Investment Structure for a Prop Trading Business

[YogiBiz]

I am wondering if anyone has any resources to figure out how investment in a prop trading firm is normally structured.

I am a consistent trader in futures for 10 years. I am thinking about starting a firm with one other trader who makes about 5 times more than me and both of us are very consistent and minimal chance of loss.

I am looking at giving 25% of my pnl to the firm in exchange for ideas and infrastructure provided by the managing partner. I can invest capital in the firm to collect 10% of the firms profits which are after payouts to traders. The managing partner would put 40% of his earnings into the firm and keep 60% for him. There is one other silent partner who is putting up half the capital in exchange for 30% of the profits until his investment is paid back and then he would convert to 15% equity ownership and the managing partner would go from 60% to 75% ownership. I would remain at 10%.

My question is how a prop trading business valued. Is it simply the retained earnings in the firm, or is it just the original investment. Do I need to put up 10% of the capital to get 10% ownership or can I put in less for the 10% ownership. And what happens if new investors come in. Will I be diluted or is it common to keep the same percentage. How does the firm value increase? What happens if I leave the firm, do i have to sell back my shares or not? I need some advice on anything related to structuring and investing in a prop trading businss.

Thanks

 

[tommcginnis]

How you (all) agree to structure it, is how it should be structured.

There are as many specifics as nearly the number of firms.

There *are* some conventions, and, no lie: they are available on Youtube.

BEST WISHES. And Congratulations.(!!)

(FWIW, I'd prepare three scenes for the pro forma: the Really Bad Day, the expected, and the Blue Sky (rainbow-farting unicorns sprinkle flooby-dust on all the group's trades...). A simple maneuver, but if you can respond to all three scenarios, you'll all sleep better at night.)

 

[Maverick74]

I am wondering if anyone has any resources to figure out how investment in a prop trading firm is normally structured.

I am a consistent trader in futures for 10 years. I am thinking about starting a firm with one other trader who makes about 5 times more than me and both of us are very consistent and minimal chance of loss.

I am looking at giving 25% of my pnl to the firm in exchange for ideas and infrastructure provided by the managing partner. I can invest capital in the firm to collect 10% of the firms profits which are after payouts to traders. The managing partner would put 40% of his earnings into the firm and keep 60% for him. There is one other silent partner who is putting up half the capital in exchange for 30% of the profits until his investment is paid back and then he would convert to 15% equity ownership and the managing partner would go from 60% to 75% ownership. I would remain at 10%.

My question is how a prop trading business valued. Is it simply the retained earnings in the firm, or is it just the original investment. Do I need to put up 10% of the capital to get 10% ownership or can I put in less for the 10% ownership. And what happens if new investors come in. Will I be diluted or is it common to keep the same percentage. How does the firm value increase? What happens if I leave the firm, do i have to sell back my shares or not? I need some advice on anything related to structuring and investing in a prop trading businss.

Thanks

I can't think of a worse business model to invest in at the moment. The reason why we went from 100's of prop firms down to like 5 is not because it's so damn lucrative right? I use to run a regional office for a prop firm in Chicago. It's a very bad business model because there are no tangible assets. You can't value the future cash flows because the uncertainty of the future cash flows is too high. You would have to apply a huge discount rate to those cash flows that would render them near zero. The only way I could see a firm having any value is there is was a "specific" technology involved. One that can be legally protected through intellectual property rights in a court of law.

 

[DeltaRisk]

I am wondering if anyone has any resources to figure out how investment in a prop trading firm is normally structured.

I am a consistent trader in futures for 10 years. I am thinking about starting a firm with one other trader who makes about 5 times more than me and both of us are very consistent and minimal chance of loss.

I am looking at giving 25% of my pnl to the firm in exchange for ideas and infrastructure provided by the managing partner. I can invest capital in the firm to collect 10% of the firms profits which are after payouts to traders. The managing partner would put 40% of his earnings into the firm and keep 60% for him. There is one other silent partner who is putting up half the capital in exchange for 30% of the profits until his investment is paid back and then he would convert to 15% equity ownership and the managing partner would go from 60% to 75% ownership. I would remain at 10%.

My question is how a prop trading business valued. Is it simply the retained earnings in the firm, or is it just the original investment. Do I need to put up 10% of the capital to get 10% ownership or can I put in less for the 10% ownership. And what happens if new investors come in. Will I be diluted or is it common to keep the same percentage. How does the firm value increase? What happens if I leave the firm, do i have to sell back my shares or not? I need some advice on anything related to structuring and investing in a prop trading businss.

Thanks

The ONLY reason, and I repeat “only reason,” to run a prop firm is for the access to haircuts without being dependent on a broker.
You will be answerable only to the exchange, your clearing firm is the enforcer of that rule.

Start ups will not be able to bilaterally swap shares, you will be lucky if you ever even get to touch an OTC product under five million and even at that level it’s incredibly restrictive.

You have incredibly high regulatory costs along with purchasing & or starting up a B/D by yourself.
Minimum costs including compliance officers and regulatory filing run into the hundreds of thousands of dollars.
Unless you have an edge that’s scalable without excessive variance on your capital/(capital requirements), there is no need to venture out above a prime broker/portfolio margining.

