things.

There is a cap though. There feasibly can't be more than 5 or 6 locations in the area and if they successfully expanded that far, it inevitably means that when my payouts do come in they would be significantly larger. If I saw no profits for almost a decade but then every year after that it was 50k+ (which it very well could be) that wouldn't necessarily be a bad thing. Hell that investment alone would fund our FIRE lifestyle indefinitely.

Wouldn’t this be just a simple CAPM equation?

I am unfamiliar with this. Will research more.

That was what I was guessing, in which case be prepared to have low or no profits for several years while they expand.  You could consider some language in the contract that the first $5000 (or some other number) per year of your share of the profit has to be paid out before reinvestment, or something like that, so you have at least a floor for what you'd get out, assuming that your 10% is at least $5000.  IOW, they would have to make $50,000 and pay out your share of that and then they could reinvest in expansion.  (Or you could say that requirement is $1k in year one, $3k in year two, and then 5k in subsequent years, or something along those lines.)  If you don't have need for any cashflow, maybe you don't need to do this, but if you are relying on that money to fund a certain standard of living you hope to maintain, it might be worth doing this.  Since you said you are okay seeing no profits for a decade, it may not be necessary, but then I think you need to be prepared for that to happen, if this expansion is the longer term plan. 

[SeattleCPA]

If invested in the business, all of my investment is at risk, and that risk is more immediate than the risk associated with index funds so it would make sense to expect a greater return. But how much greater? Have other mustachians invested in businesses before and if you've made this kind of comparison, how did you go about it?

I didn't see this question earlier because I jumped into the discussion midstream, sorry, but I would think you should hope to earn a 20% to 25% annual return.

This would put the return roughly midpoint between small caps and mico caps (roughly 12%-ish) and the 40% return venture capitalists hope for. I think you read, too, that angel investors often talk about 20% to 25%. Less than VCs and way more than public equities.

But this won't be a dependable or spendable 20%. Presumably much of the return would came at the point you guys sell out

BTW, here's the real comment I wanted to make. I like that you know the entrepreneurs. And I don't have a philosophical problem with small business investment, obviously. But the ownership percentage doesn't make sense to me. I can't imagine a scenario where some entrepreneur personally has 95% of the capital she or he needs... and then needs to top off the funding with additional money from a friend. Too much risk (mostly social) and hassle for a small chunk of change, percentage wise. Seems like it would always be easier for a veteran entrepreneur to "make it work" without bringing in a small minority investor.

[MrGreen]

If invested in the business, all of my investment is at risk, and that risk is more immediate than the risk associated with index funds so it would make sense to expect a greater return. But how much greater? Have other mustachians invested in businesses before and if you've made this kind of comparison, how did you go about it?

I didn't see this question earlier because I jumped into the discussion midstream, sorry, but I would think you should hope to earn a 20% to 25% annual return.

This would put the return roughly midpoint between small caps and mico caps (roughly 12%-ish) and the 40% return venture capitalists hope for. I think you read, too, that angel investors often talk about 20% to 25%. Less than VCs and way more than public equities.

But this won't be a dependable or spendable 20%. Presumably much of the return would came at the point you guys sell out

BTW, here's the real comment I wanted to make. I like that you know the entrepreneurs. And I don't have a philosophical problem with small business investment, obviously. But the ownership percentage doesn't make sense to me. I can't imagine a scenario where some entrepreneur personally has 95% of the capital she or he needs... and then needs to top off the funding with additional money from a friend. Too much risk (mostly social) and hassle for a small chunk of change, percentage wise. Seems like it would always be easier for a veteran entrepreneur to "make it work" without bringing in a small minority investor.

There is pretty significant chance that I could see a 20-25% return just in the normal course of running the business. I'd say it's more likely than not. This is a business that, if successful, they want to run for the rest of their lives. The way it will grow even lends itself well to bringing in other family members as it grows. Our friend who will start out running the day to day operations has a father who is ready to retire, and there's a new grandkid. The grandparents are considering moving to the area to be around more and it's the perfect scenario for guranddad to retire "to" something, pitching in with the family business.

What you say about not wanting to trade ownership for a small amount of up front capital makes sense, but I think this specific situation is a little different. They really don't want to increase their borrowing, it just raises the breakeven point for the business that much more. I think the thought could be something along the lines of, "if we can get the extra funding we need for a very small ownership stake, and we know it means bringing someone who is practically family into the equation, then we're okay with that."

Because we're FIREd and have the time, I've already told them I'm happy to pitch in if they need a hand at times. I'd do that as a friend, ownership stake or not. There's a very small chance we could become even more physically involved in the business if outside help is hard to find and we're not travelling (for an upcoming baby perhaps).

