How to admit new members in an investment club

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

24 September 2006

In last week’s discussion of how an investment club can share profits with newly admitted members, it turned out that the sharing should be in two phases: First, the founder members divide the old profit amongst themselves and then all members (old and new together) split the new profit equally.

But one question remained: Suppose the club was buying real estate and by the time the new members are admitted (the tenth month), it owned ten rental houses. Then in the last two months of the year, it bought another two more houses. Should the new members be allowed to share in the rent collected from the first ten houses?

The argument against new members sharing in that rent arises from the fact that they did not participate in purchasing the assets. One way that many clubs solve this problem is to require new entrants to put in as much money as the founders have in the fund.

In last week’s example, the new members join on the tenth month and at that time each the founders have Sh10,000 in the fund. Thus the newcomers would be asked to contribute a lump sum Sh10,000 when joining. After that they continue with Sh1,000 per month like every one else – and share all profits equally with the other members.

Although it sounds fair, this method actually asks for too much money from the new members. A fairer way to handle the situation would be recognise that the newcomers wish to become equal partners in the club. Thus they should compensate the founders for part of the cost of the old investments.

Now, before the new members are admitted, the club has investments worth Sh100,000 held by ten people – each owning a tenth or Sh10,000. After the new memberships, there will be 15 owners and it desired that all will have equal stake in the old investments. That is each person to own Sh6,666 (Sh100,000 divided by 15).

Thus each of the new members should be asked to pay a lump sum Sh6,666, that is, at total of Sh33,330. This money is divided equally amongst the founders, Sh3,333 each. By doing this, the old members have sold a share of their investment to the newcomers and now they are all equal partners. Let us find out how:

The founders had invested Sh10,000 each . From the lump sum money that the newcomers pay, the old members get back Sh3,333 each. Therefore, their net investment becomes Sh6,667 (Sh10,000 minus Sh3,333). But the new members have also put in Sh6,666, thus everyone is an equal partner…if we are willing to overlook the one bob difference!

The only hitch here is that we have assumed that the market value if the investment remained constant during the ten months. To take care of this, the club should use the prevailing market rate instead of the Sh100,000.

Finally, with the new trend of joining investment clubs, unscrupulous people have set up pyramid schemes which promise astronomical profits within a short time. What is the catch in these schemes? That is a story for another day.