In public companies, where the shares in the company are traded on a stock exchange, the price of the shares reflects a consensus value determined by the interest level of all parties aware of the stock. If there are many shares trading hands on a frequent basis and the company is publishing its progress and successes through the press and the public is paying attention and the company is generating earnings, the price of the shares is a multiple of these earnings (say a multiple of ten times earnings). The public believes that the stream of earnings from the operations of the company will likely increase through time and they collectively reward the company with a high future value that it trades on.
In private companies, there are many difficulties. First the shares are not as liquid: someone who buys shares cannot easily sell them. Private companies pay back the investors only through dividend income or when the company goes public itself or is bought by another company in the space. With a growing company that is constantly cash-hungry, income that could go to dividends has to go back into growing the company. The other exit strategies of going public or merging with or selling to another company is a risky and difficult proposition.
In the case of a founding entrepreneur bringing on another partner, these issues are less of a consideration. Someone who is considering entering a business as a partner is there to contribute their talents and skills to the growth of the business and share ownership is a way to acknowledge this investment and compensate a partner from drawing less than their market value out of the business while it grows.
There is a natural conflict that exists between the founding partner(s) and the new partner(s). The founders have invested their time (sweat equity), cash and other assets to get the venture to its current level of success. The rationale of bringing on a new partner is this: the business will be more successful and will be worth more through the combined efforts of the original and new partners.
Private companies are typically bought and sold using a number of valuation methods:
1. multiple (1 to 4 times) of cashflow or EBITDA (earnings before interest, taxes, depreciation and amortization)
2. multiple of sales (50% to 150% of trailing revenue, as a moving average for 1 to 5 years of history)
3. the book values of hard assets (goodwill, intellectual property, machinery and realestate)
4. discounted value of future cashflow (the sum of 1 to 5 years of estimated EBITDA discounted for risk and uncertainty)
When a private company has not yet broken out and realized the escalating value that the original partners believed it had, sales and earnings may be low or negative (particularly if the founders are taking draws or salaries that are lower than the market rates for the roles that they are performing). Many service-based companies have no assets or goodwill or intellectual property that is unproven. Looking forward into the future, there are many risks and factors that positively and negatively affect sales and EBITDA. These factors make the value of the company ambiguous and easily contested.
The original founders tend to over-value the company based on the immense sacrifices and investments of time, energy and money they have made to get the business to its current state.
New partners tend to under-value the company based on the future value of their contributions and the amount of financial value that has not and might not materialize. Additionally the value of future cashflow is based in part to the assumption that they will succeed in contributing to the company: the company is less likely to become financially valuable if they do not join the partnership. If this was not true, they would not be good partner candidates in the first place.
Other factors to consider are the salaries of the new partners, how much of a discount these salaries are from market rates for their roles and any human, intellectual and financial capital they might bring.
The way ultimately to frame these negotiations is to arrive at a deal that is fair and that everyone can live with, remembering that great partnerships have great synergy and that a team of people can create much greater value together than apart.
