Venture Financing:

Structuring the Deal

Equity Investor's Compensation

Selecting the Best Way for Compensating Purchasers of the Equity Interest in a Business

By Meir Liraz, CEO, BizMove. Used by permission.

 

The purchaser of an equity interest in a business expects to be compensated for the investment in any of the three following ways:

  • Income from earnings distribution of the business, either as dividends paid to corporate shareholders or as drawings in a partnership.

  • Capital gain realized upon sale of the business.

  • Capital gain realized from selling his or her interest to other partners.

Capital Gains

Capital gain is the term used to describe any excess of the selling price of an investment over the initial purchase price. For example, if you purchased an equity interest in a business for $5,000 and later sold it for $8,000, you would realize a capital gain of $3,000.

Earnings Distribution

The equity investor in a partnership is entitled to a share of all drawings paid out to partners at a percentage established when the interest was purchased. For example, assume an investor acquired a 20% interest in a partnership. The distribution of earnings to all partners in a given year is $20,000. The holder of the 20% interest would receive $4,000.

The dividends received by the equity investor in a corporation depend upon the number of shares held. For example, if a corporation voted a dividend of $1.50 per share in a given year, the owner of 1,000 shares would receive a dividend of $1,500 (1,000 x $1.50).

Sale (or Liquidation) of Business

If a business is sold or liquidated, the equity investor shares in the distribution of the proceeds. As with an earnings distribution, the share of the proceeds in a corporation sale depends upon the number of shares held. In a partnership, each partner's share of the proceeds is based upon the percentages specified in the partnership agreement.

If the proceeds received by the equity investor exceed the original purchase price, this excess is considered a capital gain and taxed accordingly.

If the business were liquidated, the assets would be sold and the proceeds would first be used to discharge any outstanding obligations to creditors. The balance of the proceeds, after these obligations had been fulfilled, would be distributed to the equity investors in accordance with their share-holdings or percentages of interest.

Sale of Equity Interest

As a business prospers and grows, the value of an equity interest grows with it. Therefore, the equity investor may be able to sell his or her interest at a price higher than the initial acquisition cost.

For example, an equity investor in a corporation may have purchased his or her interest at $10.00 per share. As the business grows, he or she is able to sell the shares at $15.00 per share, realizing a capital gain of $5.00 on each share sold.

Capital Gains vs. Dividends

In many cases, the equity investor in a small business is primarily interested in capital gains. Aside from the tax advantages, the equity investor usually realizes that the earnings of the small business are better retained in the business than distributed as dividends or drawings. Retention of earnings permits the business to grow so that the value of the equity interest increases. The investor can realize a return on the investment through a capital gain derived from selling his or her shares or upon sale of the business.