Exiting of a Partnership Question; Book Value or Market Value?

Question

Say there are some partners in an investment and all partners are involved equally, there's no preferred shares, waterfalls,  etc.   Each partner has a percentage interest according to how much money they have put in and all partners are sharing in both any potential upside or downside.

And then say a few years down the road a partner wants out of the partnership and another partner has the option to buy that partner out.  Should that buyout price be set at Book Value or Market Value?

What's most fair here?  If a market has gone crazy and appreciated a ton then that seems to be unfair to the partners who want to stay in to have to pay an inflated price for the exiting partner's shares.  And then there's the other side of the coin if a market as really gone down, how to deal with that?

I feel like there needs to be a balance between not making to easy/ attractive to just sell out, yet keeping it fair for the exiting partner if that happens to come up.  Anyone have any thoughts about this?

Basit Siddiqi · Answer

@Nicholas LohrIt should be communicated what the end game of the LLC will be.It is normally not feasible for everyone in the LLC to expect to hold their interest until they die. With that said - you may be able to avoid/mitigate some of the burden on your end.You can mention that buyouts/redemption can only occur at the end of every 3 years(you can pick any number here).

You should also mention that the partner wanted to get out of the LLC has to pay for the appraisal.The appraisal can be used to determine how much his LLC interest is worth.

Michael Plaks · Answer

@Nicholas Lohr

Whether the specific method used by @Daniel Dietz works for you or not, the important key in his story is that the buyout scenario was spelled out in the operating agreement, in advance.

If it was not, then there would be some unavoidable friction at the buyout time. There's no "fair to everyone" solution. Have to compromise or go into mediation.

Daniel Dietz · Answer

@Nicholas Lohr, we (two partners and I) have 26 doors that are held in several different entities because some we own in our SDIRAs, some traditionally etc.....

"The multiplier", meaning the 100 times I mentioned (which is often referred to as the 1% Rule) vary by which property we are talking about. More technically what we do is this: The initial rent rate when we purchased / whatever the purchase price + and capital improvements needed (if any) to make it 'rent ready' = our "multiplier number" at time of purchase.

We have agree to use that same "multiplier number" for each property if/when one of use wants to liquidate out share (or partial share).

Our 'highest multiplier' we use is on a couple of older properties we have that were purchased fairly cheaply. $1200 rent on  an 80K all-in price for two of them. That would be $1200/80,000 = .015 (similar to being called a '1 1/2% Rule'). That equate to a '66.66 times rent multiplier'. If in 5 years that property bring in say $1500 month it would be valued at $1500*66.66 = $100,000.

On a more recent purchase we bought 12 units at once from a retiring landlord/friend out of his total of about 25 units. That was 4 duplexes and a 4-plex. We proposed the "100 times rent idea" to him and he thought that sounded good. So that is what set that rate for those properties. They were all less than 20 year old with maintenance free exteriors. So on these, for a duplex bring in $1500 month cost 150K etc..

In our market, that also happens to almost mirror what sold comps are, and also mirrors what the 'tax assessed value' which in my state is supposed to be the 'fair market value'. So with those figure all more or less matching up, it was a pretty logical way to value it.

So with that same example of a duplex in that package that we bought for 150K and bringing it $1500 month, in 5 years if it brings in $1700 a month we would value it at 170K.

I hope that helps explain it. We think of it as a fair way to share both the up side of down side. Interestingly in our market when things took about a 10% of so price dip in '08'09, our rental INCOME actually went up a bit, as more people were looking for rentals as banks tightened up and some were displaced by foreclosures etc....

Dan Dietz

Nicholas Lohr · Answer

@Ashish Acharya   thanks can you think of an example structure that would "mitigate these kind of situations?" as you say.

Ashish Acharya · Answer

@Nicholas Lohr ,

I know, Seems unfair. However, investment in a partnership is just as directly investing in a property. Whoever wants out has right to get the benefit of a full market value of his/her investment and must also be ready for the decline in the market value.

This is just like investing in a house, you need to be ready for both side of the market.

Technically it is not unfair, because what you are paying for the buyout would be the same price if you would have invested somewhere else (FMV).   Maybe you are referring to actually having to have a cash outflow when it was not desired.

Maybe draft the partnership interest in such a way to mitigate this kind of situations.

Regarding the remaining partner's partnership, putting very simply.  there are elections ( sometimes mandatory)  that partnership can make after the transfer of the partnership interest to step up the basis of the partnership's asset. Will be relevant to the recognization gain/loss later on.

Nicholas Lohr · Answer

@Daniel Dietz  Thanks, curious where you got the 100 times number? I know you said you were using rounded numbers there so maybe it wasn't 100 but how did you come up with whatever number it was?

Daniel Dietz · Answer

@Nicholas Lohr, how we handled this in 'simplified language' in our LLC Operating Agreement is this, using rounded number for simplicity - 1) We bought our rentals based on a price of "100 times monthly rent", meaning a duplex bringing in $1500 a month cost us 150K. 2) That is also the price we agreed to value them at if/when someone wants to sell their share. So if 5 years down the road that same duplex is $1700 a month, then is would be valued at 170K.

It is up to the partners, both selling and buying, if they want to do the transaction at that  price. The property may still only be worth 150K on the open market or it may be up to 190K - that does not really matter.

One advantage of doing this in an LLC is that we can buy/sell shares of the LLC, and keep the existing financing in place if it is more advantageous of what is available at the time of sale.

We also have provisions in place where any one partner can stop contribution 'labor' (PM, book keeping, maintenance work etc...) and still get a share of the profits, if it is a matter of not wanting or being able to put in as much time but still interested in having the investment.

Dan Dietz

Exiting of a Partnership Question; Book Value or Market Value?

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