Behold, the Pain of a Breakup
Business breakups can be just as messy and dramatic as romantic splits. Taylor Swift, the queen of breakup songs, mines her soured business relationships for material just as readily as she does her long list of ex-lovers.
In this case, “breakup” means the end of a business partnership where at least one partner wants to be bought out.
A common (but avoidable!) breakup complication is how to value the stake of a departing owner. If the partners do not have a clear, and mutually agreeable plan for how to value the company, then determining a partner’s buyout price will be both a protracted negotiation and a profitable opportunity for the lawyers involved (yes, there will definitely be lawyers involved!).
How ambiguous valuation policies lead to bad blood
Imagine the following scenario. A family has owned a local sports bar for decades. Mom and Dad don’t want to grow the business but do enjoy the reliable cash flow and ample time at the country club. Their daughter, however, has ambition. She wants to cash out her 20% ownership so she can start and control her own new venture. Mom and Dad are not ready to sell the entire restaurant, so they agree to buy out their daughter’s stake.
How much is the daughter’s 20% worth? There are three viable options to find an answer, but if the family does not agree on which to choose, they are at risk of a painful (and expensive!) breakup.
Option 1: valuation from the perspective of a financial buyer
This option assumes that a financial buyer plans to run a business the same way as the current ownership, using the same assets. This hypothetical buyer values the business based on historical cash flow and current industry multiples.
This valuation approach may make sense to Mom and Dad, but daughter may resist this method because she knows it will value the business at less than its real potential. She knows Mom and Dad have not invested in the business in years; and that a fully-engaged operator could take it to a new level. She doesn’t want a discounted valuation just because her parents are checked out.
Option 2: valuation from the perspective of a minority owner
Investors require discounts to buy a minority position in a company to reflect the fact that they can’t compel the controlling owners to maximize the company’s potential or pay maximum cash flow distributions. They will look at how much cash their stake produces annually and how much they expect it to gain in value over time. But they may pay 25-45% less than a financial buyer to account for their lack of operational control. Less control means more risk.
This valuation method should be the daughter’s least favorite. But Mom and Dad can plausibly argue that this type of buyer is their daughter’s only real alternative to their buyout offer, therefore this perspective should determine the valuation.
Option 3: valuation from the perspective of a strategic buyer
Strategic buyers pay more for a business because they can increase its value through special marketing capabilities, better access to capital, and/or synergies with their existing business.
If a local sports legend recently started a restaurant group and is paying extra to buy up other established sports bars in the area, the daughter should push to value the business like a strategic buyer would. She can argue that there’s a viable opportunity to sell the business at a premium, and she doesn’t want to miss out on that payday just because her parents are not ready to sell.
As you can see, there are many sides to this coin, and if the daughter and parents can’t agree on a method, a protracted and potentially relationship-damaging negotiation could follow.
Don’t leave a blank space on your operating agreement
The good news is that there are steps you can take to make a business breakup less tortuous than the scenario outlined above! It all comes down to practicing good valuation hygiene.
Good valuation hygiene means defining in your operating agreement how you will value the business in case of a breakup. Often, partners leave this part of the agreement vague and promise to figure it out when the event happens because they do not know how a venture will go. While partners recognize ambiguity leaves them more options, they frequently ignore the added risks of bitterness and legal fees, as demonstrated in our example above.
Great valuation hygiene means regularly valuing your company every two years or so. A qualified valuation professional will lay out a framework for what your company is worth, which forces partners to confront how the business is performing and the ownership team’s goals for the future. A regular cadence of valuation updates can be accomplished at a modest fee level, and most importantly will protect ownership team relationships and ensure the business carries the right level of insurance in the event of an owner’s death.
Waiting until a breakup to launch a valuation process could result in upwards of $100K in valuation costs, plus legal fees. Taylor Swift reportedly spent $1 million to produce the “Bad Blood” video. While most people wouldn’t go that far, the potential cost of a damaged relationship shouldn’t be underestimated.
Afraid of a bad breakup? Want to avoid the pain? Let’s talk.
Liza Bowersox
Founder and Managing Director (804) 482-0689