I'd call it like giving a small ownership stake to your brother, who you like, and you know has a solid business head on his shoulders. It would be nice to not hassle with the operating agreement and all that but if it's the easiest thing to do from a capital standpoint, you don't mind so much because you know the money is going into the pocket if someone you love, and you know they have your best interests at heart.

[BicycleB]

But the ownership percentage doesn't make sense to me. I can't imagine a scenario where some entrepreneur personally has 95% of the capital she or he needs... and then needs to top off the funding with additional money from a friend.

^Did I misread the earlier part of the thread?

I thought the capital structure was roughly:
83% bank borrowing ($250,000)
17% equity from Mr. Green ($50,000)...meaning most of the equity is from Mr. Green.

(I had imagined that the other owners kicked in 12,500 and the loan was for 80%, with MrG at 16% and the owners 4%, but can't find clear evidence for that upon re-reading.)

So the lead couple do the work, Mr. Green does the bulk of equity investment. Is 15% or 20% in exchange for his capital a bad idea for either side? What are the best alternatives for each side in this deal?

I didn't see this question earlier because I jumped into the discussion midstream, sorry, but I would think you should hope to earn a 20% to 25% annual return.

@SeattleCPA, do you mean he shouldn't do this deal unless he gets the equivalent of 20% compounded annually? In other words, if his return is a flat $10,000/year, would that be inadequate?

[SeattleCPA]

But the ownership percentage doesn't make sense to me. I can't imagine a scenario where some entrepreneur personally has 95% of the capital she or he needs... and then needs to top off the funding with additional money from a friend.

^Did I misread the earlier part of the thread?

I thought the capital structure was roughly:
83% bank borrowing ($250,000)
17% equity from Mr. Green ($50,000)...meaning most of the equity is from Mr. Green.

(I had imagined that the other owners kicked in 12,500 and the loan was for 80%, with MrG at 16% and the owners 4%, but can't find clear evidence for that upon re-reading.)

So the lead couple do the work, Mr. Green does the bulk of equity investment. Is 15% or 20% in exchange for his capital a bad idea for either side? What are the best alternatives for each side in this deal?

I didn't see this question earlier because I jumped into the discussion midstream, sorry, but I would think you should hope to earn a 20% to 25% annual return.

@SeattleCPA, do you mean he shouldn't do this deal unless he gets the equivalent of 20% compounded annually? In other words, if his return is a flat $10,000/year, would that be inadequate?

Well, first of all, I think we've pretty clearly established that I'm not reading the messages in the thread carefully enough. Ugh. Sorry.

Second, this all does make more sense if the principal owner has the bank loan lined up and one chunk of the equity but needs the other chunk of the equity from Mr. Green..

Third, the rate of return would be an IRR or CAGR. So it would be okay if Mr. Green invested $50K and then received $10K every year, no hiccups... and then he ultimately got the $50K back. Or it would be okay if he didn't get the $10K annually... but instead in ten years, after earning 20% compounded annually for ten years he received $750K.

BTW, that annual compounding at 20% or 25% is where the private equity investor really, really grows her or his money. Obviously.

[MrGreen]

But the ownership percentage doesn't make sense to me. I can't imagine a scenario where some entrepreneur personally has 95% of the capital she or he needs... and then needs to top off the funding with additional money from a friend.

^Did I misread the earlier part of the thread?

I thought the capital structure was roughly:
83% bank borrowing ($250,000)
17% equity from Mr. Green ($50,000)...meaning most of the equity is from Mr. Green.

(I had imagined that the other owners kicked in 12,500 and the loan was for 80%, with MrG at 16% and the owners 4%, but can't find clear evidence for that upon re-reading.)

So the lead couple do the work, Mr. Green does the bulk of equity investment. Is 15% or 20% in exchange for his capital a bad idea for either side? What are the best alternatives for each side in this deal?

I didn't see this question earlier because I jumped into the discussion midstream, sorry, but I would think you should hope to earn a 20% to 25% annual return.

@SeattleCPA, do you mean he shouldn't do this deal unless he gets the equivalent of 20% compounded annually? In other words, if his return is a flat $10,000/year, would that be inadequate?

Our friends are contributing capital and the bank is actually lending money based on their capital contribution alone. We're coming in after the fact with extra capital.

So the capital would look like:

17% - $60,000 from our friends
69% - $240,000 loan (80% of 300k total cash before our investment)
14% - $50,000 our contribution

[nmitb]

My initial reaction to stuff like this is always NO!
Smarter people than you have invested with more goodhearted friends than yours, and still lost all their money.

Never bet whats important to you (your FIRE stash) to gain something thats unimportant to you (more money than you need).
If losing that 50K won't change anything for your financially or in your friendship with the owner, then what the hell go for it.

[MrGreen]

My initial reaction to stuff like this is always NO!
Smarter people than you have invested with more goodhearted friends than yours, and still lost all their money.

