Getting it Wrong Could Result in Financial Disaster or Wreck Your Business.
As happens after every major economic downturn, relationships – both business and personal – that were on the rocks before the downtown but kept going because money greased the wheels, are now falling apart because the grease is gone.
As a result, I’ve been looking at more shareholders and operating agreements recently as business owners seek help with failing partnerships.
Many of these agreements have processes for one member to leave the business. They almost all also have one giant problem that effectively eliminates the possibility of an owner leaving: they place an improper value on the equity of the business.
These faulty agreements use book value as the standard to establish the price at which an owner is paid for his equity in the business.
Book value is an accounting term. It means that an owners’ equity in a company is worth: (stay with me, I promise this is the only equation!)
(Company Tangible Asset Value – Liabilities) X Owner’s Equity Interest (%) 100
The key problem is using tangible assets as the basis of value because tangible assets excludes intangible assets, such as patents, trade names, and goodwill (customer relationships). And this is a very important exclusion.
Why? Because the typical business today has revenue and cash flow, but little in the way of tangible assets. And the tangible assets it does own are usually worth only a small fraction of the value of the business. This is especially the case in “knowledge” businesses – those that rely on intellectual property (e.g. software) or the knowledge of the owners – and service businesses, where there’s a limited amount of equipment and furniture.
And in the real-world, an operating business’ value is based on revenue and cash flow.
Yet, as you can see from the equation above, revenue and net cash flow do not factor into book value.
This means that using book value robs the departing owner (or her family if it is a sale on death) of true value of her true interest in the business.
So, rather than book value, the value should be based on a more realistic valuation standard that considers:
- Goodwill. Will the departing owner be subject to a non-compete or will he open shop down the street and take customers with him?
- Market Compensation. Are the owners being paid a fair market salary for the labor they are providing to the business? If not, the true cash flow of the business is not reflected in its financial statements – it is either too high or too low.
- Future Cash Flow. If the business stays intact, what is the likelihood the cash flow will continue into the future? Is the current economic downturn going to continue for the foreseeable future? Are there operating liabilities of the business that will be a burden after the owner leaves (e.g. the business location is too big)?
- Market Data. What have others paid for similar businesses with similar cash flow?
In fact, most often the value standard for an owner buyout should be fair market value – the price a willing buyer and willing seller would pay if neither were under any compulsion and both had reasonably complete knowledge of the circumstances. Fair market value can be established a number of ways, including an auction process, an appraisal, or an agreement among the partners before the dispute arises.*
Finally, aside from the economic effect on a departing owner, the failure to properly establish the standard of value can have dramatic negative effects on the company as well.
Well-designed partnership agreements have safety valve provisions that allow the owners to end their partnership amicably while keeping the business intact, such as a “shotgun” provision. If the relationship among the owners deteriorates, but none is willing to leave the business because the buyout provisions don’t reflect the true value, that bad owner relationship will affect the business and could destroy value for all owners.
If you have a partnership agreement that provides for a “book value” owner purchase or does not have a shotgun or other safety valve provision, we may be able to help you avoid these problems. Just call us – I am happy to talk with you about it
*Though you must be careful about setting and forgetting this value. Setting a value early on that does not have an expiration date and is never revisited can be as disastrous as using book value.
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