Buying equity in a very small startup business

[Steve Scheffler]

As far as I know VC firms don't invest in small businesses, like for example a mobile sandwich shop or a small yoga studio. But could some individual that has like $20K lying around invest in a small business like that in exchange for equity in it? $20K is a lot for some small businesses and could get them off the ground. Lets say the investor gave $20K to a small business like that in exchange for a 30% stake and this business starts generating $2K/month. That means this investor is makinglike $7K/year off his $20K investment

Am I getting anything wrong here?

[akula]

yes that's fine
in the example above, the investee company would be offering securities to the investor for $20k
the offer would not have to be registered with the SEC because of Reg D and rule 504

however, your IRR calculation is wrong
it's not a $7k IRR
you do not understand how equity finance works
do you need me to explain it?

[Steve Scheffler]

however, your IRR calculation is wrong
it's not a $7k IRR
you do not understand how equity finance works
do you need me to explain it?

Yes PLEASE!

[GotLiveChat]

I think what you're trying to do is similar to "micro loans"; where people are loaning (relatively) small amounts of money to individuals/businesses that need help with start-up costs. Try searching Google on that term to see if that's what you're looking for.

[veikoh]

Basically you as a business is asking $20K for 30% of your future profits. Profits mean that you deduct your costs from your sales. so you should provide investor your cash-flow plan, e.g. what kind of sales you are expexting and what your costs are. historical data could be valuable in this case. I'm assuming that you are not taking yourself a salary and will take 70% of the profit.

[Steve Scheffler]

And let me just give a hypothetical scenario, and let me know if this could happen or if there are any specifics I am missing. Also I have some questions at the end.

Lets say person A wants to open a modest small business like a dry-cleaning service. He/she has done their homework regarding the competition, marketing strategy, the financials and has spoken to potential customers. This person also has experience in dry-cleaning and knows all the in's and out's of the business. All the research has led this person to conclude that this venture will be a profitable one. The problem is he/she does not have the startup money needed to get it off the ground. Person A has$5K of their own but the startup need an additional $20K to get off the ground.

Now we have person B. This person has $20K laying around and wants to invest it, but doesn't know into what.

Person A gives person B a compelling argument for why this dry-cleaning business is sure to work and person B is convinced putting his/her $20K into this venture will make him a profit.

So now that these 2 parties are ready to move forward and have agreed to terms (like how much equity the person B is entitled to), I am assuming the next step is to sit down with a lawyer and put this all on paper and make it official. When doing this, does each party come together with their own lawyer or do they get one lawyer? What sort of lawyer specializes in this? Also, what are the typical terms that two parties in such a situation come to besides the investor getting equity in the business?

Thank you SO much for taking the time to read and respond to this!

[Steve Scheffler]

I think what you're trying to do is similar to "micro loans"; where people are loaning (relatively) small amounts of money to individuals/businesses that need help with start-up costs. Try searching Google on that term to see if that's what you're looking for.

Yes, that is essentially what I am asking about. Venture capital, but on a much smaller scale than that of the Sillicon Salley types.

[GotLiveChat]

Steve I can't think of the sites off-hand (I think they were in BusinessWeek mag) but if you search for micro-loans I'm sure the top players in that market will appear at the top of the results.

As far as lawyers, I can't see why Persons A+B wouldn't be able to use one -- unless each one has their 'own' they already use and trust. They'll be looking for business or corporate lawyer (no shortage there). They can always check with a lawyer (they already know) for referrals...

[akula]

Yes PLEASE!

okey dokey...let me explain to you what vc is and where the opportunities are
i'll use bullet points

1. there are a lot of different kinds of ventures in US
2. all of these ventures are at various different stages of development
3. diffrent stages of development require different kinds of finance
4. sometimes, there are ventures which want to win large market share in a significant market, but one which happens to be nonexistent
5. these ventures cannot borrow debt or raise equity in the public market because they don't have any assets (as yet)
6. venture capital (i.e. mezzanine finance) exists to fill this gap..it provides capital for firms which can't go to the banks and which can't IPO to raise money
7. vc funds make their money the same way that movie studios make their money - they lose a lot of money on most of their projects and make up for their losses by winning on one huge winner. vc is a hits driven business.
8. the reason why vc's lose money on 80% of their investments is complicated (and I will not explain this now)
9. therefore, for your purposes, when trying to calculate an IRR, it is wrong to assume that once you buy some shares in a small business, you are gonna see a return.
10. what happens when money is invested in a private company is that a) the company uses that money to earn some revenue b) expenses are subtracted from that revenue c) the resulting profit is invested back to earn more revenue.
Dividends are not paid out because capital is need for growth
11. what happens afterwards is that the small business usually fails (thre are reasons for why this happens, which I'm not gonna explain here)
12. in these situations, what happens is that the investor in the small business takes a loss
13. after taking the loss, the investor tries to recoup the loss by relying on returns from their remaining portfolio of investments
14. in other words, vc funds achieve positive IRR as a result of having a diversified portfolio
15. IRR is worked out on a portfolio basis rather than individual investments.
16. what all this means for you is bullshit.
17. the problem that you should be solving for small business is not access to finance. there are lots of competing solutions in his area already. because there are lots of solutions available, your solution is unlikely to succeed.
18. the problem that you should be solving for small business is not "how do I get finance?" but "how do I manage my risk?"
19. the problem for small business is that, unlike a vc fund, most of the owner's wealth is invested in just one venture. ventures fail all the time (for a lot of reasons which I'm not going to in to), which means that the average business owner is usually best described as an imprudent, over leveraged gambler.
20. what you need to do is understand what I'm saying to you and develop an interest in solving the diversification problem for small business owners (there are solutions available, which I'm not going to go into).

do you you now understand what vc is and where the opportunities are?

[Steve Scheffler]

Wow Akula, thank you SO much for that comprehensive reply!

I really feel like my understanding was magnified ten-fold after reading that post of yours

[Southern_Lenders]

A promissory Note is probably what your looking for, and can download one from legal zoom, or just pm me with your email and i can send you one for free that i already paid for. As far as the ownership goes, thats another question, unless an ownership clause can be built into the contract.

Also with ownership, how would you seperate yourself from liability? ..

When it comes to lending money, check with your state banking department!

- nate

[Southern_Lenders]

What your looking for in term of "micro loans" has already been done...check lendingclub.com or prosper.com ...you can invest in people and businesses online. They handle pretty much everything..from the rates, the terms, and collections if needed.

[akula]

I really feel like my understanding was magnified ten-fold after reading that post of yours

sure, let's test your understanding
what are top three reasons why it's largely impossible to make money buying equity in small businesses? and what can you do about it?

if you want to buy equity in low cap, low growth, unlisted firms - then you need to be able to answer these questions

[melisawilson20]

"Connecting Small Biz with the World".
The site is called Alamead.com, helping small business owners market their goods/services efficiently and effectively.

[akmholdings]

This is a good stream of info in the topic. Very good forum.