Quite a few privately owned businesses and professional practices have more than one co-owner partner. And unplanned departure of a partner can have a major effect on the success of a business going forward.
To safeguard business continuity, you as business owners need to plan ahead about how to transfer business ownership interests with minimal business interruption.
In addition, you should think about the value of the departing partner’s share and the sources of funding for a partner buyout. In such situations, business valuation becomes a strategic management tool.
What buy-sell agreements do
As business partners you can address the need for such future ownership transfers by creating a formal buy-sell agreement. At a minimum, such an agreement should help you address these concerns:
- Specify which events may trigger the provisions in the buy-sell agreement. Examples include partner departure due to death, illness, divorce, retirement or major falling out.
- Provide a clear way of determining the value of the departing partner’s business ownership interest.
- Specify the sources of funds to pay for the partner buyout.
- Prevent the partner’s share of business from falling into the hands of an undesirable party.
- Word the buy-sell provisions in a way that the legal and tax authorities will honor.
How buy-sell agreements are structured
To start, your buy-sell agreement must establish the party that buys the departing owner’s share of business. There are several ways to handle this:
- Entity purchase, where the business buys back the ownership from the outgoing partner.
- Shareholder purchase, where the remaining owners buy the former partner’s interest.
- Wait and see agreement, where the decision as to who buys out the partner is deferred until the triggering event takes place.
Business valuation provision in a buy-sell agreement
How you value the partner ownership interest represents an important part of the agreement. The remaining co-owners must choose how and when the business appraisal is to be done. Your key decision points here are fairness to all the business owners, affordability, and tax considerations.
To be binding, your buy-sell agreement should clearly state the standard and premise of business value as well as the approaches and methods used to calculate the valuation results. The typical ways of structuring a valuation provision for your buy-sell agreement are these:
- A business value figure set by mutual agreement among the business owners. You should update this at least annually.
- A choice of business valuation methods that the co-owners have agreed to use to determine the business value.
- Requirement that a professional business appraiser be retained to conduct business valuation.
Valuation of the entire business is the first step. The next question is how to allocate this business enterprise value among the co-owners.
One option you may choose is to divide the total business value in proportion to the partners’ shares of ownership. Let’s say there are two partners who own an equal share of the business worth $1,000,000. In the pro-rata allocation scenario, each partner owns $500,000 or half of the entire business.
Control premia and minority discounts
If, on the other hand, one partner owns 75% of the business and the other the remaining 25%, the pro-rata allocation may not be the best choice. In this case the partner holding the 75% stake has the so-called controlling ownership interest. This may be more valuable because this co-owner enjoys a number of advantages over the minority partner:
- Decision as to the timing and size of dividend payouts or partner draws.
- Election of directors.
- Key hiring decisions.
- Acquisition and sale of business assets.
- Raising additional capital for business expansion.
The controlling owner’s business share may be worth more than 75% in this case. The difference is referred to as control premium. You can estimate what that premium is by observing the share prices paid by public companies seeking to acquire a controlling stake in other firms.
Once you know the control premium, you can determine the minority discount from it. This will give you the ratio to apply to the pro-rata share of ownership held by the partner with 25% of the business interest.