What does it mean to Buy Out a Business Partner?
All business partnerships must end eventually. While in an ideal world, business partners would maintain a positive working relationship into retirement, things can change quickly in the real world.
When a business partnership ends, it sometimes becomes necessary for one partner to buy out the other. The split could be an amicable and mutual decision, resulting from a conflict or fallout between partners. In either case, finding a compromise that benefits both parties financially is crucial.
Some common reasons why business partnerships end include:
- One partner plans to retire and wants to sell their equity.
- The selling partner wants to leave for a new job to start another company.
- A partner is moving away due to personal reasons.
- Partners don’t see eye-to-eye on goals and growth strategies.
- Interpersonal conflict between partners.
- It’s time to take the company in a different direction.
A business partner’s expertise can significantly influence the buyout process and the valuation of their equity, as their specific skills and contributions are crucial to the business’s success.
Regardless of the reason, buying out a partner requires agreeing to mutual terms, defining the buyout agreements, and determining the funding mechanism for all partners involved.
How do I prepare for Buying Out a Business Partner?
Several steps must be taken when planning or preparing for a partnership buyout. It is crucial to consider the financial implications and valuations that affect the remaining partners during the buyout process to ensure a fair agreement and prevent conflicts.
Defining the Buy and Sell Agreement
A well-crafted buy-sell agreement is the cornerstone of any successful partner buyout. When launching the company, it would be ideal to define a buy-and-sell agreement as part of the initial partnership agreement (aka operating agreement). Partnership agreements play a crucial role in defining the buyout terms and conditions.
It will cover the proper procedures for retirement, incapacitation, or voluntary exit, and could also address extenuating circumstances. A buy-sell agreement that includes valuation clauses, payment guidelines, and other considerations smooths negotiations and helps finalize a buyout agreement.
Keep Things Friendly and Amicable
A business partnership coming to an end is a potentially emotional time, especially depending on why it’s ending. Feelings like anger, resentment, and blaming each other can make the process difficult. It’s important to remain objective and try to land on mutually beneficial terms. Keep negative emotions out of the negotiation process to help ensure a successful buyout.
Communicate with Your Business Partner Early
Setting and managing expectations is a vital part of the buyout process. You should set out to answer some critical questions, such as:
- Why is the buyout necessary?
- Are you comfortable with the partner retaining some ownership or being a silent partner?
- What are your goals for the buyout?
- How will you lead the business after you buy out your business partner?
Addressing these questions early on helps with negotiations. Preparing for your post-partnership role and responsibilities is also a good exercise.
Consider Consulting a Business Attorney Early
Chances are you’ll need a mergers and acquisitions lawyer to finalize the legally binding buyout agreement. Consulting with an attorney early can also help keep discussions and negotiations objective and professional.
How do you determine the price of a Partner Buyout?
One of the most important considerations when buying out a business partner is determining the buyout’s worth. For a buyout to be successful, you must arrive at a fair and agreed-upon price. There are three essential components to determining the buyout price.
Determine the Partner’s Equity
Your business partner’s equity stake refers to the percentage of the company they own. Many partnerships are simple 50/50 splits where both partners invest equal money, time, and energy. However, throughout the business, equity could shift. For example, if a business partner’s expertise is vital to business operations, they might be able to claim higher equity.
Business Valuation
The next step is to determine the business’s worth. The best way to do this is to get an independent business valuation. An independent valuation gives partners an accurate picture of cash flows, risks, liabilities, and growth. While a certified business valuation expert would be best for this process, you can also use an uncertified independent valuation expert.
Buy-sell provisions in a partnership contract are usually tied to the annual valuation. Establishing solid financial records is crucial for conducting annual valuations and facilitating future buyouts.
The valuation process determines your company’s fair market value by analyzing all tangible and intangible assets. It considers expected profits, sales, revenue, equipment, market share, and all partners’ creative and operational contributions.
Common financial valuation methods include earnings multiples and discounted cash flow (DCF) methods. Business valuations typically use one or more of several appraisal methods to determine the company’s value:
- Adjusted Net Asset Method.
- Capitalization of Cash Flow Method.
- Discounted Cash Flow Method.
- Market-Based Valuation Method.
- Seller’s Discretionary Earnings Method.
Business Partnership Buyout Formula
Once you’ve defined the partner’s equity and the business’s value, you can apply the partnership buyout formula to determine the price. The formula is:
Partnership’s Equity x Business Value = Buyout Amount
Example: Partner A owns 35% of the company, which was appraised at $1.5 million.
35% x $1.5 million = $525,000. Partner B must pay Partner A $525,000 for a full buyout.
How is a Business Partnership Buyout funded?
Securing financing should be your top priority in a partner buyout process. Several funding mechanisms are possible for a business buyout.
Self-Funded Buyout
Self-funding a buyout means the business partner buying out the selling partner pays the full buyout amount out of pocket using personal funds. This option requires liquidity for the lump sum payment. A self-funded buyout mitigates the risks associated with a financed buyout, but a small business owner might not provide the funds upfront.
