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Profit Share Investments – A warning

 

I was offered an investment opportunity by a sole trader who was seeking £1M of investment for a 10% share in the profits of a new product that was starting to take off.

I gave some initial reaction to why this method of investing was not generally valid, as well as the over inflated valuation. However after a short dialogue I decided to give a comprehensive explanation, shown below.

Dear Sir,

The reason no serious investor is going to be interested in profit share is that no private company is interested in profit.

As a public company, you have shareholders whose trading directly affects your share price and therefore your market cap. To ensure your market cap stays healthy, you must make profits and return to shareholders. The cost of making these profits is taxation, which is high.

In private companies, your shareholders are generally the owners of the business. Profits, therefore are undesirable, so anything you can do to prevent them is a priority. In many cases profits are absorbed by R&D departments.

Private companies only make profits if they are positioning themselves for investment or a trade sale.

Secondly, even if you are not deliberately trying to prevent profit, this is still an arbitrary figure that is mostly within your control. You can choose you sales price, you can choose how much you spend on cost of sales, you can choose your fixed cost base. An invester with no equity in your business has no say in your profit structure, therefore no ability to observe, let alone control profits.

As an investor with equity, at a very minimum they have a shareholder agreement. I don’t operate this way, I always take a minimum of 25.1% shareholding. This gives me vote blocking and while all day to day decisions can be taken without my vote, no “Special Resolutions” can pass without my vote. Special Resolutions include, trade sales, bankruptcy, share dilution or exit.

Also, most investors are not interested in short term returns, because of the fragility of investing, most investments are expected to exit within 5 – 10 years with a 20 X ROI. Only 5 percent typically do this giving a break even position, so investors then hope to contain at least one unicorn within their portfolio to provide them with the profits they require.

The other option you can consider is a loan, but all loans are secured. In other words, you can only borrow on what you already own.

 

Here’s the reason why you are going down a dishonest route, but don’t understand it.

You genuinely intend to return 10% profit for the investors you are seeking. However as you grow your business and start to understand how to run a business, you will realise that making profits is not the optimum objective, so you will seek to reduce these as much as possible. All investors know that and therefore all investors understand the dishonest scheme you are attempting to start even though you don’t.

The other points I made in my first response were real, but tongue in cheek. Asking for a £1M on  a 10% profit share values your company at least at £10M. However, realistically, closer to £100M+. (Established companies can be roughly valued at 12 – 14 times their annual net profit averaged over a 3 year period).

At the median (say £50M market cap), you are a huge company, you will have 100’s if not 1000’s of staff, you will have an established experienced full board (including appointed non-execs) and you will have decades of trading history and an exceptional credit history.

This is at complete odds to your profile of “Sole Trader” as a sole trader your business would be valued, at best, in the few thousands. Your borrowing facility would be restricted to the assets you own. So your ability to raise investment would be in the thousands of pounds, not millions.

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