How new members share in the profits of an investment club

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

17 September 2006

Investment clubs have seen phenomenal growth in the last few years. They have contributed a large part in the increased business at the Nairobi Stock Exchange. Many of them bought the KenGen shares during the recent initial public offer (IPO) and made tidy profits for the members. Upon seeing this, many Kenyans are now seeking to join existing clubs and this has created a difficult problem for the founder members: how do we allow new people in our club and make sure that they do not enjoy the profits that were earned before joining?

To understand the problem better, consider the following example: Ten people form a club where they contribute Sh1,000 per person every month. After ten months, their fund will have Sh100,000 in contributions. Suppose that in this duration, their investments have earned Sh2,500 bringing the total kitty to Sh102,500.

Now, on the tenth month, five more people apply to join this club. They are allowed in on the same terms as the founder members (that is, they contribute Sh1,000 each per month). In the next two months, the total monthly contribution would be Sh15,000 and at the end of the first year the fund would have Sh130,000.

Suppose that in the last two months the fund earned another Sh500 bringing the total earnings to Sh3,000. The question then is, would it be fair for all the 15 people to share this profit equally (Sh200 each)? The answer is absolutely no. The new members have only Sh2,000 in the fund and to make Sh200 in only two months would be quite phenomenon (an annualised return of over 60 percent!).

A fairer way would be to share the profits “pro-rata”, that is, in proportion to a member’s contribution in the fund. An easy way to calculate this is to start by finding out the earnings made per Sh1,000 contribution. In this case, it is Sh3,000 divided by 130, equals Sh23 per thousand.

Each of the initial ten members has contributed Sh 12,000, therefore they would get Sh276 per person (12 times 23). The newcomers have Sh2,000 so they get Sh46 each. But still, there is a problem. We have allowed the new members to share in the profit that had been made before they joined.

So, actually, the sharing should be done in two phases. First, the initial ten members divide the Sh2,500 and get Sh250 each. Secondly, all 15 members split the remaining Sh500 equally, that is Sh33 each. The difference is quite large. In this method, the newcomers get 28 percent less and the founders get 2.5 percent more. This is the fairest way to share the profit. And if the earnings are not withdrawn in cash, then the above figures would be recorded in the club’s membership register.

But there is a twist: Suppose the club is buying real estate and by the time the new members are admitted, it owns ten rental houses. Then in the last two months of the year (after newcomers have joined), it buys another two houses. The rent income for the first year is shared using the method shown above. The question is; should the new members be allowed to share in the rent collected from the first ten houses?