#18 | What to Consider When Buying a Portion of a Small Business

A friend of mine who is also looking to acquire a small business reached out to me last week to see if I would have any interest in investing in a small business he is looking to acquire himself.  He knows I have been looking to acquire a business myself + I think we both have an interest in working together on something + we think we have some complementary skill sets, so this really got me thinking. 

I had already reviewed this business through our Quality of Earnings Sniff Test that we offer to buyers, and I really did like the deal.  

One downside is that the business isn’t complementary to what I am already doing at ProjectionHub, but I think the business is relatively straightforward and my friend and I think we have an idea for an operator, so I don’t think it would take much of my time.  I would likely just provide support on the accounting and finance side of things.  

We haven’t talked about price, or investment amount, or equity percentages yet, but this conversation got me thinking about a few things when it comes to buying a portion of a small business.   

1. How much do you need to invest to make it worth it? 
2. What percentage of ownership should you stay below? 

Let me clarify:

Invest enough to make it worth it

For the sake of easy math let’s assume the business is valued at $1,000,000 and generates $350,000 in annual profit.  

Then let’s assume I just make a small investment of $25,000 for 2.5% of the company.  

Let’s assume I am entitled to 2.5% of the annual profits as a dividend, so I would earn $8,750 per year in dividends. 

But by having ownership in another business I would complicate my tax preparation and probably would cost an additional $1,000 per year just in tax preparation fees.  Plus in the first year I would probably have some legal cost and extra CPA costs for the initial investment transaction.  Let’s assume that costs a flat fee of $7,500. 

So in the first year, I wouldn’t really earn anything, not to mention my time and effort opportunity cost.  

The next year I might work roughly $7,500, then I would pay income tax on that and it would leave me with $5,000.  At that rate it takes me 6 years just to recoup the initial investment. 

Here is my point.  There are some fixed costs and effort associated with having ownership in a business.   It would probably cost the same flat amount in legal fees and CPA costs if I invested $250,000 and had 10x more ownership.  But at 25% ownership my dividend could be $87,500 minus $1,000 a year in additional tax prep fees. 

There is some level of investment and ownership that is just too small to be worth it. 

Stay under 20% ownership to avoid future complications

At the same time, there are some downsides to certain levels of ownership.  The one that comes to mind most clearly is that any ownership over 20% would require you to personally guarantee any SBA loan the small business might take out.  

So even though you don’t have control over the business as a 20% owner, you would personally be on the hook for 100% of the company’s debt should the company default. If you are not willing to personally guarantee a loan, but you have more than 20% ownership, you can really limit options for the business as it grows.  

If the business needs a line of credit to cover inventory purchases to support growth, you will have to personally guarantee, or you will hold the business back. 

Not too little, not too much

I think there is a sweet spot for anyone looking to buy a portion of a business where you need to make it large enough to make it worth the transaction cost and carrying costs, while keeping the investment low enough not to hold back the business in the future.  

What do you think?  How do you determine the right amount to invest if you are buying a portion of a business or partnering with other owners?