Purchasing Shares

[ejordan]

Hello,

A friend of ours has approached us and asked us if we are interested in buying 35 shares of her business.

I don't have hardly any experience with business ownership.

How should I respond and what things must I consider before moving forward?

Anything specific I should ask her before proceeeding? Should I ask her how much the 35 shares cost?

Just wondering how this works....

Thanks so much for any assistance.

[Business Attorney]

Talking about "35 shares" in a business is completely meaningless without context.

First of all, you need to know how many shares are issued and outstanding. If there are already 65 shares issued, then the 35 shares you would get would be 35% of the company. If there are 1,000 shares issued, then 35 shares would be about 3.5% of the company. If there are 10,000 shares issued, then you are 35 shares would be a fraction of 1% of the company.

Next, you need to know how much the company is worth. Valuing a closely held business is difficult. A valuation expert would look at things like cash flow, valuation of comparable businesses and liquidation value of the business. Most businesses are ultimately valued at some multiple of discounted future cash flows. Multiples can range significantly depending upon the type of business, but I usually use 3 to 5 times cash flow as a beginning range for discussion purposes. For example, if the business generates $100,000 in annual cash flow after deducting all ordinary and necessary business expenses, including a reasonable salary for owners who are active in the business, a reasonable starting point for evaluation would be $300,000 to $500,000.

Once you know what percentage ownership your 35 shares would represent and a valuation range for the entire business, the next step is simple math. If you are 35 shares represent 3.5% of the business and the total business is worth $300,000 to $500,000, then the starting point for valuing shares would be $10,500 to $17,500..

That is only the starting point. Shares in a closely held corporation are not readily salable like shares in a major blue-chip corporation. That lack of liquidity effects the value of the shares. Normally, I would apply a 30% to 40% discount due to the inability cash out of your investment in the shares. Sticking with the same example, the valuation would range from a low of $6, 300 (applying a 40% discount on $10,500) to a high of $12,250 (applying a 30% discount on $17,500). Using the midpoint, I would estimate that a 3.5% interest in a company generating hundred thousand dollars year cash flow would be worth about $9,275.

That is only the beginning. There are bunch of questions that you need to get answers on.

Is the company a pass-through entity? If so, you are going to be taxed on your pro rata share of the company's income without regard to whether there are any distributions of cash. If that is the case, you would want to consider an agreement requiring that there be annual distributions at a minimum in an amount sufficient to cover the taxes due.

Can the company issued additional shares? If so, your interest can be diluted. You may want to negotiate some limitations on the issuance of additional equity interests.

These are just a few of the questions. There are many more. If you are talking about a substantial investment, you really need an experienced business attorney to discuss all the implications with you.