Commissions and Private Equity

It seems you always ending up paying  when you sell something. The more complex and difficult the sale, the more you’ll have to pay.

real-estate-commissions

Most of us use realtors when we buy or sell real estate. This is in spite of the fact that real estate commissions represent a not insignificant cost.

While real estate commissions are arguably quite high, the market for realtors is really quite competitive. For that reason I would argue that real estate commissions are probably appropriately priced.

Pricing real estate is really quite simple. All realtors look at market comparables to determine a price. They look primarily at location, size and condition – which most of us can easily understand. What’s more the vast majority of real estate listings result in a sale – at least if the price is right.

MOST STARTUPS FAIL TO RAISE ANY PRIVATE EQUITY

Selling private equity is exceedingly difficult and complex by comparison. This is particularly true for early stage companies. For one thing the vast majority of early stage companies fail to raise any private equity – except from ‘friends and family’ (also lovingly referred to as FFF for ‘fools, friends  & family’). So if you take on the job of raising money for your company by yourself, you are likely to fail.

When selling an established business, there are 3 generally accepted approaches to establishing a value:

  1. income approach
  2. asset approach
  3. market value approach

These approaches can be learned, but each is significantly more complex than the market comparables approach used by realtors. While the market value approach resembles the methodology used by realtors, it is much easier to value a single tangible asset like a condominium than it is to understand a complex organization like a business.

When it comes to early stage companies as compared to established businesses, the complexity – and hence the risk – is significantly higher. First, because none of the 3 generally accepted approaches actually work.

STANDARD VALUATION APPROACHES DON’T WORK FOR STARTUPS

Consider also that the investor is not buying the entire business, simply an equity position in an existing small business. Effectively then the investor is taking on ‘partners’ who will be relied upon to manage the business and who will almost certainly have a controlling interest. So the investor will be evaluating management and the valuation at least as much as anything else.

THE LEHMAN SCALE

The Lehman Formula, also known as the Lehman Scale, is a formula to define the compensation a bank or finder should receive when arranging for and handling a large underwriting or stock brokerage transfer transaction for a client. The formula usually applies to the entire value of the stock.

The following is the Lehman Formula as originally described:

  • 5% of the first $1 million raised from investors
  • 4% of the second $1 million raised from investors
  • 3% of the third $1 million raised from investors
  • 2% of the fourth $1 million raised from investors
  • 1% of everything above $4 million raised from investors.

The Lehman Formula was widely used in the 1970s, 1980s and 1990s but is no longer the standard that it used to be. The original formula tends to be in current use only with the finding of private investors, where the finder has little or no liability, legal work or administrative work.

– Wikipedia

In fact the Lehman Scale has been largely supplanted by the Double Lehman for private equity deals.

In modern investment banking transactions, this Lehman structure is
augmented heavily by upfront fee, retainers, hourly fee and other fee to compensate for the expenses in the transaction.
 – Elite Mergers & Acquisitions

divestopedia-lehman-scale

The takeaway is you will almost certainly pay substantial fees, if you want to raise private equity for your company – unless you do it yourself. And if you try to do it by yourself, you are very likely to fail.