Never bet whats important to you (your FIRE stash) to gain something thats unimportant to you (more money than you need).
If losing that 50K won't change anything for your financially or in your friendship with the owner, then what the hell go for it.

The loss of 50k doesn't change our FIRE position at all. I'm prepared to invest knowing it could be a total loss so there's no impact to the friendship. Since we wouldn't really be involved in operational decisions it prevents any kind of blame game if there were to be a failure.

[BicycleB]

Our friends are contributing capital and the bank is actually lending money based on their capital contribution alone. We're coming in after the fact with extra capital.

So the capital would look like:

17% - $60,000 from our friends
69% - $240,000 loan (80% of 300k total cash before our investment)
14% - $50,000 our contribution

^Thanks!

If you plug in the return assumptions you expect, do you get an IRR similar to what SeattleCPA suggests?

[MrGreen]

Our friends are contributing capital and the bank is actually lending money based on their capital contribution alone. We're coming in after the fact with extra capital.

So the capital would look like:

17% - $60,000 from our friends
69% - $240,000 loan (80% of 300k total cash before our investment)
14% - $50,000 our contribution

^Thanks!

If you plug in the return assumptions you expect, do you get an IRR similar to what SeattleCPA suggests?

Yes. The return ends up in the 20-60% range depending on how successful the business gets. However, that's with the profit payout every year. If it didn't payout for a decade, it definitely wouldn't compound into a 750k payment in one year. That's not necessarily a bad thing though. I'd rather have a yearly payout that still gives me finer control over our annual income than a lump sum deal.

Here's a snapshot of the balance sheet summary from the pro forma projections over 10 years. It reflects solid, middle-of-the-road growth for the first seven years and then leveling off. It assumes our ownership stake is 12.5% (1/8 share).

[SeattleCPA]

Our friends are contributing capital and the bank is actually lending money based on their capital contribution alone. We're coming in after the fact with extra capital.

So the capital would look like:

17% - $60,000 from our friends
69% - $240,000 loan (80% of 300k total cash before our investment)
14% - $50,000 our contribution

^Thanks!

If you plug in the return assumptions you expect, do you get an IRR similar to what SeattleCPA suggests?

Yes. The return ends up in the 20-60% range depending on how successful the business gets. However, that's with the profit payout every year. If it didn't payout for a decade, it definitely wouldn't compound into a 750k payment in one year. That's not necessarily a bad thing though. I'd rather have a yearly payout that still gives me finer control over our annual income than a lump sum deal.

Here's a snapshot of the balance sheet summary from the pro forma projections over 10 years. It reflects solid, middle-of-the-road growth for the first seven years and then leveling off. It assumes our ownership stake is 12.5% (1/8 share).

Obviously, caution is the byword here. And high potential returns always come with higher risks. But this deal seems reasonable to me based on Mr. Green's descriptions.

[MrGreen]

Our friends are contributing capital and the bank is actually lending money based on their capital contribution alone. We're coming in after the fact with extra capital.

So the capital would look like:

17% - $60,000 from our friends
69% - $240,000 loan (80% of 300k total cash before our investment)
14% - $50,000 our contribution

^Thanks!

If you plug in the return assumptions you expect, do you get an IRR similar to what SeattleCPA suggests?

Yes. The return ends up in the 20-60% range depending on how successful the business gets. However, that's with the profit payout every year. If it didn't payout for a decade, it definitely wouldn't compound into a 750k payment in one year. That's not necessarily a bad thing though. I'd rather have a yearly payout that still gives me finer control over our annual income than a lump sum deal.

Here's a snapshot of the balance sheet summary from the pro forma projections over 10 years. It reflects solid, middle-of-the-road growth for the first seven years and then leveling off. It assumes our ownership stake is 12.5% (1/8 share).

Obviously, caution is the byword here. And high potential returns always come with higher risks. But this deal seems reasonable to me based on Mr. Green's descriptions.

I appreciate the input.

We've had a more formal conversation about joining the LLC and it looks like the plan is to contribute $40,000 in capital for a 10% stake in the business. This follows the same ownership to capital contribution ratio as what we kicked around informally so I think I'm feeling pretty good about making the investment. If anything I like the idea of risking a little less capital on something that looks really good, but does carry significant risk.

[SeattleCPA]

Our friends are contributing capital and the bank is actually lending money based on their capital contribution alone. We're coming in after the fact with extra capital.

So the capital would look like:

17% - $60,000 from our friends
69% - $240,000 loan (80% of 300k total cash before our investment)
14% - $50,000 our contribution

^Thanks!

If you plug in the return assumptions you expect, do you get an IRR similar to what SeattleCPA suggests?

