Business Valuation: Partner Buy Out

When you enter into a business with a partner, it often makes sense to include a buyout clause in the partnership agreement (for a partnership)/operating agreement (for an LLC)/shareholder agreement (for a corporation)/joint venture agreement in the event that one of the partners is interested in selling (or buying) its interests.  Any buyout clause should include not only the mechanisms for exercising the buyout, but the methodology for setting a value for the business.  Sometimes the business partners feel it is too early to agree on a valuation method when starting a business or are concerned that defining the method at early on will lock them in if they try to raise capital or sell the business in the future.  On the other hand, if the partners choose not to include a buyout clause, they may find themselves arguing over the valuation if there is an opportunity to buyout all or some of the partners.

In the context of a buyout, whether your governing document has a buyout clause or not, at some point  valuation of the company itself becomes the issue.  The method of valuation of the business is the heart of the matter, and there are differing methods that can be used (Asset-based Methods, Income Capitalization, Discounted Projected Future Earnings, Sales Multiples, Earnings Multiples and others).  If the valuation method is not be defined ahead of time in a buyout clause, then  the parties will need to agree on a method at the time of the buyout (which can lead to time-consuming negotations or even a deadlock).  

The buyout clause (if one exists), or a future buyout agreement, can include the obligation to retain an accounting firm, investment bank, or a professional who is experienced in valuing similar business, to conduct the valuation. The partners should decide in advance how much they are willing to spend on the valuation/appraisal, how the costs will be shared and whether the determination be accepted as final.

The key to avoiding buyout disputes is to address the valuation issue in the Operating Agreement, Shareholder Agreeement, Partnership or Joint Venture Agreement rather than negotiating it when a buyout opportunity arises.  However, if the partners have decided not to define the valuation method ahead of time, they should at least agree on the retention of an independent third party to make the determination.