Paying Back Private Investors

Start by assessing the expectations of each individual. Then modify commercial practices to fit your company's needs

I am going to build an assisted living facility, at a cost of $2.4 million. The bank will finance 80% of this project. I've raised $300,000 from private investors but we haven't discussed how they will be repaid. What's the best way to pay them back? I want to propose a win-win solution.

—J.R., Beeville, Tex.

If your private investors did not lay out repayment terms up front, it's probable that they are "friends and family" rather than angel investors (, 2/1/08) or venture capitalists (, 2/1/08). Professional investors typically go into deals with detailed ideas about when and how they will be repaid and how much profit they will derive from their investments. Before you got commitments from those kinds of investors, you'd have to negotiate terms and sign legal agreements with them (BW Small Biz, June/July, 2007). If you haven't already done this, it's likely your investors are people who know and trust you personally.

It's also likely that you have a proven track record in the senior care industry, given that you've been able to arrange hefty bank financing for your construction project and attracted money from friends and relatives. However, any new business is a risky venture and you'll need to be very careful about what commitments you make to your private investors. "The only thing more painful than losing my own capital in a business venture is losing capital that others have entrusted to me," says Peter Cowen, an investment banker and senior partner at GroundWork Equity in Los Angeles.

Minority Stake?

Start by assessing the individuals who have invested in your new business. When do they need the money back? What kind of interest and/or dividends are they expecting? Talk to them about whether they anticipate being repaid, whether they want equity, or whether they expect some combination of the two. If your investors want repayment with interest, you could structure their loans as notes with interest accruing over time that are subject to a balloon payment at some point in the future.

"You want to use good commercial practices, but modified to accommodate the flexibility and long-term strategy that's in sync with small business," says Quentin Fleming, a family business consultant and adjunct professor at the University of Southern California. "What I've seen done successfully is a nine-year, interest-only loan with a balloon payment at the end. Writing in zero prepayment penalties gives the entrepreneur the ability to start paying down principal if the business is doing well, but also gives her several years before she has to pay principal if cash flow is slower than expected during the early years." He recommends using the mid-term federal funds rate as your interest benchmark.

If your private investors are interested in a combination of repayment and equity, there are a number of variables that can be used to determine what their minority stake would be, Cowen says. "For argument's sake, you might plan on them getting a 10% to 20% equity stake in the business, assuming your company can achieve several million dollars in annual sales at a 20% net profit."

Be careful about bringing in minority owners, Fleming cautions, because selling equity shares will trigger fiduciary duties and additional regulations on your firm. "Any time you bring in other owners, you need to determine whether their long-term interests are fully aligned with your own," Fleming says. "Once you're in bed with them, you're in bed for the long term. You'd need to have buy-sell agreements in place and limit their ability to sell their interest to a third party." You'd also need to get proper legal documentation of ownership, showing that you have the controlling interest in the business.

An Extra Buffer of Cash

Go over your business plan with an accountant who is familiar with small business startup financing. A professional should be able to help you make realistic projections of your cash flow that you can use to come up with a proposal for repaying your investors in a way that will allow you to get the company going strong and reward the people who've trusted you. If you structure these investments as loans, you should be able to draw up one-page documents stating how much money is being borrowed and at what interest rate, specifying periodic, interest-only payments and the final balloon payment on a specific date. "As long as you both sign the document, have it witnessed, and it would be clear to a third party exactly what's been agreed to, it's a legally enforceable document," Fleming says.

One major thing to remember is that you'll be going into business with 80% financing, and you'll eventually want to reduce the amount of debt and interest your firm is carrying. "Be aware that you'll have to pay back interest and principal on the construction loan starting even before your facility is built, so you'll need to figure those costs in," Cowen says.

You'll probably also want to arrange for additional working capital. Construction delays are almost a given, and you'll need money to purchase insurance, pay overhead and regulatory costs, get a staff hired and begin paying them, market your services, and cover myriad additional startup expenses. "Even if you have experience in this field, you may not have forecasting, financial, or building experience," Cowen says. "I can't emphasize enough that you'll need to build in an extra buffer of capital to help you. The biggest problem I've seen with startups is that they didn't allocate enough money to reach the necessary milestones of bringing in business and reaching positive cash flow."

Before it's here, it's on the Bloomberg Terminal. LEARN MORE