Yes. The return ends up in the 20-60% range depending on how successful the business gets. However, that's with the profit payout every year. If it didn't payout for a decade, it definitely wouldn't compound into a 750k payment in one year. That's not necessarily a bad thing though. I'd rather have a yearly payout that still gives me finer control over our annual income than a lump sum deal.

Here's a snapshot of the balance sheet summary from the pro forma projections over 10 years. It reflects solid, middle-of-the-road growth for the first seven years and then leveling off. It assumes our ownership stake is 12.5% (1/8 share).

Obviously, caution is the byword here. And high potential returns always come with higher risks. But this deal seems reasonable to me based on Mr. Green's descriptions.

I appreciate the input.

We've had a more formal conversation about joining the LLC and it looks like the plan is to contribute $40,000 in capital for a 10% stake in the business. This follows the same ownership to capital contribution ratio as what we kicked around informally so I think I'm feeling pretty good about making the investment. If anything I like the idea of risking a little less capital on something that looks really good, but does carry significant risk.

One thing to keep in mind--and maybe this has already been discussed--is that you can with a partnership (or an LLC taxed as a partnership) break out the profit sharing and loss sharing more granularly.

E.g., rather than give the original investor a 90% interest for capital and sweat equity and then give you a 10% interest for capital, you could do this:

For work in venture, the original working partners get up to the first, say, $100K for their effort. That amount gets treated either as a guaranteed payment or more optimally as a special allocation (see postscript for reason why).

Then, any amounts leftover *after* the working partners are paid for their sweat gets split proportionally based on capital investments. So sort of 55% to the them and 45% to you.

This approach rewards working partners for their actual work and protects them on the downside... and it doesn't over-reward them on the upside.

BTW, it might be interesting to dig up common venture capital ownership percentages. I think commonly first round VC funding (which is sort of what you're providing) means the founders give up a lot more than 10% of the equity.

P.S. Here's why a partnership wants to avoid guaranteed payments if possible: Salvaging Partnership Section 199A Deductions

[MrGreen]

One thing to keep in mind--and maybe this has already been discussed--is that you can with a partnership (or an LLC taxed as a partnership) break out the profit sharing and loss sharing more granularly.

E.g., rather than give the original investor a 90% interest for capital and sweat equity and then give you a 10% interest for capital, you could do this:

For work in venture, the original working partners get up to the first, say, $100K for their effort. That amount gets treated either as a guaranteed payment or more optimally as a special allocation (see postscript for reason why).

Then, any amounts leftover *after* the working partners are paid for their sweat gets split proportionally based on capital investments. So sort of 55% to the them and 45% to you.

This approach rewards working partners for their actual work and protects them on the downside... and it doesn't over-reward them on the upside.

BTW, it might be interesting to dig up common venture capital ownership percentages. I think commonly first round VC funding (which is sort of what you're providing) means the founders give up a lot more than 10% of the equity.

P.S. Here's why a partnership wants to avoid guaranteed payments if possible: Salvaging Partnership Section 199A Deductions

We haven't discussed in detail breaking up the profit sharing more granularly but I do know we can do that. I had looked into some VC stuff and it did seem like more equity is typically given up. However, I think the original partners would balk at anything approaching that level of equity split. I did learn last night that they are putting up their house as collateral on the loan. The bank will put a six-figure lien on the property until the debt is repaid. I had asked about collateral previously and they said the loan had none but that situation clearly changed. It certainly elevates their risk in the deal and helps explain why they don't want to increase the loan amount. Though it's dawning on me now that this makes less of an endorsement of the business plan. Between the collateral and the capital assets the business has to purchase, the bank would basically recover all their money if the business failed.

I don't think the original partners would be against a more granular breakout of profit sharing but I'm not sure what the best way to do that would be. One person is quitting their job to run the business. He'll be the only full-time employee as the business is being established and will pay himself a salary because they need the consistent income to support the household. I do know that LLCs can treat salaries by owners as either an expense or as part of the profit equation. Though, I'm not sure how I feel about the potential scenario of there being a "profit" (his salary) which mandated a payout to me where the business was otherwise still losing money.

The immediate goal for the original partners is for the business to become successful enough to bring on the wife as another full-time employee. This is part of where we need to figure out how to protect interests in the operating agreement. In theory, if the business was earning enough profit, they could pay her a full-time salary even if there wasn't really the demand for a second full-time position. That move would be at my expense if owner salaries were not part of the profit equation.

So we have to get into the weeds a bit more on that. I don't want to get greedy, but I do want to make sure that the profit structure adequately reflects the risks of this kind of deal. Perhaps that means something like I see a small return on my investment first and then other profits paid out in a ratio. This would help hedge against poor performance and potentially address the possibility of added salaried positions which benefit the original partners at my expense. I imagine there are other ways we could address this in the operating agreement as well.