“How the hell did he come up with that number?” – quote from a new client reacting to his partner’s price to be bought out.
Almost every week, I get the chance to see a number of potential transactions among partners — mostly negotiating buying each other’s shares or debating what value to use in a buy-sell agreement. All different types of markets with the operative words being “fair value.” So I have been in the middle of this before and I have a solution that I have used, but it involves some education and “faith” by both parties if it is going to work. Let me explain.
Fair market value is used in a somewhat cavalier fashion in these type of deals but there is little focus on the key aspects of the definition of this term which is a value based on what a knowledgeable, willing and unpressured buyer would probably pay to a knowledgeable, willing and unpressured seller. Valuation experts use common tools to arrive at a number or range, but in the end, most importantly, you need a “willing buyer.” So what is the problem?
When you go to sell your business, the willing buyer may be a financial sponsor of some type (hedge fund, private equity, venture capital, etc.) or even your competitor or someone who wants to get into that market (often called a strategic buyer). Most of these willing buyers have another way to measure the results of their transaction. For example, I had a client sell a significant division of his company to a strategic for about 15 times earnings. This was a great deal for him, but the purchaser was public, selling at 25 times earnings; and my client’s ongoing $10 million in earnings increased the buyer’s market value by $250 million. Not bad. However, this does not translate into the private company market of “willing buyers.”
Using this example, if my client wanted to sell to his partner who wanted to continue to run this business for a long time and not sell, that partner would have to fork over all earnings (at current levels) for 15 years before he would see a plug nickel. What willing buyer is going to do that? Yet, it is a problem I confront quite often. So in this case, the “willing buyer” will only offer something a bit more reasonable from a pure cash-on-cash recovery basis – say 3 to 5 years. Many buy / sells I see have a price of 3 to 5 times EBITDA which gets you to the same place.
So I often suggest that the offer be based on projected cash flow for a 3 to 5 year period. I also suggest that a provision be added such that if the company is sold in say a 5 year period, there is some form of “claw back” – that the previous owners are paid in part as if they still owned some shares (all negotiated). The alternative is to wait for that outside purchaser to come along and prolong an important exit event. So while fair market value is a sacred term, please remember when in comes to partners, it is governed by the provisions of the “willing buyer.”