Buying into partnership

[boutros]

I work at a small but fast growing company. We are organized as a Sub S Corp. We are owned by several of the employees at the firm and they regularly invite other professionals at the firm to be shareholders. I was hoping to be invited to be a shareholder within 3 years. I have no experience valuing private companies. How do private companies value themselves when offering partnerships or shares for employees? How do employees typically finance these purchase? It may be seen as presumptuous to ask my boss so I wanted to ask here as I know there are a few attorneys and doctors around who may have dealt with something similar.

Here are some basic facts. Our company has revenues of 4.5mm and profits of 1.5mm. I would guess that our growth rate will be ~15-20% for the next 7 years and then slow to ~10-12% for another 7 years. Then a terminal 7%. I would guess that a new shareholder would be offered 5% of company which in my back of the envelope calculation should cost 600-750k (5x earnings or 2x revenues). Few people have this kind of money lying around so I imagine it must be borrowed or purchased over time.

Soft benefits would be added job security, additional vacation time. I plan on working for 17 more years so I imagine this would pay off.

Thank you for any help

 

[Milton]

Typically, the cash contributions of new partners / employee-shareholders are financed by reductions from their future draws / dividends.

Sometimes a new partner / shareholder may be asked to pay part of the cash contribution up front, and in that case you will need to get a loan (assuming that you don't have private assets that you could sell to raise the money). The business can probably help you to secure financing on reasonable terms.

If you are asked to fund 100% of your new equity interest in cash, that might be a danger sign that the business is not as financially secure as it should be.

There are professional business evaluators available who could help you to confirm your rough calculations. Of course they would charge a fee for their time, but if you are considering a $600,000 or greater investment, it might be money well spent.

One final thought: the added job security might be largely illusory. Being a shareholder is nice, but if you only have 5% of the equity you have very limited say in what goes on. The other shareholders will certainly have the right to ask you to leave if in their judgment you're no longer a productive part of the team.

 

[justin]

Hey - I work in a similar sized professional services firm (S corp) with similar revenues and profit and similar historical growth. We are valued at closer to 3-3.5x earnings. We have a business evaluator put a price tag on company stock every year (we pay him). When you buy, you are forced to sign a buy/sell agreement that governs what you pay for stock, how you can dispose of stock (in event of death, termination, sale, etc), and sales price of stock, among other things. My understanding is that buy/sell agreements are the rule for closely held corps like mine/yours.

Keep portfolio allocation and diversification of risk in mind. If $600,000 would represent a significant chunk of your assets, do you really want your future income stream (your paycheck) coming from the same source as your hopeful investment returns on that $600,000. If the corp goes south, you lose your job and you lose a big chunk of change, too. I've opted not to invest additional funds in the corp I work for due to this consideration.

Look into this a little closer: For our S corp, we were offered to buy in, however they warned us that if we own more than 2%, our health insurance becomes taxable compensation.

edited to add: Our pres/VP have a relationship with the bank where we hold our accounts, and they are willing to loan funds to share purchasers at fairly reasonable interest rates (was 8-9% a couple years ago - maybe prime plus a percent or two). The thought is that the company stock goes up 20-30% a year while you are only paying 8-10% in interest. Basic leverage. Not sure how these personal loans are securitized, if at all (maybe by a security agreement on the shares purchased?).

 

[boutros]

Thank you for your help. 3-3.5 x earnings sounds really good. At that rate if things remain stable 4 years and the investment could be paid off with interest.

Point well taken regarding job security.

It would be a bit of a diversification problem. The partnership would represent 40% of my gross assets and 60% of my invested assets. But it is expected that I would want to be a partner. It would be a career and salary limiting move to turn the offer down. If I went to another company with a similar job I would eventually face the same conundrum.

 

[chrisdut]

I became a partner at a sub S corp seven years ago. There are a multitude of ways to value a private business. Our value is determined as the book value plus a factor times the average profit over the past several years. We require new shareholders to pay their portion of the book value up front (our book value generally ranges between 15 and 25 percent of the company value). The remainder of the purchase is essentially financed through a payroll deduction over a period of years. Although you seem to be reluctant to talk to your boss, I would encourage you to approach him (or her) in a friendly manner, and request a meeting to discuss the matter further. Since today was National Boss's Day, you could offer to have a lunch meeting and pick up the tab .

For what it is worth, our company has similar revenues, profits (maybe slightly less profit ), and growth rates as your company. Becoming a partner was the best financial decision I have ever made. In my seven years as a partner, my equity has grown from next to nothing (my book value buy in of about $30,000) to roughly $400,000.

