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S&T Test Prep Case: Fundamental Partnership Economics

Sonja and Tarsha are friends who decide to go into business together at S&T Test Prep, LLP. They decide they will be 50/50 owners of the business, so their first order of business is to decide how much they will each put in to “buy” their ownership stake.

Technically, founding Partners can put in as much or as little as they want to establish their business and secure their ownership shares. At KA, our Partner buy-in has been permanently set at $1. Typically, though, the amount of the initial investment is based on some estimate of what it will cost to get the business up and running. For Sonja and Tarsha, startup costs includ:

  • Paperwork related to founding and registering the business with the state and county
  • Acquiring business insurance
  • Initial marketing, including setting up a website and distributing fliers
  • $3,000 per month rent for their office/tutoring space
  • $5,000 to fit out their office

All in, they calculated it would cost about $26,000 to operate the business for their first 6 months. To give themselves a little cushion, Sonja and Tarsha each kicked in $15,000 to create an initial “capitalization” of $30,000. Drawing off that pool of funds, they set up their office and starting serving clients.

So- now Sonja and Tarsha are each effectively $15,000 in the hole. How did they pay themselves to meet their monthly expenses and get their initial investment back?

In most Partnerships, Partners are not hired as 1099 subcontractors the way we are at Kenning. Instead, your annual pay is based on this equation: business profit  x percentage of the business owned.

So, let’s say that in their first 12 months, S&T Test Prep brings in $120,000 in revenue (i.e., fees from tutoring services). To calculate their profit, they have to subtract their expenses/costs from that number. We know it cost them $26,000 to get up and running for 6 months. $120,000 minus $26,000 leaves $94,000. We also know that they had to pay an addition $18,000 in rent for the last 6 months of the year. $94,000 minus $18,000 leaves $76,000. They also incurred an additional $4,000 in costs for materials, marketing, etc, leaving their profit for the first year at $72,000 ($120K revenue – $48,000 expenses = $72,000 profit).

Since they each owned 50 percent of the business, Sonja and Tarsha are each entitled to $36,000 for the year. This will end up being the distribution amount on the K-1 they receive.

But what if like most people Sinja and Tarsha can’t wait until the end of the year to get their money? How do they cover their monthly expenses? They do this by establishing what is called a “draw,” which is essentially a loan against the expected end of year distribution.

Sonja decides that she needs to get $1,500 a month to keep the lights on. Therefor, the business gives her a check for $1,500 every month. This is her draw. After 12 months, Sonja’s draw amounts to $18,000. This is less than the $36,000 distribution she is entitled to as a 50 percent owner of the business, so she is entitled to and additional $18,000 at the end of the year.

Tarsha has larger monthly needs, so she takes a $4,000 per month draw. At the end of 12 months, she has received $48,000. This is more than the $36,000 she is entitled to as a 50 percent Partner, so she owes the business $12,000, and she needs to figure out how to pay that back at the end of the year.

There is one additional factor to consider in year 1 of S&T Test Prep; Sonja and Tarsha each contributed $15,000 to the business to get it started. In essence, the business “owes” them that money, which was used to cover expenses.

Put another way, The business had $48,000 in money out expenses to pay for. It had $120,000 in money in revenue to pay for those expenses and provide profit for the Partners. But it also had $30,000 in seed capital, so the annual books actually show a total of $150,000 of available money. If the Partners don’t mind having no working capital to being year 2, they can actually split $150,000 (year 1 profit plus seed capital) minus $48,000 (year 1 total expenses), or $102,000. If they do distribute all the Partnership’s cash on hand, they would each be entitled to $51,000 for the year. Subtracting the total amount of their draw from this amount, Sonja would get a end-of-year pay out of $51,000 minus $18,000, or $33,000. Tarsha would get an end of year payout of $51,000 minus $48,000, or $3,000. If they paid themselves these amounts, they would have paid themselves pack their initial $15,000 investments plus an additional $36,000 and the books would balance. They would, however, have $0 working capital, which would mean that is an expense had to be covered early in year 2, they might have to put money back into the business (i.e., a “capital call”) to cover it.

At first, Sonja and Tarsha do all the tutoring themselves. Pretty quickly, because they are good at what they do, Sonja and Tarsha have more clients than they can serve on their own. They bring on some 1099 contractors to handle the extra clients, and initially this proves to be a good way to expand their customer base and revenue without taking on the expense of hiring a W-2 employee.

However, they fairly quickly realize that the contractor model has limitations. Turnover is quite high, and the quality of work delivered is uneven. They try to address these problems by devoting some of their time to training the contractors, but they don’t get much of a payoff for their investments because the turnover rate remains high.