Partner Buyout Financing
Another option is agreeing to an installment plan to buy out the exiting partner’s share. Self-financing involves the departing partner lending money to the remaining partner. In this situation, the exiting partner essentially acts as a lender, and the partner or partners buying them out make scheduled payments over months or years. Partner buyout financing is usually only an option when partners are on good terms. Even then, a financing agreement between individuals can strain the relationship.
Business Loans
Sometimes, you could take out a business bank loan to fund the buyout. However, there are some challenges in obtaining loans for business buyouts. Traditional banks are usually hesitant to offer financing to SMBs for partner buyouts. When banks issue business loans, regardless of size, they usually only agree to fund business initiatives that will increase revenue or profits. A business buyout doesn’t increase the bottom line, so obtaining funding from a traditional lender like a commercial bank will be difficult.
Another option is a Small Business Administration (SBA) loan. The SBA 7(a) loan is versatile, allowing one to use the funds for various purposes, including buying out a partner. Since the U.S. Small Business Administration partially guarantees up to 85% of the loan, lenders are more likely to approve these loans for a buyout. SBA loans often have lower interest rates and longer repayment terms than traditional ones. When securing financing, a solid operational history and good credit can help qualify for an SBA loan.
The third option is to obtain alternative business financing. Alternative lenders are often more flexible than traditional lenders and can find unique funding solutions. You can attempt to get an alternative business loan to finance the buyout or at least a significant down payment. Cash flow loans may be suitable for SMBs with considerable growth potential but little physical property to use as collateral.
Mezzanine financing closes the gap between the cash needed and the available amount. A small business home equity loan allows buying partners to use their home equity to finance the buyout.
Equity Financing – New Investor/Partner
Equity financing allows the remaining partner to sell shares to raise the cash needed for the buyout. The partners could also agree to sell the departing partner’s equity stake to a new investor or investors. This often means forming a partnership with a new investor or giving them some control as a board member.
What are the tax implications of a Partner Buyout?
Business partners should know tax implications during a buyout, as the IRS might define it as a taxable event. Typically, buyouts for small businesses that average less than $500k in annual gross receipts are not taxable. Buyouts for businesses that average over $500k in annual gross receipts are typically taxable.
Partnership buyouts are considered a Section 381 transaction, meaning they are so complex that businesses should consult an accountant or tax professional. The tax implications could include, but are not limited to:
- The exiting partner must pay taxes on the buyout amount received.
- The business owner may have to pay taxes on income generated after the buyout.
- The business owner may assume tax liabilities that the partner had before departing.
What should go into a Partnership Buyout Agreement?
The buyout agreement should include the financial considerations discussed above, such as:
- The agreed-upon buyout amount.
- The mechanism for funding the buyout.
- Roles and responsibilities of the former partner.
- Roles and obligations of the remaining partner(s) post-buyout.
A buyout agreement can include non-compete agreements and trademark rights clauses.
Non-Compete Clauses: You want to protect any trade secrets, customer lists, and client contacts. A non-compete agreement (NCA) should prevent the departing partner from using their industry and insider knowledge to create a competing company. The agreement must define how long the NCA remains in place.
Non-Disclosure Agreements: Similar to an NCA, a non-disclosure agreement (NDA) might be necessary to protect intellectual property (IP) and trade secrets.
Additional Protections: The agreement should also define IP ownership and usage rights, such as trademarks, copyrights, and patents.
Negotiating the Buyout
Negotiating a partner buyout can be challenging and delicate. Approaching negotiations as straightforward business discussions helps reduce emotional stress during the buyout.
It’s essential to approach the negotiation clearly, understanding your goals, the business’s value, and the partnership agreement’s terms. Engaging an independent valuation expert can prevent disputes during the buyout process.
Here are some tips to help you navigate the negotiation:
- Start with a Clear Proposal: Begin with a clear and concise proposal outlining the buyout terms, including the price, payment structure, and any conditions. This sets a professional tone and provides a solid foundation for discussions.
- Be Prepared to Negotiate: Flexibility is key. Be open to alternative scenarios and creative solutions that could benefit both parties. This might involve adjusting payment terms or considering different buyout structures.
- Use Data and Expert Opinions: Support your position with data and expert opinions. An independent valuation can provide a fair and objective assessment of the business’s value, a crucial point of reference during negotiations.
- Focus on Business Aspects: Keep the negotiation focused on the business aspects of the buyout. Avoid personal attacks or emotional appeals, as these can derail productive discussions.
- Consider a Mediator: If negotiations become challenging, consider using a mediator or facilitator. A neutral third party can help manage the negotiation and keep the discussion productive and focused.
Finalizing the Buyout
Once the buyout terms have been agreed upon, finalizing the agreement in writing is essential. Here are some key elements to include:
- Business Description: A clear description of the business and its assets.
- Buyout Terms: The terms of the buyout, including the price, payment structure, and any conditions.
- Roles and Responsibilities: The roles and responsibilities of each partner during the transition period.
- Non-Compete and Non-Disclosure Agreements: Any non-compete or non-disclosure agreements are to protect the business’s interests.
- Dispute Resolution Plan: A plan for resolving possible disputes or disagreements.
