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S&T Test Prep Part 3: Making someone a Partner

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.

 

 

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