Sonja and Tarsha decide they need to hire some w-2 employees to keep their business healthy and growing. Their first full-time employee is Prashanth. They offer Prashanth a 1-year contract that will cost them $60,000 when you add together his salary, employment taxes, workers comp, insurance, and all the other expenses that bringing him on will incur. To cover this cost, the owners each make a $15,000 dollar contribution to the business and they take out a $30,000 loan.

It takes almost 2 years for Prashanth to “break even,” meaning that the money he has brought into the business is sufficient for Sonja and Tarsha to repay themselves their $15,000 contribution and also pay off the loan along with all interest and servicing charges. Once Prashanth breaks even, the money he brings in each month is sufficient to cover all the costs associated with having him as an employee plus some left over that can be booked as profit.

A few years later, Prashanth is an invaluable part of the team, booking considerable revenue and also managing and training newer employees. Recognizing the gap between what he brings in and what he is paid, and also feeling like he has earned the right to be an owner, Prashanth asks to be made a Partner, and Sonja and Tarsha agree.

In practical terms, what this means is that Sonja and Tarsha will need to sell some of their equity shares to Prashanth. To do that, they must answer two questions. First, what should the distribution of equity be once Prashanth has been made a Partner. Second, what should the shares cost?

For a quick overview of some of the ways Partnerships determine what their equity shares are worth, select the Next Unit button below..

You can value a business using three commonly used approaches: the market, income and asset-based approaches. You must also make adjustments to reflect characteristics specific to partnerships with respect to liquidity and control. These are known as valuation discounts. You can find relevant information in a company’s Partnership Agreement, which should detail any restrictions on transfers of interests and corporate control issues such as voting rights. Once the value of the business is determined, the specific share value is determined by calculating the proportionate ownership interest. For example, if a business is valued at $100 and you need to calculate the value of a 10 percent partnership share, you would multiply 10 percent by $100 to arrive at a partnership share value of $10.

Market Approach

The market approach involves analyzing transactions involving guideline companies that are highly comparable to the subject business in terms of line of business, size and profitability. Transaction values are used to develop valuation multiples, which are then applied to the subject company’s financial metrics. For example, if a peer company with annual net income of $1 million is acquired at a deal price of $10 million, this implies a price to earnings ratio of 10.0 ($10 million transaction price divided by $1 million in net income). If your subject business has annual net income of $500 thousand, applying a price to earnings ratio of 10.0 results in an indicated value of $5 million (P/E ratio of 10.0 multiplied by $500 thousand).

Income Approach

The premise underlying the income approach is that it is more valuable to hold a dollar today than to receive it some time in the future, because it can be invested today in risk-free securities and earn a return. This is known as the time value of money, and implies that a business’s value is the present value of the sum of its expected future cash flows. The two basic inputs in the income approach are cash flow (or earnings) and risk. Risk is represented by the discount rate, which reflects the typical investor’s required rate of return on the business. It is the percent return that is required to entice an investor into investing in the company, given the various risks associated with the investment. For example, if common stocks historically earned returns of 12 percent, an investor in a particular common stock may use a discount rate of 12 percent to calculate expected returns going forward. These risks include market-related risks and company-specific risks. A higher discount rate is indicative of higher perceived risk. Using the income method, cash flow is capitalized, or converted into value. For example, if a company is expected to generate free cash flow of $100 per year in the future, using a 12 percent discount rate, cash flow is capitalized by dividing it by the capitalization rate. Therefore, cash flow is converted into value by dividing $100 by 12 percent, resulting in a value of $833.33 ($100/12 percent).

Asset Approach

The asset approach focuses on the balance sheet and is best applied to holding companies, or companies with assets with carrying values that already closely approximate market value, like an investment company that holds marketable securities. The approach calculates net asset value by subtracting the fair market value of the business’s liabilities from the fair market value of its assets. For an operating company, the net asset value can be viewed as a floor of value, because, at a minimum, the company is worth what it can obtain from liquidating its assets, after paying off its liabilities.

