What Percentage of Business should I give to partner?

[EricG]

I am running a successful business that has grown over the last several years. I currently have 100% equity and ownership in this company (An "S" Corp). I have a customer who has been talking to me about a partnership. He offered to come in and learn all aspects of the business and then open a few more locations before deciding on franchising and getting really big. His goal would be to make the concept huge. He does NOT have expertise in my service industry but has all the intangibles of getting into this kind of stuff (background in Area Development Franchising, taking over several companies and making them profitable). He also seems to possess personality intangibles and business process skill sets and drive that compliment me perfectly. The question is what percentage should I give up? There would be a couple of scenarios I can think of:

1) What percentage would I keep if was only the founder/owner of the concept and wanted to be passive including my involvement, risk (no personal guarantees, liabilities, etc) and no money given on my end.

2) What percentage would I keep if I wanted to be involved and also be willing to sign liability but not give money (I/we would find outside financing for all money needed and I would not ask him to put up money out of his pocket).

Thanks in advance,
Eric

[lucas.bowser]

Well... The answer to that question is complicated and depends on a lot of factors.

In general, the answer to the question ends up being what is his involvement worth to the business, and will it increase the value of your reduced stake beyond what it is today? Here's an example in its simplest form:


Determine what your business is worth today. Let's assume its worth one million dollars.
Let's further assume that if you sold the business today you could get that million dollars and invest it at a 5% annual return.
Let's assume you are using a 7 year time frame for your equity analysis.
If so, then the value of that company to you at the end of seven years is 1 million dollars * 1.05^7 which is $1.4 million dollars.
Let's assume that the potential partner is requesting a 50% ownership stake. In order for it to be worth it to you, the total value of your business would need to be greater than $2.8 million after 7 years of time.


Now in reality, you really shouldn't just "give" the man an ownership stake from day one if he is not putting any of his own money in. So, if the business is valued at $1 million, then he would need to put up $500K to get his share of the business. If you really feel that he is necessary to grow your business, he doesn't want to put his own money in and he is demanding an ownership stake you need to have an earn-out schedule put together that says he earns his ownership as certain value milestones are reached. This schedule needs to spell out what the milestones are, what will measure if they have been achieved and what % ownership stake this is worth. It should contain what ownership stake he will start with and what the maximum stake he can achieve is. You need to do an evaluation of this plan and make sure that you have value preservation for your stake at a minimum every time he earns an additional % of the business. So, if he has earned a 10% stake at the end of seven years, your measuring stick should say that your business is worth $1.6 million (this maintains your 5% return over the 7 years from above). If he has earned 50%, your measuring stick should say that your business is worth $2.8 million.

Now this is just a general idea of what you are looking to do when you structure this deal. Ultimately, if there is significant value in this business as it stands today, you need to consult either a business broker or attorney that structures these types of deals on a regular basis. Otherwise you are setting yourself up for a bad result in the long run. Especially if the man is as experienced in these types of arrangements as you have conveyed above.

[SteveM]

One top of what Lucas said, I wouldn't give your new partner ANY percentage of your existing business.

Perhaps the best way to go would be to form a new corporate entity for the expansion/franchising businesses, and negotiate your ownership profiles for that entity. Spending $250 or so with a small business attorney might be worth it before you start throwing numbers around. Sounds like fun though...good luck!

[lucas.bowser]

One top of what Lucas said, I wouldn't give your new partner ANY percentage of your existing business.

That was kind of implicit in what I was saying. Tie ownership to a growth level that is beyond the value of your existing business. The arrangement being discussed here, is very typical arrangement in a private equity deal when you need certain skills to grow your business but don't have the wherewithal to pay for them outright. The biggest danger with this type of arrangement is often the over-valuing of what that person's contribution will be and the under-valuing of your current business. Reason: you can only give away your equity once.

In my original response, I probably should have said a business broker and an attorney instead of or. Attorneys, while qualified to give you legal advice about structuring the deal, are often very bad at valuing your current business. For that your really need an experienced business broker (or an investment banker.) They should be able to work up a reasonable value estimate for you that you can start your negotiations from, as well as what you would need to do to increase the value long term. Measuring business value is a little like measuring real estate value, an inexact science. There are three fundamental ways you can value a business: asset value, sales comp (for similar business) and discounted cash flow. These three can all yield wildly different values, so the trick is knowing which one is the correct one to select as your basis for negotiation.

You also need to understand exactly what value this guy brings to the table and how he is going to take you to the "promised land". It's one thing to understand the mechanics and contracts behind franchising. It's a whole different thing to understand how to construct a business so that it is franchisable. When you franchise, it's more than just giving your name to a location. People franchise because they want a turn-key business that has a high likelihood of succeeding as long as they follow the secret formula. This is actually the hardest part of building a franchise capable business.

So, if I were putting this deal together I would do the following:

1) You need to talk with a business attorney who is experienced in this type of arrangement. This should be a general discussion (1-2) hours where he lays out exactly what your negotiating parameters will need to be for an initial memorandum of understanding (the specifics that will be baked into the contract, but are pre-negotiated to help save extensive contract negotiations down the road) between you and the prospective partner. This will also give you a good idea if the pain of doing this will be too much for you.

2) Get a strong idea of what someone would pay for the business if you were selling it today. Business brokers are probably best suited for the job in this case.

3) You need to understand if your business is "franchisable" or not. Not all businesses are. In order for your business to be franchisable, you need to provide some type of service and/or support to the franchisee that they could not easily do on their own. This is usually more than just letting them use your name.

4) Have the guy write a business plan that details what he is going to do to expand your business, and have him present it to you like you were an investor. Included in this plan, he would have to outline what skill sets will be needed, how he will be filling them and what type of compensation they will be expecting to come on board. This guy may have experience in doing this work, but he will probably need to put a team together in order to make it happen. People he brings in may also want an equity stake. You need to understand what that will need to be as well, or what type of compensation it will take to avoid giving up equity.

5) Understand exactly how your businesses value will grow, especially as you move towards franchising. Your business broker should be able to give you guidance here, but make sure that he understands you are planning on franchising the business and your future plans for financing (debt to equity ratios will affect your valuation.) The cash flow, revenue and margin metrics you need to achieve to increase your business value may be very different from the retail business you have today.

6) Once you have an understanding of the first 5 (and there is a lot to do in those first five steps) you can then start to negotiate the framework you got from the lawyer in step one. The contract should provide you reasonable assurances of growth when compared to your original equity stake.

These deals tend to be complicated, but can be very worth it if you can tolerate the inherent risk associated with them and you have a clear understanding of how and when your value grows. Good luck.