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Investment equity in start-ups
Expert: Randy Berry
Michael McMurray asked:
I am starting a charter flying service and several people have expressed an interest in taking an equity interest in my startup. I plan to lease-to-purchase the aircraft, so there will not be a lot of equity in the company for the first five years. How do I figure out what percentage of the company an investor should receive in exchange for say, a $25,000 investment? Can an investor hold the shares in a self-directed RRSP?
Randy Berry answered:
Given that this is a start-up operation, a discounted cash flow method ("DCF") should be used to calculate an enbloc value for the business. Generally, the after-tax cash flow (positive or negative cash-flow), including the business' residual or terminal value and the business' annual net working capital requirement, will be discounted by an appropriate rate of return that takes into consideration the business and financial risks applicable for this type of business. With the information provided there appears to be little equity that will be used to finance the business start-up. Accordingly, the financial risk for the business will be high.
Once the enbloc value for the business is determined, a pro-rata equity interest can be calculated based upon the proposed investment to fund the business start-up. For example, if the post-money enbloc value of a business is estimated at $100,000, a $20,000 equity investment could provide an investor with a 20% ($20,000/$100,000) pro-rata interest in the business. Normally there would be a discount for a minority position as well as a marketability discount for investment in a private company. These discounts could arguably be offset by the additional risk of being an under-funded start-up business, and a pro-rata calculation maybe appropriate.
An Investor can hold the shares of a private company in a self-directed RRSP, which will require additional administrative considerations as follows:
* A formal valuation or comfort letter by a qualified independent professional will be required by the financial institution that administers the self-directed RRSP.
* General investment criteria stipulated by Canada Customs Revenue
Agency ("CCRA"), prescribes that related parties can not hold more than 10%
of any class of shares in the Company, and non-related parties can own more
than 10% of any class of shares in the Company but their investment is
limited to a maximum of $25,000. CCRA provides specifically defines related
and connected parties under this section of the Tax Act. The aforementioned
is a summary of CCRA's requirements. Qualified professional tax and legal
advice should be obtained prior to an investment through a self-directed
RRSP to ensure the tax legislation is complied with.
About the author
Randy Berry is an accountant with the Alberta branch of BDO Dunwoody.