Feb 24, 2023 | Financial Acceleration

How do we decide a fair price for buying out our partner?

Q. Dear Zenagos,
I have two business partners, and we own a Bed & Breakfast in a tourist location. Two of us operate the business and third provided the majority (but not all) of the funding. We’ve been doing well for about 3 years. We two operators want to buy out our third partner, but he wants way more than he put in. I think he’s being unreasonable. How do we decide what a fair price is?
–Valerie

Determining the fair market value for a private transaction is tricky. The market value for any business is what someone else is willing to pay for it, but you can’t really figure that out if you’re not willing to sell it. Even if you do put the business on the market (without really intending to sell it), your third partner may argue that bidders will naturally lowball, trying to get the best possible deal.

The best way to decide is to agree upon an authority, who will appraise the business. If all three of you agree to the process in advance, this provides the best chance for an amicable solution. Sometimes the process is to have the business appraised by two parties (one selected by you, and one selected by the third partner) and then agree in advance to average the two appraisals. It doesn’t really matter what the process is, as long as all three of you agree to it in advance.

The Equity Has Appreciated
If the business has been doing well, then its equity has almost certainly appreciated. It is not unreasonable for your partner to want considerably more than the initial amount invested. The value of a business is determined based on all of the money that it is likely to earn in the future (not just what it is earning right now). Those future earnings are called “cash flows,” and they are usually “discounted” a bit in order to account for inflation and other factors that make cash in hand more valuable than cash that is promised in the future. There are two common methods for valuing a business.

Method 1: Future Cash Flows
The future cash flows method uses some complicated mathematics to arrive at the current value (the Net Present Value or “NPV”) of all of the business’ future cash flows. This is the method used by Wall Street analysts to derive the value of companies that are publicly traded on the stock market. There are commonly accepted rules for this method. Still, two analysts could arrive at different valuations using this method, since they might have different assumptions about what will happen in the future. That’s why you hear about “consensus” estimates, which combine the estimates made by several analysts.

If you want to use this method to value your business, you should probably hire a business broker, who can either perform this analysis or refer you to someone who can. Since your business sits on a property, you should probably have the property appraised separately from the bed and breakfast business.

Method 2: Exit Multiple
The exit multiple method is simpler than the future cash flows method. It is similar to the method used by a realtor to decide what price to use when putting a house on the market. You and the seller would agree to a multiple of revenue or a multiple of earnings, based on the prices of comparable businesses (or “comps”) that had sold recently (just as a realtor bases the price for a house on the prices of other properties sold recently in that area). For example, if all parties agreed to use a 5X earnings multiple, then you would take the bed and breakfast’s earnings for the past 12 months and then multiply that number by 5, and that would be the price for the business. (Again, the real estate should be valued separately.)

Sometimes it’s difficult for the entrepreneurs who do the day-to-day work to understand why the financial partner (who doesn’t put in that day-to-day “sweat equity”) should get so much out of the business. You have to remember that without the financial partner, the business wouldn’t exist, so the financial partner has the right to benefit from the risk of putting money on the line.

Ultimately, your third partner is testing what you are willing to pay for the business. You should ask yourself why it is so important to you to cash out. Could it be best for you to keep your hard-earned cash and invest it yourself? It may be easiest to back off and offer to keep things the way they are. That way – if your partner has become attached to the idea of cashing out – then he/she/they may come back to you with a new offer, putting you back in charge of the negotiation.

 

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