The points made by Milton and Justin are good ones, so I will not repeat them, but one other important item to consider is your relationship with the existing shareholders. I have a great deal of respect and trust with the shareholders of our company, but a friend of mine became a shareholder at a competing firm where this is not the case. The culture at that firm is vastly different than ours and things did not work out for him. The majority owner at that firm had a reputation for stepping on toes to elevate himself and my friend knew this before becoming a minority partner. Needless to say he would have an entirely different opinion than mine whether becoming a partner is a good idea.

I am curious...what type of work do you do (Justin and I are both civil engineers)?

 

[Martha]

Companies are all over the board on how they determine a buy in amount, you are not going to be able to guess. To add to what Justin and Milton said, there usually is a shareholder agreement with buy/sell provisions and usually a separate employment agreement.

If you are uncomfortable talking to your boss about it, is there someone else you could ask? I remember way back when I was an associate, through the gossip mill we managed to know the details of how the buy in worked.

 

[brewer12345]

Just a general question, really, as I have no particular insight to add:

If you do buy in, you are essentialy married to the firm, no?

 

[retire@40]

Four more things to add:

1. Know your exit strategy.

2. Make sure the company pays out enough distributions to cover your taxes on your K-1 income from the S-corp. It doesn't hurt to review the company policy regarding taking Sec 179 deductions since they are allocated to you on your K-1 form. Don't forget that you will not be able to prepare your personal tax return until you get your K-1 form from the company. If the company elects to go on extension, you may not see it until September in some cases.

3. Review all the notes in your company financial statements making sure that they are at the very least "reviewed" financial statements prepared by an outside CPA firm and not just in-house "compiled" statements with no notes.

4. Estimate your rate of return. Ask yourself if the rate of return is justified by the risk of investing.

 

[Buckeye]

My question is do you trust the folks in charge and do you have a strong and independent board to keep an eye on things? I went through one of these situations run by a genius who was basically a crook (the company's money was his money). We did not have a strong board who could see through the lies and when I tried to speak up he had already poisoned the board against me and anyone else who spoke the truth. Lots of money lost on a great product.

 

[Nords]

If you do buy in, you are essentialy married to the firm, no?

I've never had a "real" job, so let me make sure I summarize this correctly:

If you bust your butt working for a company and sacrifice hundreds of hours of family time over years of effort, your "reward" is being given a chance to spend the majority of your net worth (or, better yet, take on a huge debt) to buy a highly illiquid and speculative security over which you have little control, inadequate pricing information, and highly unreliable cash flows.

Couldn't you just get an extra $10K-$20K bonus and buy a nice low-cost equity index fund?

1. Know your exit strategy.

Boy, I'll say. Unfortunately it sounds a lot like what a coyote does to get out of a leg trap...

 

[Gumby]

..

 

[Ronstar]

I became a partner in a sub-s 15 years ago. I financed my purchase through the 2 selling shareholders (who kept 35% of the stock each when they sold 15% each to me and another guy). I had an attorney review everything. The company had an evaluation done by an outside source, and the sale price was considerably less than the evaluation. I think I paid about 0.5*revenues. We now have 10 partners. The new partners are paying roughly 0.5* revenues. They are financing through their individual banks. I also have a buy/sell agreement, employment contract, and my health insurance premiums are taxable income as described by others.

The good thing about this is that my ROI is twice the the company profit margin since I bought at 0.5* revenues. Its not uncommon for my share of the annual profits to be twice my salary. My original 75k investment is now valued at 440k after I have sold off 25% of my holdings.

The bad things:

1. Sometimes the company may not disburse as much funds as what is indicated on your k-1. This means you will be personally paying tax on money you didnt get. I'm lucky that my senior partners are retiring and they are getting the profits out to the shareholders as much as possible.

2. Being a minority partner does not give you much control of the company (unless you are on the board of directors) and therefore little control of your investment. Significant management and other changes can be made and there's not much you can do about it. In fact, the board of directors could increase salaries or grant bonuses as they wish effectively resulting in no profit.

3. Partnerships are generally tied to employment contracts that have non-compete clauses and other terms that are more beneficial to the company than the employee. (The employment contract and projected disbursements of profits are employer's means for holding on to key people)

4. A minority share in a private company may not be easy to sell. The best source of buyers are the current shareholders and their personal situations may not be conducive to buying more stock. The seller has to put the plan together and make it happen.

All in all, I'm glad I did it.

 

[boutros]

If you bust your butt working for a company and sacrifice hundreds of hours of family time over years of effort, your "reward" is being given a chance to spend the majority of your net worth (or, better yet, take on a huge debt) to buy a highly illiquid and speculative security over which you have little control, inadequate pricing information, and highly unreliable cash flows.

