So you are starting a new business and you and your partners are really excited about the endless possibilities that await you. The last thing you want to think about is the worst-case scenario — the failure of the business or a partnership gone wrong.
Failure to plan and lack of funding are both leading contributors to small business failure in the U.S. If you are planning to go into business with a partner, then it is critical that you set up a partnership agreement. This is easy to do, but often overlooked during the business planning process. Without an agreed-upon strategy on how you will handle certain unforeseen events, how will you know how your partners will react? If you have a disagreement, will they be willing to exit the business and sell you their shares? These are important questions to address in the early stages of planning your business. It is easiest to come to a consensus when all the partners have the same interest in mind—building a successful business.
Once the business begins to operate, the partners’ personal interests may vary considerably, so it is vital to negotiate all of the terms while you all have similar objectives. This could prevent major issues from arising further down the road, and it allows everyone to clearly understand and sign off on the “rules” moving forward. This important step is not only for start-ups. If you have an existing business that is a partnership without a partnership agreement, you need to get one in place as soon as you are done reading this!
Let’s say you own a small company with one partner and you are both employees with equal ownership of the company. For argument’s sake, let’s say you have been operating without a formal partnership agreement for a year and a half and the money is really starting to roll in. Suddenly, without prior notice, your partner has a life-changing event. This might include personal bankruptcy, divorce, or even worse, a sudden death. Do you know what effect this will have on your business? Who will own your partner’s shares? Do you have the right to buy those shares in any of these cases?
Without an agreement up front, these questions cannot be answered easily and you run the risk of having some unanticipated new partners. Imagine your partner getting a divorce and now having to deal with the ex-spouse as an equal partner. Think of a partnership agreement as a “prenuptial” agreement between you and your business partners. You don’t expect to have the partnership break up, but you just never know what could happen down the road.
So what does a partnership agreement look like? It can be as simple as stating the terms in which one partner would buy out the other, sometimes referred as a “Buy-Sell” agreement. It should clearly state what occurs in the event that one partner needs to exit the business for any number of reasons. The best way to generate a partnership agreement between you and your partners is to consult an attorney and have the agreement created with your specific requirements. If you would prefer to save a little money, there are other options available, from legal business software to standard legal forms available from your stationery store. Whichever method you choose, just make sure you have one in place. You can always go back and revise it, but without one, you might be working those 80-hour work weeks for nothing!
An important component of the partnership (or buy-sell agreement) is the valuation portion of the contract. If you need to execute the agreement, how are the shares going to be valued? This can quickly turn a simple agreement into a very complex document, and is something that needs to be considered carefully in the early stages. Not only does this need to be established during the early planning stages, but it should also be reviewed on an annual basis. The simplest form of valuation to use is a multiple of total revenue. For many small businesses, this is the best option to use when setting up your initial agreement. Not only is it easier to agree upon a fair calculation, but there is less room for subjective or questionable amounts to be produced.
For example; if at the end of the first year your business had gross sales of $500,000 and you agreed that you would use a multiple of two for valuation purposes, then the company has a stated value of $1 million. This may not have anything to do with the true market value of the business, but it should, as closely as possible, match your best estimate of the market value for your business. As the company grows and additional shareholders become involved, you may want to consider a different approach to the valuation within your agreement. As long as all partners agree, this can be changed at any time. If fundamental changes occur in your business, you can always update this valuation to reflect the current situation. This is especially important when experiencing fast growth or bringing on additional partners.
As your business becomes more complex, so may your valuation terms. You may prefer to create a formula that uses a multiple of earnings to value the business. The stock market is a prime example of this type of valuation, also referred to as “market value.” You will often see a reference to the PE (Price to Earnings) ratio when looking at the price for publicly-traded stocks. This is no different from creating your own PE ratio to value the business. You are simply stating the exact formula to use, since an open market for your shares does not exist within a privately-held company.
There is no right or wrong way to value the business in a partnership agreement. It just needs to be clear so it cannot be questioned, should you need to use it in the future. Ideally, it should include an easy-to-understand formula or calculation on which all the partners agree. As mentioned above, this can be as simple as a multiple of revenues, multiple of earnings, multiple of actual book value or net worth, or anything else that can have a value associated with it.
Many partnership agreements include a clause stating that when they need to value the shares of the business, a CPA will be retained to place a real market value on the business. Although this will most likely result in a true market value for the business at that point in time (since it considers market competition, minority shareholder discounts, and many other market factors), it is still subject to challenge. Depending upon the nature of the situation for enacting the agreement, this could also create an increase in professional fees paid out, particularly if one partner does not agree with the calculated valuation. Although this is a widely accepted way to value the business in a partnership agreement, it is not always the best option, particularly for smaller partnerships and businesses.
Determining the valuation for the business within a partnership agreement is meant to protect the business from an unexpected change in ownership. Since this is an internal document, it does not have any impact on the valuation of the business outside of the partnership, should you and your partners want to sell the business to a third party. The true value of any business is simply the amount someone is willing to pay for it.