Some years later, S&J Test Prep has grown significantly, boasting annual revenues of $10,000,000 and 5 Partners. They have added IP, so that in addition to providing tutoring services they also do consulting with schools and sell a line of branded Test Prep materials. The have kept their margin at a healthy 30 percent, so annual profits now reach $3,000,000.
The founders, Sonja and Tarsha, remain “senior” Partners. Each retains 25 percent of the business. Prashanth now owns 20 percent (he was given the opportunity to buy more shares over the years, and did so), and two “junior” Partners own 15 percent each. At this point, none of the Partners retains a W-2 wage. So, in a year where the business has $3,000,000 in profits, the payouts are:
- Sonja and Tarsha each make $750,000
- Prashanth makes $600,000
- The two junior Partners make $450,000 each
Sonja decides is time to retire, so she wants to sell her ownership stake. Most Partnerships have restrictions on who you can sell your shares to, so Sonja can’t just sell her ownership to an investor who wants to collect the annual K-1 revenue and likes the chances that the business will become even more valuable over time (in some cases, she could, but let’s say that is not an option). Within the terms of the S&T Partnership agreement, when a Partner leaves, the other Partners have to buy that Partner out. That means the firm has to determine the fair market value of the business again.
When they do this, they decide that the business should be valued not at 1x annual revenue, but at 1.5x annual revenue. This is justifiable because the business is much larger, has a longer track record of success, and has assets beyond just tutoring sales (i.e., multi-year school consulting contracts and branded materials). So, at the moment Sonja decides to leave, the value of the business is $10,000,000 x 1.5, or $15,000,000. That makes Sonja’s 25 percent ownership stake worth $3,750,000. That means the firm has to pay Sonja $3,750,000 to buy her shares back.
Once the firm has bought the shares back, the remaining Partners get to decide what to do with them. They could allow existing Partners to buy some of those shares at $150,000 for each 1 percent of the business, or they could use the shares to let new Partners buy in to the business, or they could hold them as a firm asset that, if the firm continues to grow, will hopefully appreciate over time. That’s for them to decide. Sonja just collects her money and walks.
Some firms allow Partners to retain their ownership shares, or some portion of them, even after the Partner retires. Some firms allow shares to be transferable assets that can be sold or even inherited. Many, though, have policies like McKinsey’s, where Partners are expected to surrender their shares once they are no longer actively working within the business.