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, or sometimes it comes from a conflict or fallout between partners. In either case, finding a middle ground to benefit both parties financially is crucial.
Some common reasons why business partnerships end include:
- One partner plans to retire and wants to sell their equity.
- A 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.
Regardless of the reason, buying out a partner requires arriving on mutual terms, defining the buyout agreements, and determining the funding mechanism for the buyout.
How do I prepare for Buying Out a Business Partner?
There are several steps to take when planning or preparing for a partnership buyout.
Defining the Buy and Sell Agreement
When launching the company, defining a buy and sell agreement as part of the initial partnership agreement (aka operating agreement) would be ideal. A buy-sell agreement defines the buyout terms and conditions.
It will cover the proper procedures for retirement, incapacitation, or voluntary exit. It could cover extenuating circumstances as well. A buy-sell agreement that includes valuation clauses, payment guidelines, and other considerations smooths negotiations and helps to 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.
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, if not the most important, considerations of buying out a business partner is determining how much the buyout is worth. You must arrive at a fair and agreed-upon price for a successful buyout. There are three essential components of 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 determining how much the business is worth. The best way to do this is to get an independent business valuation. Contacting a certified business valuation expert for this process would be best, but you can also use an uncertified independent valuation expert.
The valuation process determines a fair market value for your company by analyzing all tangible and intangible assets. It considers expected profits, sales, revenue, equipment, market share, and all partners’ creative and operational contributions.
Business valuations typically use 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?
There are several funding mechanisms 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. 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 be unable to provide the funds upfront.
Partner Buyout Financing
Another option is agreeing to an installment plan to buy out the exiting partner’s share. 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. Banks are hesitant to lend to small businesses in general. 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.
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.
Equity Financing – New Investor/Partner
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 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.
The agreement should also define crucial non-financial conditions.
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.
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 partnership where one partner retains ownership and buys out the other partner is called a disassociation, which is the focus of this guide. However, 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 with your partner becoming a silent partner or taking 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 make the investment. But if the business is still viable, all partners could agree to a complete 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 supporting operations or growth. However, it might be possible to fund a buyout, or at least the down payment, with a business term loan.
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 partner 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.
Maintaining a level head throughout the process and approaching it objectively and professionally is essential. 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.
