Australia has more than 2.1 million businesses trading, and this number is continually increasing. If your friend or family member is starting a business, and you want to invest, there are a number of issues you should think about carefully.
It’s important to frame any funding into their business as a commercial relationship, separate from your friendship. You should also understand that many small businesses fail and even a successful business is quite illiquid (i.e. not holding much cash) – there is no public market to sell a debt instrument or shares. So, if their business takes off, it may still be several years before you are repaid or you will be able to sell the shares.
This article considers three questions from a legal and business perspective, namely:
- Due Diligence: Is this a business I want to invest in?
- Valuation: What is the business worth?
- Debt and Equity: How will I invest in the business?
1. Due Diligence
Due diligence is the process where you investigate a business to determine whether its records are accurate and reflect its revenue forecast. The process involves reviewing balance sheets, profit and loss statements, tax returns, purchases and bank statements. You should also ask your friend or family member to explain their numbers, for example:
- customer acquisition cost
- customer lifetime value, and
2. Valuation of the Company
Valuations can vary considerably, and it’s worth understanding how the founder(s) have valued their business and to make your own independent assessment.
(i) Valuation Based On Net Worth
Assets – Liabilities = Net Worth Valuation
Using this method, the net worth of the business is the difference between the assets it owns and the liabilities it owes. This method is useful for businesses with tangible assets.
(ii) Valuation Based on Annual Revenue or Net Profit
Revenue (or Net Profit) x Multiple = Valuation
Online businesses with fewer tangible assets will typically value their business using this method. The valuation is based on annual revenue or net profit, multiplied by a ratio for that industry. For example, many professional services firms are valued at 2X annual revenue. Pre-revenue or businesses with limited revenue information will unlikely find this method helpful.
(iii) Startup Valuation – DCF, NPV
Valuing a high-growth startup is imprecise because it has limited historical information and few tangible assets. It depends on many factors including how much funding the business needs to reach the next milestone and what the founders will give to obtain that funding. Common methods to determine a startup’s valuation are:
- Discounted Cash Flow, or
- Net Present Value.
Discounted Cash Flow involves valuing the intrinsic value of a business today, based on future cash flows. It is ‘discounted’ as it takes into account the time value of money (i.e. money in the future is worthless than its value today). There are many variables to determine and discount a business, often using the weighted average cost of capital. Discount methods often factor in the forecast period, the yearly cash flow, the discount factor/rate, current value and continuing value.
Net Present Value is the difference between the current value of cash flowing into the business (i.e. revenue) and the present value of cash outflows. The Net Present Value of a company reflects the degree to which cash inflow/revenue, equals or exceeds the amount of investment capital required to fund it.
3. Debt and Equity Funding
How you invest in the business depends on your goals, the risks you are willing to take, and the commercial deal between you and your friend/family member. The two key investment methods are:
- debt funding (usually a loan), and
- equity funding (usually subscribing for shares).
Debt Funding – Loan
If you lend the business money, you have a legal right to be repaid, usually at an agreed interest rate, over time. For example, you may lend $100,000 to be repaid over five years at 10% interest per year. Unlike a shareholder who owns shares which they can sell at a higher price if the company succeeds, a lender doesn’t own part of the company.
You will likely require a loan agreement which should set out:
- when you will be repaid;
- the interest rate;
- at what frequency (e.g. monthly); and
- on what conditions (if any).
Lenders typically have little involvement in the business, but the loan agreement can set out business parameters or key decisions that need your approval.
If the company does not succeed, it can’t repay your loan. You should secure the loan over all the business or over specific business assets (e.g. mortgage over company property) to help manage this risk. It’s prudent to obtain legal advice regarding documenting and registering the security.
A friend can become a guarantor where they will be personally responsible for repayment if the company does not repay the loan. If your friend has personal assets to become a guarantor, it will be easier to obtain a loan. However, it is not advisable for them to become a guarantor if they cannot repay the loan.
Equity Funding – Shares
If you sign up for shares, you legally own a part of the company. For example, you sign up for 100,000 shares (10% of the company) for $100,000. If the company succeeds, you can:
- receive dividends periodically (e.g. annually), and
- sell the shares at a higher price than you paid (e.g. the business is sold in a private sale or lists on a stock exchange).
As a shareholder, you have rights set out in the Corporations Act 2001 (Cth) and the company’s constitution. Shareholders should also have a shareholders agreement setting out the following matters:
- who can appoint a director;
- how often the board of directors will meet;
- which decisions directors and shareholders can make;
- share sale and buy-backs;
- how to resolve disputes between shareholders and/or directors.
You can include certain rights in the shareholders agreement, for example:
- providing financial statements quarterly, twice a year or at least annually;
- right to appoint a director or observe at board meetings; and
- right to be involved in, or even veto, certain key decisions. A veto right means the board would require your consent to make the decision (e.g. purchase a major asset, take on major debt or sell the business).
3. Alternative Funding – Convertible Note
There are other funding options open to you and your friend, for example, a convertible note which is a hybrid of debt and equity. An investor (you) lends the startup money which converts to equity on a predetermined trigger event (e.g. the startup raises a round).
A convertible note is beneficial as the company receives funds immediately and the investor receives the right to purchase shares at a discount when a later event occurs (e.g. the company grows and raises more capital). If you then lend the company $100,000, when the company raises $250,000, you have the right to receive shares at a 25% discount and so receive $125,000 worth of shares.
Australians are increasingly starting their own businesses, and investors are keen to get on board due to the potential high returns if one succeeds. Founders typically turn to their friends and family for their initial capital injections. It’s important to treat any funding, whether a loan or share subscription, as a business relationship. Do your homework and thoroughly investigate the business’ cash flows and revenue forecasts.
We’ve assisted hundreds of startup founders secure capital as well as advised companies bringing on investors. We know how to help you negotiate and how to draft legal agreements that work. If you have any questions, get in touch with our specialist startup lawyers on 1300 544 755.
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