Partner Wants Out of a Property: Fair Business Practice Exit?

Question

$126,000 property purchased by three partners, each putting the same amount of $42,000. Each partner holds the same number of shares, therefore.

All cash inflows and outflows have been split 3-way.

One of the partner now wants out (wants to sell their shares), the two others don't want to sell the property.

Property has appreciated to ~$148,000 since purchase.
Property turns a net profit every year.

What's fair business practice for determining the value of these shares, i.e. the partner's exit package?

Thanks!

R.

Pat L. · Answer

In the past we only paid them back their money plus 3%.

The last one we did (June 2019) the no-show partner (his idea to do the flip) wanted his money plus $8k for all the work he didn't do. Op Agreement said your money back plus you pay all costs to extricate y'self. He got back his original investment & reluctantly paid all legal, filing costs etc. It delayed us 3-4 months but we doubled our $$$. He decided that investing in the 2019 Bull Stock Market was a lot less work & he didn't want to miss the great opportunities !!! He hasn't talked to me since....

Rabih El-Khoury · Answer

Thank you all for your relevant feedback. We're heading towards a "current valuation less cost of sale." The back and forth that's on the table relates to an additional amount calculated as Net Income After Tax x 2 Years x 75%. Two years because that's the estimated hold time before property is sold. And 75% vs. 100% to account for unrealized profit / unforseen costs etc. The thinking behind adding that additional amount is that partner's 1/3rd didn't just contribute to an increase in asset value wealth; it created a profit stream. So, at exit, it is both the appreciation + some of those profits that constitute the calculation. Luckily, the three of us are long time buddies and all this is happening in good faith. It has been an eye opener though. As you can see from your answers -- all relevant and applicable options -- there are many ways to go about it. One day, I hope to syndicate deals and pool in many investors. That exit clause needs to be not only fair but attractive, particularly on holds of 5-7 years (one never knows what happens), to give investors peace of mind. How do you make something attractive and not shoot yourself in the foot by paying market price? The 100x Rent is real interesting and it is fair because it was agreed to before going into the deal. But is it attractive? I don't think so. The valuation less 8% is fair but it's heavy on the other partners staying in the game as they have to dish out some of their gains and "buy something at market value"... when we're all trying hard to buy something below market price. The other way to rationalize 100x rent or valuation less 8% (cost of sale) less an additional say x% (so as not to pay market price) is to look at other industries: if you buy a long term retirement plan and you choose to exit before the "break even" year (usually around the 8th), you pay a penalty. Clients the world over have accepted that. In this spirit, perhaps, it could be a fair cost/fee to charge the person exiting the deal before maturity.

Carl Fischer · Answer

Is there a mortgage? If so who is on the hook for it? How much cash do you need to buy the partner out?

Have the partner sell his shares on the open market and you have the “right of first refusal” Buy it or meet your new partner. You may have to pay taxes and or expenses to update paperwork. Or let the partner buy you out if his price is to high and  he can sell the property. You have a lot of great examples-it happens all the time.

Anthony Wick · Answer

@Rabih El-Khoury  We also have a LLC with 3 equal partners. Easiest and least costly way is to simply agree on the valuation and buy out the partner. Perhaps refinance the property to get the cash? I say easier and less costly because it doesn't have the LLC paying for appraisals and extensive attorney fees. My Buy/Sell agreement states the LLC has first right of purchase (by a vote of partners, using the LLC reserve funds), then the two partners (with personal cash), then the partner that wants to sell can look on the open market to have somebody purchase 1/3 of LLC if the LLC itself or two partners decline. Our agreement does not force the LLC to sell properties just because one partner wants out.

If you cannot agree on a valuation, you could certainly do professional appraisals. However, I would not agree to a simple 1/3 cut of the appraisal value, as that does not take into account about 8% costs if the properties actually had to be sold. So, perhaps 1/3 of 92% of valuation? But I do like Daniel's method of 100 times current rent rates.

I'll be very interested in hearing how this ends up.

Lance Lvovsky · Answer

@Rabih El-Khoury

Is operating agreement in place? What does it say? Generally buy sell provisions should be available. Business can do a valuation for property and either the business can redeem the one partners shares or the other 2 partners can buy the one partner out. Definitely speak to your attorney to make sure they draft up all required transfer and sale docs. Speak to your CPA to advise on buy sell tax provisions.

Christopher Smith · Answer

The best solution would have been to address this when the joint venture operating agreement was drafted. If that wasn't done and the split is an amicable one, then presumably a buy out is negotiated among the participants which can be structured as the parties see fit.

Partner Wants Out of a Property: Fair Business Practice Exit?

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