Simple corporate finance question (real life)

CFA General
#1

Hello fellow AF’ers

I have a simple real life corporate finance question to run past you.

A friend has a business. He is the sole shareholder with 100 shares.The business has been valued at $800,000.He wants to bring in a new equity investor who will invest $100,000 for 12.5% of the business, in addition to a ‘free gift’ of an additional 7.5% to bring the new investor’s stake up to 20%.

He plans to have the company issue new shares to the new investor, rather than sell part of his existing holding.

Am I right in thinking the company just issues 25 shares to the new investor, which gives him a 20% stake in the company, which now has 125 shares in issue?

However, it seems to me that the original owner’s stake has fallen from 100% of $800,000 to 80% of $900,000, which is only $720,000. This doesn’t seem right? Shouldn’t his stake in the business only fall by $60,000, being the ‘free shares’ granted to the new investor?

#2

You’re right the company should issue 25 shares. That gives the new investor 20%.

But, there is no such thing as a “free gift” of shares. The company is valued by the transaction at $500,000. You can’t inflate a company’s value by calling some shares a “free gift.” This is nonsense.

This is why it’s not so simple as looking at 80% of $900,000. The 20% of the company was sold at a value of $500,000.

If you were to ask me, I’d say the owner’s stake is worth ~$400,000 now.

#3

Two things to add, I’m still thinking…

Can’t you give “free shares” by thinking about it like a call option with a strike of 0?

And also the transaction value of the deal of $500,000 is the total value of the company on a minority interest, yes? Owner’s stake should be worth more on a per share basis due to control, depending on the rights in the agreement, of course.

#4

You could give “free shares” like a call option with a strike of 0, but then it would be an expense that would hit the original owners value through retained earnings. Greenie would be a better source than me on this one, but I’m sure your equity is getting dinged this way.

It’s like when a company pays its underwriters their fee in options or warrants. In that case its a financing fee, this would be somewhat similar I think.

And yes, that’s true on the second point. I’m thinking from a simple accounting perspective there. A new owner may need to pay a higher value for control. However, the transaction values the company at $500k. The new shares would be issued with a book value of $100,000 for 25 shares.

At the end of the day, a valuation opinion isn’t worth much. It’s all about what someone is willing to pay for the business (though I admit that likely would be higher with control).

#5

Thanks guys. Point taken that the transaction effectively values the business at $500,000 and not $800,000.

The 7.5% of the company was effectively viewed as a bonus as the would-be investor is also an employee, however for tax reasons it is preferable to treat the $100k as full payment for 20% of the company.

#6

Probably correct on the tax front.

#7

Here is why:

Case 1: If he SELLS 12.5% of the company, implying that the company will still worth $800,000 after the transaction, then $100,000 for 12.5% is a fair deal.

Now considering the “gift”.

7.5% of the company, which is $60,000, will be transferred from your friend to the invester. Your friend’s wealth is $100,000 (from the transation) + $640,000 (stakes in the company, representing 80% of the company) = $740,000, a fall of $60,000 (representing the value of the “gift”) from $800,000 (original wealth)

But the actual plan is this:

Case 2: If he ACQUIRES NEW CAPITAL, implying that the company will worth $900,000 after the transaction, then $100,000 will only represent 11.11% of the new company. By giving the investor a 12.5% stake, your friend is already transferring a partial of his wealth to the investor. Because 20% of the new company is actually worth $180,000, if he uses the 20% for the $100,000 new capital, his loses $80,000, which is precisely the difference between 100% of $800,000 and 80% of $900,000.

You mixed-up this two cases. Of course, the accounting and tax treatments for the two cases are also different. Hope my answer helps.

#8

This reminds me of PE valuation from Level 2 :slight_smile:

#9

^ I hope you get to change your username soon.