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Why Business Valuation Matters in a Partner Ownership

By Quiet Light
| Reading Time: 6 minutes

Accurate business valuations are a crucial aspect of partner ownership companies, particularly when it comes to partner buyouts. Without a proper valuation, partnership buyouts are more likely to devolve into disagreement, and potentially even litigation. As part of a thorough partner ownership agreement, business valuations can help maintain harmony between partners, helping you achieve a profitable and amicable exit together. 

In this article, we discuss:

  • Why business valuation is important in a partner ownership
  • How to value a business for a partnership
  • What happens if partners can’t agree on a valuation

Related Article: How Business Valuations Work and Why They’re Important

Business Valuation in a Partner Ownership

Why Business Valuation Is Crucial in a Partner Ownership

As a business owner, navigating a partner ownership can be challenging. Over the course of the relationship, plenty of opportunities for disagreement can arise. Fortunately, there are a number of things you can do to help keep the relationship, and your business, on track.

Partner buyouts

When you take part in a partner ownership enterprise, there is always a chance that one or more of the partners will want to sell their portion and leave the partnership before other partners are ready to move on from the business.

When this happens, it raises the question of how much the exiting partner’s portion of the business is worth. This, of course, depends on their share in the business as well as the overall value of the company. The question of how much the business is worth can be a natural sticking point between partners.

For example, let’s say the partner who is leaving thinks the business is worth $800,000, but the partner who is staying estimates it is closer to $500,000. That’s a fairly large discrepancy in estimated buyout value. When so much money is at stake, these disagreements can become serious.

“The question of how much the business is worth can be a natural sticking point between partners.”

One key aspect of partner buyouts is agreeing on a method for accurately calculating business value. It is important to settle on a valuation process ahead of time in order to avoid disagreements during a buyout.

In order to ensure there is no conflict of interest, it is important to seek out a truly independent business valuation. When you conduct your own valuation, it opens the door for disagreements, but an independent valuation from an outside expert will help to assure each partner that the final outcome is accurate and free from bias. 

Some partnerships go a step further by agreeing on getting a valuation somewhat regularly. For starters, this helps to improve business operations and performance. It also helps to establish a baseline value for the business. And if a partner decides to leave, all parties already have a rough idea of business value. This helps to calibrate expectations and avoid surprises.

Establish a thorough partnership agreement early on

Established procedures for calculating business value during a partner buyout should be clearly documented ahead of time as part of a thorough partnership agreement. This agreement should be created early on in the partnership in order to preempt potential future disagreements.

Partner Agreement Image

The partnership agreement should cover many other areas besides business valuation in the event of a partner buyout. That is beyond the scope of this article, however. What is clear is that establishing a method for calculating business value is a crucial component of any credible partnership agreement.

The agreement should spell out who will conduct the valuation. It should also cover situations when a valuation is necessary as well as the valuation method. It can also highlight a valuation schedule if preferred (e.g., an annual valuation, once every two years, or just when a partner wishes to leave).

The agreement should also contain clauses that highlight how disputes about company value will be handled in the event they arise.

“Established procedures for calculating business value during a partner buyout should be clearly documented ahead of time as part of a thorough partnership agreement.”

How to Value a Business for a Partnership

As mentioned, one of the key aspects of a thorough partnership agreement is settling on a method for calculating business value.

Business Valuation in a Partnership Agreement

Business valuation methods

There are a number of business valuation methods available. These include:

  • Fair market value
  • Market approach
  • Book value
  • Asset-based approach
  • Income approach
  • Discounted cash flow
  • SDE multiple method

When it comes to privately held online businesses, the SDE multiple method is the most commonly used method for valuing a business.

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SDE multiple method

According to the SDE multiple method, the value of a business is equal to SDE times a multiple. In other words:

Business value = SDE x the multiple

While this may seem straightforward on the surface, there is a lot involved with accurately calculating SDE and assigning a multiple value.

“When it comes to privately held online businesses, the SDE multiple method is the most commonly used method for valuing a business.”

Calculating SDE

SDE stands for seller’s discretionary earnings. It is the discretionary income that the business generates for the owner. While it is similar to normal income, it varies in a few key ways.

To calculate SDE, start with income and then add back certain discretionary expenses. These include taxes, interest, depreciation, owner’s salary, one-time investments, unrelated costs or income, and noncash expenses.

SDE does a better job of describing the true money-generating capacity of a business than income. While two companies can have similar income figures, their money-generating power will be more clearly revealed after taking into account discretionary expenses.

SDE Image

Knowing which expenses can be added back is not always a straightforward process, and getting SDE correct has a big impact on overall business value. In order to avoid disputes between partners about how to calculate SDE, it is important to enlist the help of a valuation analyst or other qualified professional.

Understanding the multiple

The multiple incorporates the company’s tangible and intangible assets into the valuation process. While two companies could have identical SDE figures, they could have dramatically different valuations depending on a range of other factors. These factors are captured in the multiple.

The multiple incorporates many individual aspects, but they can largely be grouped into four categories. Together, these are known as the Four Pillars of Value. They include:

  • Growth
  • Risk
  • Documentation
  • Transferability

Companies that exhibit strong past and current growth trends are more valuable than those that are stagnant or in decline. Risk, on the other hand, serves to lower the value of a business, all other things being equal.

Business Valuation in a Partnership Agreement

Clear and orderly documentation makes a business more attractive to prospective buyers. This, in turn, raises its value. Lastly, the easier it is to transfer business ownership without negatively impacting its performance, the more valuable it will be.

“Your partnership agreement should spell out dispute resolution mechanisms in the event of a dispute.”

What Happens if Partners Can’t Agree on a Valuation?

Ideally, your partnership agreement should cover exactly how business valuation will be handled, helping to avoid disagreements. If a disagreement does arise, there are several ways to handle it. Your partnership agreement should spell out dispute resolution mechanisms in the event of a dispute.

Preferably, you and your partner(s) should discuss the disagreement and negotiate an amicable solution. In these situations, it can be helpful to have a neutral third-party facilitator, such as a mediator, present.

If mediation fails, the disagreement may go to arbitration. In this instance, an arbitrator makes a judgment about how the dispute will be settled. For extreme cases, litigation is an option.

Given the costs of disagreement over business valuation, it is important to proactively take steps to avoid it in the first place. Fortunately, a well-drafted partnership agreement can set clear expectations around business valuation. This sets you up for a harmonious and productive partner ownership.

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