Partners in a partnership derive value from their investment through direct distribution of profits, retention of profits and increases in the partnership’s value. Retained profits increase a partnership’s value through the company’s reinvestment of those earnings into expansion projects. When one, several or all the partners decide to exit a partnership, the partners must calculate a fair value of that partnership.
Because a partnership involves two or more people, the likelihood that both or all the partners will agree on the value of the partnership depends on the circumstances of the buyout, the roles of the partners involved and their communication levels. To ensure that everyone agrees on a buyout price for the partnership, the partnership can hire an external valuation firm to do a formal, written valuation. If it's done by a valuation firm and not an asset-based appraiser, this written valuation typically incorporates several valuation methods, selects the best method for the business type and situation and provides a full explanation for doing so. Therefore, valuation firms generally successfully defend court challenges to their formal written valuations.
A newly formed partnership or a partnership that retained much of its profits in cash or recently acquired high quality assets can use its book value as the value of the business. Alternatively, the partnership can hire an external appraiser to conduct an asset-based valuation of the partnership. The appraiser will determine the current market value of all the assets the partnership owns, including accounts receivable, inventory, equipment, computers, furniture, buildings and leasehold improvements. Partners unconcerned about legal challenges can do these assessments by talking to suppliers, vendors and brokers.
Partners who choose not to use an external valuation firm can determine the partnership’s value by using industry-specific finance multiples. Partners can review business sale announcements in trade journals and use the multiples that those companies sold for to assess their partnership’s value. For example, three private companies in one industry sold at three times the prior year’s sales. The partnership would multiply its last year’s revenue by three. If, in another industry, private companies sold at four times EBITDA -- earnings before interest, taxes, depreciation and amortization – the partnership would multiply its EBITDA by four.
Partnerships allocate distributions and buyout percentages according to the capital account, which tracks changes in ownership percentage that occur as a result of partner contributions and withdrawals. Instead of defining the ownership percentage by the amounts indicated by the capital account, some partnerships allocate profits, losses and liabilities based on terms in the partnership agreement or another document. Whichever indicator of ownership percentage the partnership uses determines the buyout distribution to each applicable partner.