Ask the Editor: How to Evaluate a Business Investment Opportunity

Question: I have the opportunity to become an equity partner in a 12-year-old company that owns four pizza restaurants. The company has been earning $350,000 per year, on average. The current owners are raising $600,000 by selling a 25% equity interest. They are willing to repay the investment over five years, level principal and interest paid quarterly at a 5.5% annual interest rate. At the end of the five years, the new investors will continue as 25% owners and begin getting 25% of all profits. This sounds like a pretty good deal to me. I get all my money back and keep the equity interest. Am I missing anything?

Answer: To assess this opportunity, we need to look at several issues before drawing a conclusion:

• What kind of profit does the $350,000 represent? Operating profit? Net profit? Adjusted profit? EBIT? EBITDA? (See “Making Sense of the Sales Multiple” on page 10.) If this is an equity investment and we are talking about after-tax profit, then valuation of the company at $1.4 million may be reasonable.
• How will the five-year an obligation be structured? Will the company sign a note that obligates it to specific repayment terms?
• How will the repayment obligation be secured? What if the company can’t repay the capital as stipulated? Can you take control of the company? Will any current owners guarantee the obligation?
• What does the company’s balance sheet look like? How much debt does it have? How valuable and liquid are the assets? If outside borrowing exists, which obligations will be senior and junior? How easily will current and projected cash flow cover existing debt and the new obligation?
• What is a fair rate of return for money you invest in opportunities like this? Assuming 10% return is fair for your money, why accept 5.5% as with this opportunity? You would not, of course, unless there were a very good probability you would enjoy nice returns after the first five years. How sure are you that this will occur? Remember, a lot can happen in five years. Be sure to run the numbers.
• As a minority owner, you likely have almost no say in what controlling shareholders do with the company or its profits. What prevents controlling parties from raising their salaries and perquisites to the detriment of your return?
• If you ever want out, who is going to buy your minority shares? This is called lack of marketability. Unlike publicly traded stock, you’re probably stuck unless you have a good buy-sell agreement.

In summary, you should work out many of the protections discussed above before you take this opportunity seriously. Move cautiously, get all the facts and use common sense. Keep in mind that private businesses are risky and investments in them merit annual rates of return well in excess of what you can get from the public equity market (i.e., average annual return around 12%).