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Three ways for investors to profit from SMEs

Investors can get returns in a variety of ways from their early-stage investments.

Every now and then you have to marvel at the internet and the ability to share knowledge quickly and succinctly.

Recently technology entrepreneur Chris Mills posted a really interesting question on Facebook around whether or not he, as a potential investor in a business, should look at a profit share or an equity share in a start-up business. What followed was a string of really insightful comments around the pros and cons of each, plus an unconsidered third option which was certainly quite interesting.

For anybody who has ever had a little bit of money, the scenario will sound familiar: A friend or family member will come to you looking for early stage funding and you will have the sticky question of “what’s in it for me?”.

The most likely answer [from the entrepreneur] is going to be “profit share” while the investor is likely to be looking for equity ownership with visions of Zuckerberg-type wealth in their dreams.

The problem with the profit share approach is well, most start-ups don’t make revenue – let alone profits. The problem with the equity ownership is … you guessed it: 10% of nothing is still nothing.

That’s the negative side of the discussion out of the way but here are perhaps a couple of strategies to consider if you are having these debates internally.

Strategies

Profit share typically works well when you combine two revenue-positive entities where the likely outcome is profits in a reasonable timeframe. Anybody can promise a profit, not a lot of people can generate it.

For instance if Moneyweb made an investment in another business on a profit share basis, I would do it on the basis that I knew when the profits were expected to come in and what specific project they were coming from. Yes, there may be further downstream profits, but I want to know that in six months or a year, a specific project will generate a reasonable return on investment. Otherwise it’s better for me to leave money in the bank.

The other aspect which invariably crops up down the line is that one partner will push for profits to be reinvested – which benefits an equity investor – while the investor seeking share of profits wants to see money in their bank account.

The key is revenue

Equity ownership is also a potential minefield. Apart from the awkward conversations about who gets what percentage, there are three other aspects which don’t receive a lot of attention until it’s too late:

  • You don’t know what you don’t know. A few years back I made an equity investment at a price I thought was a steal. Literally 30 minutes after transferring money into the bank account of one of the founders, they started referring all their creditors to me and one of my business partners.
  • Almost every early stage investment is going to be under-capitalised. At some point down the line you are going to need to inject more capital and whether you sell further equity or share of future profits, your investment is going to dilute at least once.
  • If you have ever tried to sell a minority stake in a business, you will discover that your pool of buyers is relatively small and the most likely buyer is going to be the person who sold it to you in the first place. There is an above average chance that your fellow equity owner is already tight on cash having come to you for money in the first place and he / she will be looking to minimise the ‘value’ if they do try and take you out. No secondary market for your equity can be a killer.

The third model, which can work out quite nicely for an investor, is revenue share where the investor takes a percentage of revenue generated by the business.

Early-stage businesses (with a bit of luck) generate revenue – they don’t generate much in the way of profits.

If an investor is able to focus the entrepreneur on the goal of generating revenue, this can become a win-win situation for both parties.

For the entrepreneur, it is very important to make sure you agree on specific timeframes for revenue or even profit share agreements, particularly as the business kicks into gear. Rather approach it with a ‘sprint’ mentality and then re-negotiate (ie approach it with a specific short-term goal).

Probably one of the most infamous revenue sharing agreements is one that was struck by the NBA in 1976. The NBA has spent more than 30 years trying to unwind a deal with two brothers which has cost them more than $300 million because the basketball league generated revenue way beyond expectations.

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