Q: I’m planning to invest in a startup business that has been operating for over a year now. The business is doing well but I don’t know how soon I can recover my investment since I’m paying a little premium. What financials should I ask from startup founders and how do I compute for my payback? – Carlo by email
A: One of the first tasks that you need to do when you are given the opportunity to invest in a business is to determine whether the investment is feasible or not. The business may be profitable but may not be feasible to you.
When you are paying too much for your share in the business, the premium may be high that it may take too long for you to recover your investment or the returns may become comparatively too low.
Unless you are investing for strategic reasons to benefit your existing business where you can justify paying for huge premium, every investment must be financially feasible. There is nothing wrong with paying premium because you are coming into the business when there is already value created. What matters is how much you can get out of your investment annually and how soon you can recover it.
Assess the risk
Normally, when a business is looking for investors, there is a financial projection prepared that is part of the investment prospectus. You will find the earnings forecast for the next five years based on certain assumptions about the future. Pay attention to the first two years. How probable that the forecast will be achieved? What are the risks that it will not be achieved?
If you feel that the forecast is too optimistic, you can reduce the forecast to your own numbers. Once you are comfortable with it, you can compute for your projected investment returns.
Let’s say you are investing in this business for P1 million ($21,346.99) at 10% share. You find that the business is projected to earn P1.2 million ($25,605.39) this year. You can simply multiply 10% and get your share in the net income of P120,000 ($2,560.54). At this projected income share, your return on investment will be 12%.
This may look good from scratch but as an investment yield, this may depend on the actual cash flows received. The board of the company may decide to declare only 50% of the net income as dividends because the other half will be reinvested to grow the business. So in this case, your actual investment yield would be 6% only.
It is always helpful when you know the dividend policy of the business so you can have more or less an idea on how much to expect. A dividend policy can state how much of the company’s net income will be distributed as dividends every year. If you cannot find this in the business, you can raise this with the founders and make them to commit it on paper so everyone will be on the same page.
Determining on how soon you can recover your investment will mainly depend on dividends. Your dividends can grow every year as the business grows. The higher the net income, the higher the dividends. The speed of payback depends on the magnitude of cash flows, in this case, dividends.
Forecast the cash flows
The other way to look at it is to forecast the cash flows of the business every year. From the projected income statement, you can add back depreciation and other non-cash expenses to net income to derive the cash flow. Once you have the cash flow figures, simply multiply your share in the business to get your portion of the cash flows and apply it against your investment.
For a minority investor, this computation may only be done for purposes of determining feasibility of the investment. Actual payback may not be the same as dividends may be less than the cash flows of the business. But for a major investor who has controlling interest in the business, the probability of making the cash flows as dividends is higher because of flexibility and control in decision making.
Investing in business requires some skills in financial analysis. Knowing how to read a financial statement can help you in evaluating investment feasibility of any business. Computing for payback period is just one of the many methods of measuring investment.