In business, partnerships can be particularly fruitful endeavors. They allow for two or more people to share in the decision-making and management of an enterprise. Doing so can empower the business to foster more growth than would be possible with one partner alone.
However, before you decide to partner with another individual and establish or acquire a business together, it is important to make sure you understand the risks and obstacles you may face.
An estimated 60 percent of business partnerships are unsuccessful, so being selective when choosing a partner is key. When entering into a partnership, owners may find it difficult to imagine a future in which they are not working together but it happens more often than you may realize. Partners may disagree on a major issue, one may branch out on their own, or another partner may pass away.
The reality is, all business partnerships eventually come to an end, whether amicably or not. It is, as a result, wise for the sake of continuity to draw up a buyout agreement to prepare for those eventualities.
What Is a Buyout Agreement?
Also known as a buy-sell agreement, a buyout agreement is a contract between business partners that identifies what will happen following the departure of one of the owners. These agreements account for all possible situations including voluntary separation and the untimely death of a partner.
Buyout agreements establish a succession plan and limit the potential for squabbles or disagreements. Determining which type of buyout agreement you want — either cross-purchase and redemption — will be an important step. With a cross-purchase agreement, remaining partners are permitted to buy the interest of the departing owner, while a redemption agreement allows the business itself to make the purchase.
You may also choose a blended variety, in which remaining partners can purchase some of the other owner’s shares while the company itself purchases the rest. Knowing in advance the options that remaining owners will have can reduce stress and uncertainty while also promoting coexistence, amity, and the protection of the business’ values and objectives.
Beyond ensuring a smooth transition of ownership and limiting conflict when the time comes, a partnership buyout agreement can also establish the value of a business’s shares and make clear how that value is determined. This clarity can help facilitate the sale of a company’s shares when the time comes in a way that has been mutually agreed upon.
Your buyout agreement may exist as its own document or it may be a part of a longer agreement such as a partnership or operating agreement. Because co-owned businesses are not legally required to have a buyout agreement, you do not need to file this document with the state, but you should make sure that all owners sign the document.
Additionally, regularly ensuring that the document is accurate and updated, especially in regards to business growth and the involvement of additional partners, will keep everyone on the same page.
When Should You Consider One?
Most, if not all, multi-owner businesses should have a buyout agreement in place. Creating them early in the partnership, preferably before conducting any business, is advised. Having a business buyout agreement in place can prevent unnecessary arguments and tension as circumstances change over time.
Buyout agreements can also benefit single-member LLCs as they can outline a process for allowing a third party to acquire the company from the owner or the owner’s estate following their departure. In all cases, a business buyout agreement allows for smooth transitions, limited conflict, and optimal practices following the departure of an owner.
If you are starting or acquiring a business with one or more partners, or you are operating an LLC, you should consider drafting and finalizing a buyout agreement as early in the process as possible. Doing so will benefit all involved parties by providing a clear idea of the business’s future.
Buyout Agreement Terms
When drafting a buyout agreement, you should be sure to address specifics pertaining to your business and what will happen upon the departure of an owner. The terms you will want to identify and explore include the following:
- Involved parties
- Valuation of the company in question
- Buyer funding options
- Withdrawal events
- Purchasing rights to departing owner’s interest
- Valuation of said interest
- Payment terms
- Tax obligations
Value statements in these documents may feature an estimated numerical value or a formula to calculate the value at the time of an owner’s departure. If opting for the former, it will be important to update the document frequently to ensure the information presented is as accurate as possible.
Accounting for all possible qualifying events that would invoke this agreement will be essential during the drafting stage. An owner’s death or departure may not be the only relevant situation, so working with your partners can help you identify and document any other potential events that may require consideration of your partnership buyout agreement.
Keep in mind that this document is meant to provide structure and security for your business in the event of an owner’s departure, so you should make an effort to include any and all relevant information when drafting your business buyout agreement.
Typical Withdrawal Events
There are a number of situations in which a buyout agreement will be beneficial, primarily relating to the departure of one or more owners. In recent years, business buyout agreements have become more prominent and important as Baby Boomers continue to retire in larger numbers, resulting in younger owners buying out their businesses.
In addition to retirement, there are several other events that typically invoke a buyout agreement including:
- Divorce
- Death
- Bankruptcy
- Disability
- Voluntary separation
- Involuntary separation
A buyout agreement may also be useful in a situation where a third party makes an offer to purchase the business. Some buyout agreements explicitly prohibit such transactions, so when you draft your agreement, be sure to discuss this possibility with your partner(s).
Because business partnerships can be volatile and shift over time, buyout agreements are often useful when there is a difference in power, responsibilities, values, or philosophies. If one partner holds more responsibilities than others or owners’ opinions regarding the company’s direction differ greatly, a partnership buyout agreement may be a reasonable solution to prevent distress and animosity.
Some business owners have recognized that the challenges brought about by the coronavirus pandemic (and the ensuing economic upheaval) have caused an increase in philosophical discrepancy among partners. In many of these cases, business owners have opted to invoke a “delayed trigger” to prolong the partnership for at least two years, during which time the company will prioritize regaining its financial standing in preparation for the buyout.
While the aforementioned events are among the most common to enact a buyout agreement, it is important for business owners to consider all possibilities. Failing to do so can easily result in wasted time and money.
Is a Buyout Agreement Right for You?
Starting a business partnership can be a productive and profitable endeavor, but it is important to be selective and decisive when choosing a partner. Additionally, formalizing a business buyout agreement at the start of your partnership can help you avoid unnecessary stress and challenges upon the ultimate end of the arrangement.
At their core, these agreements are effective fail-safes to facilitate smooth, amicable transitions. By considering the possible progression of your business in advance, you can effectively grant you, your partners, and your business a path toward success.
Whether your buyout agreements are made through legal documents or more informal arrangements, Saratoga Investment Corp. can help finance the actual buyout and foster a smooth transition.
If you are pursuing a buyout and are seeking funding for your business partnership, consider reviewing Saratoga’s investment portfolio to identify if our experience and expertise suit your needs.