Partnership interests are generally illiquid and often restricted by the partnership agreement from being transferred. In some cases, a right of first refusal is in place, which states that if a partner wishes to sell his interest, the interest must first be offered to the partnership or other partners for sale at the desired transaction price. Also, limited partners are generally passive investors exercising little control over the business. Due to these factors, there are two types of valuation discounts typically applied to partnership interests:

  1. Discount for lack of marketability – Investors greatly value liquidity and discount the value of securities lacking liquidity. The discount for lack of marketability reflects the reduction in price required to entice a hypothetical investor into investing in the partnership given the factors surrounding its lack of liquidity. Partnerships can commonly be discounted between 20 percent and 35 percent due to illiquidity_._
  2. Discount for lack of control – Corporate control is valuable because it allows you to set dividend policy and influence the company’s operations. Just as investors pay a premium for control, they apply a discount for lack of control, which can be similar in magnitude as illiquidity discounts.

It’s now time for Sonja and Tarsha to make Prashanth a Partner. Let’s look at 3 different scenarios for how that might play out. But first, some basic financial data that will inform the transaction no matter which option they take.

Sonja and Tarsha decide to take a market-based approach to determining a value for ownership shares. They learn that when a business like theirs is acquired by an outside entity, the sales price typically runs between 1x and 1.5x annual sales (revenue). The companies that got the higher multiplier tended to have larger businesses ($5 Million annual revenue and up) and more assets, such as proprietary test prep materials. SInce they do not yet have that kind of scale or IP, Sonja and Tarsha decide to value their company at 1x their revenue for the previous year (in real life this would usually be an average over a few years, but we will call it most recent to simplify here).

For the year in question, S&T brought in $1,000,000 in revenue and paid $700,000 in expenses (which includes the money they paid to their W-2 employees and any 1099 contractors), leaving them a profit of $300,000. Since they both own 50 percent of the business, Sonja and Tarsha each earned $150,000 for the year.

That same year, S&J paid $60,000 to employ Prashanth. Prashanth’s salary was $40,000. The other $20,000 went to taxes, unemployment insurance, and other expenses Sonja and Tarsha incurred to employ Prashanth.

Option 1: Equal Partners with a one-time buy in

Prashanth says he wants to be an equal Partner, meaning that he, Sonja, and Tarsha will all own 33 percent of the business after his buy in. To make this happen, Sonja and Tarsha each agree to sell shares equaling 16.5 percent of the business to Prashanth.

They calculate the value of the company to be $1,000,000 x 1, or $1,000,000. At this value, each percentage share of the business is worth $10,000. That means Prashanth’s 33 percent ownership stake costs $330,000. Theoretically, Prashanth might have access to that amount of money and just pay it to the firm. Let’s say, though, as is commonly the case, he doesn’t have the cash on hand and therefore takes on a loan using his ownership shares as collateral (essentially a kind of mortgage). He pays in his $330,00, which Sonja and Tarsha split.

Let’s say the following year the business again generates $1,000,000 in sales. Let’s say all their expenses remain the same, except that this year they do not need to pay Prashanth, which saves them $60,000. That means their profit for the year will be $1,000,000, less $640,000 in expenses, leaving $360,000. The three equal partners get 33 percent of the profit, meaning they each make $120,000 for the year. For Sonja and Tarsha, this means that making Prashanth a Partner actually reduced their annual earnings, at least in the first year of the new Partnership. However, they each collected a one-time payment of $165,000 for the shares they sold. For Prashanth, becoming a Partner significantly increased his annual earnings, but he also has taken on significant debt to buy his shares, meaning that it will take a few years before he will break even and the money he gets from the business will be greater than the money he has put into it.

Option 2: Equal Partners with a buy in financed by the original Partners

Let’s say that the numbers for this option are the same as the numbers above. The difference here is that the original Partners want to make it easier for Prashanth to purchase shares by not making it necessary for him to make a one-time payment from existing assets or to get a loan. He still needs to pay $330,000 to buy his shares, but Sonja and Tarsha, through the business, loan it to him. This is essentially the same as buying a home from an owner who provides the financing- you get the house and the mortgage, and the owner collects on the mortgage instead of getting a one-time payout at closing.

Terms for this kind of financing could get quite complicated, but let’s say for simplicity sake that Sonja and Tarsha allow Prashanth to buy his shares over a 10-year period with no interest charges. That means that at the end of their first year, each of the Partners gets $120,000. However, $33,000 of Prashanth’s money has to go back to the firm, where it is split by the original Partners to compensate them for their shares. This means that Prashanth’s “take home” money for the year is $87,000, while Sonja and Tarsha get $137,500.

In other words, Prashanth’s annual income, even after his “loan” payment, goes up, while Sonja and Tarsha see their annual earnings go down slightly, and they do not get a one-time windfall. This dynamic makes providing a new Partner with generous loan terms unappealing to the original Partners unless they believe that making Prashanth a Partner will meaningfully increase the business’s annual profits or the value of their remaining equity shares.

