Answering Common Questions from Clients:
My Business Partner Wants Out. How Much Should I Pay Them?
By Alina Niculita, ASA, CFA, ARM-BV, MBA
Your partner’s ready to leave the business. You’re committed to staying. Now the question is on the table: How much is it fair to pay them for their share? Should you use a rough estimate of value, or hire a qualified business appraiser?
We help business owners determine a well-supported, defensible value when a partner exists, whether it’s amicable, court-ordered, or somewhere in between.
We assist with:
- Valuing the business using income, market, and asset approaches
- Applying relevant discounts for lack of control or marketability, when appropriate
- Navigating the implications of buy-sell agreements, operating agreements, or disputed terms
- Reviewing historical compensation, distributions, and capital accounts
- Providing an expert opinion and report to support settlement, mediation, or trial
Valuing the business
To value an interest in a business, whether it is a minority interest (less than 50%) or a controlling interest (more than 50%), we typically start with valuing the business as a whole. In business valuation, just like in real estate appraisal, we have three valuation approaches: 1) the income approach, 2) the market approach, and 3) the asset approach.
- Income approach determines value by answering the questions: how much cash flow will there be and how risky is the cash flow? The company’s estimated future cash flows are converted to value using an appropriate rate of return.
- Market approach determines value by looking at what other people paid for similar types of businesses. This is very similar to real estate appraisal where a house is valued by looking at what other people paid for similar houses.
- Asset approach determines value by figuring out what assets are worth and subtracting the liabilities, just like you would do to determine an individual’s net financial worth.
Once we have determined the value of the whole business, we are ready to apply relevant valuation discounts.
Applying relevant valuation discounts
The concept of valuation discounts comes as a surprise sometimes to business owners. First, there are several types of valuation discounts, broadly grouped into entity-level discounts and shareholder level discounts.[1]
Entity-level discounts
- Discount for key person
- Discount for built-in capital gains taxes
- Portfolio discount
- Discount for contingent liabilities
- Discount for lack of marketability
Shareholder level discounts
- Discount for lack of marketability
- Discount for lack of control
- Nonvoting versus voting stock
- Blockage
From the above list of shareholder level discounts, the most well-known are the discount for lack of marketability and the discount for lack of control. These discounts commonly apply to the valuation of a minority interest in a business under the fair market value standard. The underlying reason for the application of these discounts is because a minority interest has less control and less marketability in comparison to a controlling interest in a business. The theory behind the discounts under the fair market value standards is that a hypothetical willing buyer of a minority interest would recognize these value detriments and require a discount to buy the interest, and similarly a hypothetical seller of a minority interest would grant the discounts.
Owners of minority interests in businesses need to be aware that the fair market value standard of value typically assumes discounts for lack of control and lack of marketability, and they can be sizeable, averaging 30%-40% or more on a combined basis. Valuation discounts vary and they need to be estimated on a case-by-case basis.
If on the other hand the standard of value is fair value, which is a standard of value that applies in dissenting shareholder or oppressed shareholder actions, the discount for lack of control typically does not apply, while the discount for lack of marketability may or may not apply, based on the case law in the jurisdiction where the case is being tried. Valuation analysts need to seek guidance from the attorney client and be familiar with the case law in the specific jurisdiction regarding the application of discounts.
Reviewing corporate governance documents
As part of our valuation process and consideration of valuation discounts, we also factor in the implications of buy-sell agreements and operating agreements.
Buy-sell agreements may include a formula for the valuation of the business in the case of the buyout of a partner’s interest and/or guidance regarding a valuation process for the valuation of the partner’s interest, including factors such as the standard of value to be considered and the applicability of discounts. Sometimes, whether the buy-sell agreement is determinative of value in certain circumstances is a disputed issue and may again be based on the case law in the respective jurisdiction. In this case, the appraiser needs to seek guidance from the attorney client.
Operating agreements include important information regarding the marketability and control of the partner’s interest subject to the valuation.
Considering other key information
We also review other information that is important in the valuation of a partner’s interest such as historical compensation, distributions, and capital accounts. In a business valuation it is important to review owners’ compensation and make sure that it reflects market compensation.
The relevant question to ask is: what would be an appropriate market level of compensation for owner(s), assuming the business hired qualified management to perform the owner’s work functions from the open marketplace? If the owner’s compensation differs greatly from a market level, for valuation purposes, the compensation of owners must often be adjusted, up or down, to industry guidelines. That adjustment will in turn impact the value of the business and the partner’s interest subject to valuation.
Providing a valuation report
The conclusions of our work are presented in a format that matches the needs of the client. We can prepare appraisals reports, calculation reports, short letters, presentation slides, or even present our conclusions in the form of an oral report. Regardless of the format, we strive to provide superior reports that are:
- Well supported
- Transparent
- Well written
- Well organized
- Free from mathematical and grammatical errors
Bottom line
When a business partner wants to exit, determining a fair payout requires a thorough, defensible valuation of their ownership interest. This involves valuing the entire business using income, market, and asset approaches, and then considering relevant discounts (such as lack of control or marketability) based on the ownership structure and legal standards.
Key factors include buy-sell agreements, corporate documents, historical compensation, and distributions. A clear, defensible written opinion is also often needed to support the work.
Whether you’re aiming for fairness or facing a legal dispute, our goal at Morones Analytics is to provide clarity, transparency, and confidence as you move forward — without overpaying or underestimating your exposure.
[1] Shannon Pratt’s Valuing a Business, 6th edition.
Want more on this topic? See our previous articles:
Answers to Top 3 Questions on Business Valuation Approaches
Answers to Attorney FAQs on Preferred Business Valuation Methods.
————————————————–
Alina Niculita, ASA, CFA, ARM-BV, MBA is a valuation and testifying expert who has specialized in business appraisal and appraisal review for litigation cases and business transactions for two decades. She has appraised hundreds of companies in diverse industries and sizes up to several billion dollars in revenue and testified in support of her opinions.
503-906-1585 | [email protected]