 

[Chuck Krug]

What happens if I leave the firm, do i have to sell back my shares or not?
Make sure to draft a repurchase agreement (reverse vesting)

 

[tommcginnis]

The ONLY reason, and I repeat “only reason,” to run a prop firm is for the access to haircuts without being dependent on a broker.
You will be answerable only to the exchange, your clearing firm is the enforcer of that rule.

Start ups will not be able to bilaterally swap shares, you will be lucky if you ever even get to touch an OTC product under five million and even at that level it’s incredibly restrictive.

You have incredibly high regulatory costs along with purchasing & or starting up a B/D by yourself.
Minimum costs including compliance officers and regulatory filing run into the hundreds of thousands of dollars.
Unless you have an edge that’s scalable without excessive variance on your capital/(capital requirements), there is no need to venture out above a prime broker/portfolio margining.

All good and true things, but I "chose" not to read 'prop firm' as the OP had written, but to substitute "a small set of guys who group capital as equals" -- as I thought that was closer to the details provided.

 

[YogiBiz]

Thanks to all who contributed responses. I am just trying to figure out if it is worth it to give up 25% of my pnl to gain ownership in a small firm with very profitable traders. I was curious if the business can increase in value but I think that the value is whatever profits have been made and then paid out to the shareholders at the end of the year. I am thinking if i cashed out i would get my original investment back and not a multiple of that even if the firm has major pnl growth. I am trying to figure out if want to argue to put a lower amount up to get 10% and if that 10% stays constant if we add capital later. I was trying to avoid using a lawyer but I can see I will need to hire one.

 

[Maverick74]

Thanks to all who contributed responses. I am just trying to figure out if it is worth it to give up 25% of my pnl to gain ownership in a small firm with very profitable traders. I was curious if the business can increase in value but I think that the value is whatever profits have been made and then paid out to the shareholders at the end of the year. I am thinking if i cashed out i would get my original investment back and not a multiple of that even if the firm has major pnl growth. I am trying to figure out if want to argue to put a lower amount up to get 10% and if that 10% stays constant if we add capital later. I was trying to avoid using a lawyer but I can see I will need to hire one.

Why not just start a fund? I don't get what the purpose of having a prop firm is. Your costs will be insane and to what ends? Even if you start a fund you will have costs but if it's just you and a couple of guys and you are not marketing yourself to the public, you can keep your admin costs down. I just don't understand this. This business is so risky even with your own trading. Why would you want the added risk of someone walking away with all your capital? Rather do this. Trade your capital, then take some portion of the rest and just invest it. Hell, buy some bitcoin with it if you are so anxious to live in the fast lane. I just can't figure out what you are trying to get out of this. I mean if this were 15 years ago the idea would be to grow the firm to 100's of traders. But that is a pipe dream today.

 

[tommcginnis]

Why not just start a fund?

...which I think is what the OP intends.

I am just trying to figure out if it is worth it to give up 25% of my pnl to gain ownership in a small firm with very profitable traders. I was curious if the business can increase in value but I think that the value is whatever profits have been made and then paid out to the shareholders at the end of the year.

I would disagree.

The *existence* of places like ET depends on adding value somewhere. ET has advertisers, sure, but just like TV, *we* are the product. So, what do *we* get out of it??
We get different views, different methods, occasionally intelligent debate/argument.
We get an ability to share our hard-won knowledge, but perhaps more important, to *summarize* and to *synthesize* that knowledge into something resembling sentences and paragraphs and even more. THAT is valuable. TO US.

What might you get out of grouping up with fellow-traders-of-some-repute? GOOD COMPANY: people who might listen/critique; people who might afford you the opportunity to gather thoughts intelligently and share with them; AS WELL, people who might have NAVs climbing when yours are falling, and who might very well value *your* climbing NAV when their's also have hiccups.

If you're all rowing in the same direction, the boat'll go faster with everyone pulling in sync, rather than 3 or 4 or 8 boats all trying to make essentially the same wake.

 

[NorthernLimit]

Thanks to all who contributed responses. I am just trying to figure out if it is worth it to give up 25% of my pnl to gain ownership in a small firm with very profitable traders. I was curious if the business can increase in value but I think that the value is whatever profits have been made and then paid out to the shareholders at the end of the year. I am thinking if i cashed out i would get my original investment back and not a multiple of that even if the firm has major pnl growth. I am trying to figure out if want to argue to put a lower amount up to get 10% and if that 10% stays constant if we add capital later. I was trying to avoid using a lawyer but I can see I will need to hire one.

Depends on the profitability and corporate structure (family office, LLC, partnership, etc.) You need to talk to a tax accountant for the final implications, and do a pro forma statement out to 5 years. Then talk to a lawyer about an exit strategy in case it goes to hell (presumably along with the growth in liabilities). It also sound like you are confused about the capital you are putting vs. the capital you are trading with. As a firm you are officially a regulatory "professional", so tax/liability implications of personal capital vs. firm capital ned to be addressed.