Option 3: Unequal share distribution and hybrid employment for junior Partner

The larger an organization, the less likely it is that all Partners will own an equal share of the business.  It is also pretty unusual for a person who is making the jump from employee to Partner to get a full and equal share all at once. So let’s say that in our story making Prashanth a Partner means allowing him to buy a 10 percent equity stake rather than a full and equal 33 percent stake.

Sonja and Tarsha each sell Prashanth a 5 percent ownership stake. Since all the numbers are the same as above, that means that Prashanth’s buy in is 10 (percent) x  $10,000 (price per percent) or $100,000. Now let’s look at what happens financially in year one of the new Partnership, making the same assumptions as above.

S&T Test prep brings in $1,000,000 in revenue. Again, its expenses for the year are $640,000 ($7000,000 less the $60,000 that used to go for Prashant) leaving a profit of $360,000. Because Sonja and Tarsha each own 45 percent of the business, they are each entitled to 45 percent of the profits, or $162,000. This is actually more than they made the year before, and each also gets a one-time payment of $50,000 for the shares they sold Prashant.

Prashanth, as a 10 percent owner, is entitled to 10 percent of the profit, or $36,000. This is actually slightly less than his previous take home pay of $40,000, and he is also down the $100,000 he used to buy his shares. To soften the blow, Sonja and Tarsha agree to give Prashanth a W-2 employment contract in addition to his Partner stake. They pay him a W-2 wage of $20,000 per year, which costs the business a total of $30,000.

Here is how that change impacts the payouts. Expenses go up by $30,000, meaning annual profit goes down by $30,000. So now the Partners are splitting $330,000.

As 45 percent owners, Sonja and Tarsha each get $148,000. As a 10 percent owner, Prashanth gets $33,000 plus the $20,000 in W-2 earnings. So, while Prashanth has incurred a $100,000 debt, his annual earnings have actually gone up, and he now has an asset (his 10 percent ownership share) that will not only spin off K-1 earnings every year that will increase if the businesses profits increase but will also appreciate it value so that, hopefully, he gets significantly more than $100,000 back when he sells his shares to someone.

Some years later, S&J Test Prep has grown significantly, boasting annual revenues of $10,000,000 and 5 Partners. They have added IP, so that in addition to providing tutoring services they also do consulting with schools and sell a line of branded Test Prep materials. The have kept their margin at a healthy 30 percent, so annual profits now reach $3,000,000.

The founders, Sonja and Tarsha, remain “senior” Partners. Each retains 25 percent of the business. Prashanth now owns 20 percent (he was given the opportunity to buy more shares over the years, and did so), and two “junior” Partners own 15 percent each. At this point, none of the Partners retains a W-2 wage. So, in a year where the business has $3,000,000 in profits, the payouts are:

  • Sonja and Tarsha each make  $750,000
  • Prashanth makes $600,000
  • The two junior Partners make $450,000 each

Sonja decides is time to retire, so she wants to sell her ownership stake. Most Partnerships have restrictions on who you can sell your shares to, so Sonja can’t just sell her ownership to an investor who wants to collect the annual K-1 revenue and likes the chances that the business will become even more valuable over time (in some cases, she could, but let’s say that is not an option). Within the terms of the S&T Partnership agreement, when a Partner leaves, the other Partners have to buy that Partner out. That means the firm has to determine the fair market value of the business again.

When they do this, they decide that the business should be valued not at 1x annual revenue, but at 1.5x annual revenue. This is justifiable because the business is much larger, has a longer track record of success, and has assets beyond just tutoring sales (i.e., multi-year school consulting contracts and branded materials). So, at the moment Sonja decides to leave, the value of the business is $10,000,000 x 1.5, or $15,000,000. That makes Sonja’s 25 percent ownership stake worth $3,750,000. That means the firm has to pay Sonja $3,750,000 to buy her shares back.

Once the firm has bought the shares back, the remaining Partners get to decide what to do with them. They could allow existing Partners to buy some of those shares at $150,000 for each 1 percent of the business, or they could use the shares to let new Partners buy in to the business, or they could hold them as a firm asset that, if the firm continues to grow, will hopefully appreciate over time. That’s for them to decide. Sonja just collects her money and walks.

Some firms allow Partners to retain their ownership shares, or some portion of them, even after the Partner retires. Some firms allow shares to be transferable assets that can be sold or even inherited. Many, though, have policies like McKinsey’s, where Partners are expected to surrender their shares once they are no longer actively working within the business.

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