- Timeline: A timeline for completing the buyout and transferring ownership.
It’s also essential to ensure that all necessary documents are executed and filed, including:
- Buy-Sell Agreement: A formal buy-sell agreement outlining the terms of the buyout.
- Partnership Agreement Amendment: An amendment to the partnership agreement reflecting the changes.
- Transfer of Ownership Document: A document officially transferring ownership from the departing partner to the remaining partner(s).
- Tax Documents: Any necessary tax documents to ensure compliance with tax regulations.
Managing the Transition
The transition period following a partner buyout can be challenging for all parties involved. Establishing clear roles and responsibilities post-buyout helps maintain business stability and continuity.
Here are some tips to help you manage the transition:
- Clear Communication: Communicate clearly with employees, customers, and suppliers about the changes in ownership and management. Transparency helps maintain trust and stability.
- Smooth Transfer of Responsibilities: Ensure a smooth transfer of responsibilities and tasks. Clearly define who will take over the departing partner’s duties.
- Update Documents: Update all necessary documents, including business licenses, permits, and contracts, to reflect the new ownership structure.
- Consider Hiring a Transition Manager: Consider hiring a transition manager or consultant to help oversee the process and ensure a smooth transition.
Common Mistakes to Avoid
Here are some common mistakes to avoid when buying out a business partner:
- Lack of a Clear Partnership Agreement: Failing to have a clear and comprehensive partnership agreement can lead to misunderstandings and disputes.
- No Independent Valuation: Not obtaining an independent business valuation can result in an unfair buyout price.
- Unfair Price Negotiation: Not negotiating a fair and reasonable price can lead to financial strain and resentment.
- Ignoring Financing Options: Not considering alternative financing options can limit your ability to fund the buyout.
- Poor Transition Planning: Not planning for the transition period can lead to operational disruptions and loss of business continuity.
- Lack of Communication: Not communicating clearly with employees, customers, and suppliers can create uncertainty and instability.
- Failure to Update Documents: Not updating necessary documents and systems can lead to legal and operational issues.
- Not Seeking Professional Advice: Not seeking professional advice from an accountant, attorney, or business consultant can result in costly mistakes and oversights.
By avoiding these common mistakes, you can ensure a successful partner buyout and a smooth transition for your business.
Frequently Asked Questions
Here are the most common questions about business partnership buyouts.
Do I need an attorney for a Partner Buyout?
The specific laws governing partnership buyouts will vary by state and local government. Even if you are not legally required to hire a lawyer, best practices state that it is necessary.
Attorneys for both the buyer(s) and the seller(s) of the ownership stake should review the buyout agreement before any party signs. Consulting a business attorney also plays a vital role in buyout negotiations and arriving at a fair price.
Business attorneys can also advise you regarding laws governing the buyout. In addition to an attorney, having a tax professional advise you on the buyout would be best.
What are the alternatives to a Buyout?
A dissociation is a partnership in which one partner retains ownership and buys out the other. This guide focuses on disassociations, but there are different ways for a business partnership to end.
Here are a few alternatives to a full buyout.
Partial Buyout: A partial buyout means your business partner will retain some ownership stake in the company. For example, if you have a 50/50 split, you could buy out 50% of their ownership stake, making it a 75/25 split. In this case, your partner would become a silent partner or take a diminished role in leadership.
Dissolution: When a business partnership ends in dissolution, the business usually shuts down. The remaining debts are paid off, and any remaining business assets are split between the partners according to their equity shares. Dissolution typically occurs because the business is failing, there is a legal issue resulting in court-ordered dissolution, defaulting on business debt, or other extreme circumstances.
Outright Sale: Sometimes, a business partnership ends, and no one can buy out the other, or they’re unwilling to invest. However, if the business is still viable, all partners could agree to complete the sale of the company.
Initial Public Offering (IPO): This is unlikely to be an option for most small businesses or general partnerships. However, suppose you formed as a corporation or converted your general partnership into a C-Corp. In that case, it’s technically possible for partners to exit the company by selling their shares after going public.
Are there small business loan options for a Partnership Buyout?
Some business loans can help finance a buyout, but your options are limited due to the nature of the transaction. As mentioned, the SBA 7(a) loan is the best financing option for buyouts.
Most alternative small business loans are designed to provide short-term working capital to support operations or growth. Alternative lenders typically have a quicker application process than traditional banks. However, a business term loan might be used to fund a buyout or at least the down payment.
Your best bet is to discuss your financing needs with a lender or lending marketplace. Some business loan brokerages can help find unique funding opportunities for business transactions and negotiate the best deals on your behalf.
How to Buy Out a Business Partner – Final Thoughts
The ending of a business partnership is an emotional experience. Even if the relationship ends on friendly terms, it’s a transformative time. Changes can be scary due to the uncertainty that lies ahead.
It is essential to remain calm throughout the process and approach it objectively and professionally. Following the steps in this guide will help you ensure a fair, equitable buyout.
Contact us if you have more questions on business partner buyouts or to apply for a small business loan. Our business loan experts can help you find available funding strategies, such as applying for an SBA 7(a) loan.