Just a general question, really, as I have no particular insight to add:

If you do buy in, you are essentially married to the firm, no?

That about sums it up.

I am curious...what type of work do you do (Justin and I are both civil engineers)?

I am a Portfolio Manager. Somewhat similar to Saluki from what I gather, if he still hangs around here.

It sounds like most people were happy with the decision to become a partner. I guess if it didn't work out they would be too far off of FIRE to come to these boards so I am sure it is a somewhat skewed sample. An engineering firm or lawyers office would seem more stable than my firm because one one client's experience is not necessarily correlated to the next. While I put my clients in similar investments, especially in equities. So if one does poorly they all do poorly. And they all might head to the door at once.

 

[justin]

My firm's revenue sources are non-diversified. We are geographically concentrated in a few states and focused primarily on clients in a single industry or two. If the economy slows, we'll get hit pretty hard. It seems to be a feast-famine thing here, where no clients have work for us, or all the clients need all of their work done ASAP.

 

[boutros]

My firm's revenue sources are non-diversified. We are geographically concentrated in a few states and focused primarily on clients in a single industry or two. If the economy slows, we'll get hit pretty hard. It seems to be a feast-famine thing here, where no clients have work for us, or all the clients need all of their work done ASAP.

Makes since. My father is a Civil Engineer but just recently started working in the private sector. How much business is available to bid for seems to depend on who is in office at the statehouse.

 

[kcowan]

A lot can change in 17 years. In addition to the very good advice offered here, I would emphasize the need to have a documented exit plan for both voluntary and involuntary departures. What about a partial liquidation in the event that you have unforeseen expenses?

Try to get an income stream from the investment that will cover a loan payment. Then you have not "put all your eggs in the company basket". Your savings can be allocated to a diversified portfolio.

 

[Milton]

Being a minority partner does not give you much control of the company (unless you are on the board of directors) and therefore little control of your investment. Significant management and other changes can be made and there's not much you can do about it.

This is so true. For example, as Buckeye notes you can have one or more founding partners who see the firm as their private fiefdom to run as they please. Say for example they decide to splurge on fancy offices with expensive artwork, etc., or to sponsor some obscure sporting event near and dear to their hearts. From their point of view, they have a much bigger investment in the firm, so they are entitled to run things without your objections ... but it's still (partially) your money they're [-]wasting[/-] investing.

Gumby and Nords are quite correct: the rewards of partnership are far from clear-cut, and it may be that boutros may be better off remaining an employee and investing his money (leveraged or non-leveraged, as he sees fit) in a more diversified manner. On the other hand, I can certainly sympathize with boutros' retort that "It is expected that I would want to be a partner. It would be a career and salary limiting move to turn the offer down."

 

[saluki9]

I am a Portfolio Manager. Somewhat similar to Saluki from what I gather, if he still hangs around here.

Boutros

I'm still here and I've recently gone through just what you did.

My buy in wasn't as big as yours but it's a big commitment to make. It certainly hurts a little at the end of the year when you're used to getting a nice check and instead you trade that for a journal entry

That being said, I know this business pretty well, and there is no other investment I could make that would have this high a probability of an above market return. Let me know if there is anything else I can share that would help.

BTW: In this business (and most others I assume) turning down an offer of partnership is the same as saying that you're going to clean out your desk.

 

[pinkmali]

Re- taxable health insurance to more than 2% shareholder. The health insurance is reported as income, but further down the list on page 1 of the tax return is a deduction for self employed health insurance so the end result is zero.

 

[ZMAN]

My last law firm, which we put out of its misery through a merger in 2001, had a shareholder agreement (it was a PC) skewed heavily towards the older lawyers. The firm had been around for 100 years, but the older lawyers had taken control in the 70's and 80's when the firm grew and wrote an agreement, as you would expect, heavily in their favor.

When turmoil struck, they got out early through a financial re-casting with their capital and the "younger" lawyers (already in their late 40's and 50's at that point) lost all of theirs, which had been paid in over time from post tax payroll deductions. Founders got hundreds of thousands and those in the same boat as me lost from $50,000 to $70,000 each. Some lost $15,000 in capital put in the year before the ship went down.

New firm has a milder pay in formula so that I now have only $20,000 at risk.

I think you need to see it as the cost of keeping the job and not as a traditional investment. My thought was that I had phantom income to buy the capital. Still it was a sting to lose it.

Be very careful as you will indeed be married to these partners and likely will not be on top.

 

[Milton]

I think you need to see it as the cost of keeping the job and not as a traditional investment. My thought was that I had phantom income to buy the capital.

Well said, ZMAN.