The value standard in a partnership agreement is, as it suggests, the standard at which the partnership is valued. It is a critical component of a partnership agreement and one which should be serious considered before being memorialized in this legally binding contract. At some point, a partner may want to leave the partnership. In this case, the value standard will play a pivotal role in determining the equity the exiting partner has in the partnership. When an improper value standard is used, it discourages partners who want to leave from leaving which can lead to big problems in and of itself. So, before you put just any old standard in your partnership agreement, consider the big implications misvaluing your partnership could have on its longevity.
The Value Standard in a Partnership Agreement
You will often see partnership agreements that set the value standard of the partnership at its book value in order to determine how much a partner has paid for their equity in the business. Book value is the company’s tangible asset value minus the business’s liability times a partner’s equity interest. While you may see the book value as the default method for determining the value of a partner’s equity in a business, it is far from the ideal standard.
When you use the book value, you are only accounting for the value of the company’s tangible assets. Intangible assets, however, can create significant value in a business. Intangible assets include:
- Patents and other intellectual property,
- Trade names
- Customer relationships
When it comes down to it, many modern businesses do not have many tangible assets, but can still be successful at generating revenue and steady cash flow. When tangible assets make up only a portion of a business’s value, and even when it may make up a significant chunk of the business’s value, it makes important omissions from the value calculation. As a result, the value of a partner’s equity in the partnership can be greatly reduced.
When including the value standard in your partnership agreement, consider going beyond its book value. Consider the value of goodwill. Consider accounting for how much partners are being paid and the impact that could have on the company’s financial statements. The future cash flow of the business should also be considered in valuing the partner’s equity including the potential impact on the business’s future prospects after the partner leaves. Additionally, market data can be important in valuation of a business. Look to what other similar business operations and cash flow have sold for to get a better idea of what the partnership’s value really is on the open market.
Providing a sound value standard in a partnership agreement is important for a number of reasons. If a partner wants to leave a partnership, having a bad value standard could deter them from leaving. This could lead to resentment and a bad business relation. Such souring relationships can quickly eat away at what would otherwise be a successful business endeavor.
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Put a solid partnership agreement in place that promotes the best interests of your business and protects the partners involved. For all of your business agreement needs, you can trust the team at Kumar Law Firm. Contact us today.