FUNDING YOUR BUSINESS: THE CHOICE BETWEEN A PASSIVE INVESTOR AND A BUSINESS PARTNER
In this article we discuss the difference in valuation coming from a business partner and a passive investor. We also discuss the challenge of negotiating with a sophisticated, value-add investor.
Shark Tank (S1, Ep9: Channel 10 Shark Tank Website) introduced Australia to the founders of Dinner Ladies, Sophie and Katherine. Let me present the numbers mentioned on the show:
From this we would forecast a profit of $350,000 for the coming year, although it is not clear whether this is before or after tax. Given we are significantly into the current financial year, the forward forecast should be accurate.
You might infer that the business has equity used to fund the acquisition of a commercial kitchen of at least $250,000. This is based on the typical requirement of a 20% deposit for a conforming mortgage loan, and the mortgage loan amount of $950,000.
Steve Baxter decided to throw out the first valuation – he suggested a valuation of $800,000. That equates to 4x current earnings, or 2.3x fwd earnings. A valuation is 2x earnings is a value typically attributed to a small business which requires significant investor involvement, has little or no growth, or significant risk.
Given the broad customer base of the Dinner Ladies existing business, its current growth trajectory and bricks and mortar assets, Toro would place this business in a below average risk category compared to peers of similar size. In general, businesses of this scale are still riskier than businesses with $5mill+ of profit, however these larger businesses generally trade with a valuation of 6x earnings, and significantly higher if investors believe in a high growth trajectory. As a result, an $800,000 pre-money value should be a floor for such a business, from the perspective of a passive investor, in Toro’s view.
So why was Janine Allis able to buy 33% of the business for $216,000? ($216,000 was the number negotiated on the show, although Janine’s website values the investment at $271,000 at the time of writing: Janine's Website
PASSIVE INVESTOR’S VS VALUE ADD INVESTORS
The answer requires us to distinguish between passive and value-add investors. A passive investor provides capital, but does not provide input into the strategic direction or operations of the business. Janine positioned herself as a value-add investor; she argued that because she operates in the quick serving restaurant (QSR) industry, she was well positioned to add value.
So did Katherine and Sophie make the right decision? It all comes down to whether or not Janine Allis is able to add sufficient growth and profit to the business to justify her discounted valuation, a point that she makes herself in the show: “My dollars are worth more than any other sharks’ [based on her industry involvement]”.
Frequently business valuations come down to more than just dollars and cents. Where you are partnering with a value-add investor, there are several options to be negotiated:
- Define services that the value-add investor must perform free of charge, for example introductions to new customers, suppliers or distributors
- Define the terms of engagement with any related parties of the value-add investor
- Conduct a trial period and provision for the investor’s withdrawal if you do not work well together
- Create a shareholder’s agreement to formalise the commitment of the investors to the business
The issue for many entrepreneurs is that the value-add investors are much more experienced at negotiating not only their buy-in price, but also the non-financial terms of the transaction.
How can a business founder negotiate successfully with sharks?
Unless you have experience negotiating in venture capital and private investments, you should consider using an advisor. It’s hard to negotiate when you aren’t familiar with the rules of the game, the almost limitless range of structuring options, both financial and non-financial, and a knowledge of current market practice.
Value-add investors can be one of your greatest assets, but only when everyone feels that a ‘fair’ deal has been negotiated, and everyone is incentivised for success. So start by levelling the playing field and bringing specialised expertise to your side of the negotiating table.