This is the question that a friend of mine is facing right now! He has been offered preferred shares in his high school buddy’s company but swears the only way he can afford to invest is by taking out a loan. He got me on board to bounce thoughts off, brainstorm and hopefully come-up with an informed decision.
First the facts of the company, it started out as a mom and pop company built from the ground way back in 2004 and right now has already 11 organic branches and 16 franchises. It is in the service industry with a business model that has a wide blue ocean written all over it – think how Facebook revolutionized social media, or Cirque de Soleil re-invented the circus, or just Google Blue Ocean Strategy to get what I mean. Last year it posted a net profit of 1.5M and according to the nicely written business plan that was sent to my friend, its projected profits 3 years from now is in the vicinity of 5M. The founder, who is my friend’s buddy used to work for a giant chip manufacturer (the “I” inside the computer), quit his job at the prime of his career and started the company with his girlfriend, now his wife. By the way, my friend thought he was crazy when he quit his job back then but have since revised his opinions.
At the minimum participation, the value of each share is very affordable and projected to increase by as much as 30% after 3 years. Exit strategies offered: redemption after 3 years at 12% per year straight interest, 1% interest every year thereafter and on 6th year callable at 15% straight interest. The company also aims to pay dividends after 3 years.
My friend can get a loan, payable in 3 years with a total annual interest of 4.9% that includes insurance and he swears he can afford the monthly payments. This means that at the minimum cost of participation, he gets to pay a total of 14.7% for three years.
Comparing the above 14.7% to the 36% he can get if he chooses to exit after 3 years, I say the math is pretty simple, right? I know that preferred shares are generally regarded for their long term benefits. They also have the advantage of low price per share, price and income stability and of course liquidity.
I think my friend should get that loan and buy those preferred shares. Or is my view too simplistic? What other risks should my friend take into consideration? More importantly, would you advise him to get that loan?