Article Written By:
Kelly Noll
Senior Manager
In a Forbes article titled “Why Partnership is Harder than a Marriage”, Amanda Neville stated a sobering statistic:
The truth is that partnership is far more difficult to maintain than marriage. In fact, whereas 50% of marriages end in divorce, the number is closer to 80% for business partnerships.
The article cited a number of number of factors why this is the case, but failed to mention one of the most contentious points in a partnership dissolution: the purchase price of the interest. The purchase price language or “buy-out clause” is specified in every operating agreement, and there are four ways it is generally written:
- Fixed Price – This calls for the interest to be purchased at a fixed price (e.g., $100 per share). The benefit of a fixed price is that there is certainty in the purchase price – when one gets bought out, he or she knows what will be received. The downside of this is that the fixed price may not resemble the investment’s fair value (typically, the reason one enters into an investment is to get bought out at fair value).
- Book Value – Book value is the value stated on a company’s balance sheet equal to assets minus liabilities. While this is an easy number to look-up, similar a fixed price agreement, it is often not representative of fair value, particularly if the company is in a service industry and many of its assets aren’t on the balance sheet (e.g., intangible assets like customer relationships and trade names). As such, if you are getting bought out, you generally stand to receive substantially less if you are bought out at book value as compared to fair value (which isn’t so bad if you are the one buying the shares, though when the agreements are written, you don’t know who will need out first).
- EBITDA Multiple – Many agreements are written such that an investment will be purchased at a multiple of EBITDA (e.g., 5x EBITDA). This is intended to represent the fair value of an investment, but it is often a poor metric as EBITDA is easily manipulated. Are you the one purchasing the shares after a disagreement with your business partner? Just run through a few big expenses and get EBITDA down to zero, or choose any of the many other ways to manipulate EBITDA. We like to think there aren’t unscrupulous people like that out there, but when business partnerships break-up, oftentimes “the gloves are off.”
- A Valuation-Based Price – A valuation based-price states that fair market value will be determined by an independent appraiser. Valuators are trained to adjust for non-recurring expenses (such as the one described above) and focus on the future cash flow generating ability of the business, the ultimate source of value in any investment, which isn’t always captured in an EBITDA multiple.
Our perspective is that hiring a quality appraiser before the partnership dissolution or other triggering event (death, divorce, disability, etc.) occurs provides the most accurate value for the company. It requires investing only a small annual fee to create comfort and avoid costly issues later. Before there is a triggering event, shareholders’ interests are much more likely to be aligned and it will result in better, more accurate and fairer valuations, and greater certainty for shareholders. Further, valuations can be customized to satisfy multiple uses such as estate & gift tax planning, issuing stock options, possible sale of the business and goodwill impairment testing.
