Locking in partner buyout financing can seem challenging, especially for small and medium-sized businesses that haven’t secured one before.
A business partnership, especially among small and medium-sized businesses (SMBs), can dissolve for several reasons, including diverging visions, a new opportunity, or — as is common now, given the ages of many Baby Boomers — retirement.
Regardless of the reason, a company’s transition and continued success depend on all parties reaching a mutually satisfactory agreement. One crucial and necessary element of this transition is usually a buyout of one partner. This can require a great deal of capital, and companies that don’t have enough cash upfront typically need to secure a partner buyout loan.
Alternative lenders like business development companies (BDCs) can help SMBs with partner buyout financing. Such arrangements have their advantages and risks, and business owners need to be fully informed about the implications for the future of their enterprises.
What To Be Aware of With Partner Buyout Financing
Perhaps the best time to plan for a partner buyout is in the company’s infancy. Among other things, a partnership agreement establishes what happens when partners split, regardless of the reason. Even with a solid understanding in place, all parties should still expect to engage in some negotiation.
When a buyout becomes imminent, all partners need to clearly communicate their expectations, goals, and positions. Having these discussions before attorneys enter the picture will make the process simpler. The series of conversations should allow all parties to ask questions and get honest input. Taking thorough notes of each meeting can be helpful during negotiations.
When legal advice is necessary, the company will benefit from a mergers and acquisitions lawyer who can help the company gather records, identify and overcome legal obstacles, and develop a fair buy-and-sell agreement.
In addition to lawyers, business accountants are valuable because they draw attention to the financial aspects of the buyout. An accountant can analyze the SMB’s losses and profits, forecast sales after the buyout and help the owners understand the company’s equity stake.
Fortunately, a partner buyout is one of the easiest transactions to make from a legal point of view. Although the parties might have disagreements about future directions or compensation, most of the time, they want to see a smooth transfer and part on a cooperative note.
Determine The Value of The Business
Although there may appear to be agreement on the surface, most partners will likely see things differently when it comes to the details of the buyout, particularly in the valuation of the business. Having a partnership agreement from the very beginning can help resolve some discrepancies, but it doesn’t determine the buyout amount. In many cases, both parties can use the average of both assessments to set this quantity.
Instead, partners can hire an independent business valuation service to eliminate any second-guessing and ensure the buyout process moves along. This option removes most of the subjectivity, ensures fairness in the negotiation, identifies unforeseeable liabilities, and uncovers strategies for debt resolution and restructuring.
Common Types of Buyouts
Type 1: Lump-sum Buyout
In a lump-sum buyout, the buying partner makes an up-front payment to the seller, which often entails a large amount of money. If a company’s valuation is relatively high, this might prove difficult for an SMB owner who lacks sufficient cash. Lump-sum buyouts also have tax implications, with just one payment resulting in a gain or loss on a sale that the IRS would recognize in a given year.
In general, the lump-sum buyout represents the ideal. However, many SMB partners don’t have enough capital to make this happen. Also, creating a payment agreement can get complicated. In most cases, setting up a payment plan or acquiring external capital through financing is necessary.
Type 2: Installments
Because of the cash shortfall that hamstrings many buyers, they will pay regular installments to the seller until the purchase is complete. Both parties should carefully work out this arrangement’s details, which should include the number of installments and how to handle late or delinquent payments.
Type 3: Seller Financing
Many partners on both sides of the transaction prefer seller financing, which involves the buyer and seller agreeing on monthly payments in exchange for ownership. The buying partner typically makes a down payment and then signs a promissory note outlining the terms of the payment plan.
Type 4: Lender Financing
Lender financing can be difficult for SMB partners to get. Many lenders won’t offer this type of financing partly because it doesn’t benefit the borrower directly. If a buying partner does find a willing lender, they might have to wait months to get approval.
Type 5: Earn-Out
In an earn-out, the selling partner stays with the company while they receive payments from the sale. This arrangement can include flexible payment options and often pays out more if the company continues to show financial strength.
Options for Partner Buyout Financing
Banks can be good sources for partner buyout financing, but they’re out of reach for many SMBs. Smaller enterprises with good credit and steady profits can turn to alternative lending for options they might not get from traditional banking institutions.
Option 1: Debt Financing
Many debt financing options exist, including non-bank cash flow lending. A cash flow loan to buyout business partners can be an excellent option for SMBs with little physical property but significant growth potential, which BDCs typically use to underwrite a loan.
Another type of debt financing is recurring revenue lending, which appeals to companies that offer subscription-based services and have proven customer loyalty. The lender usually determines recurring revenue based on annual or monthly figures.
SMBs can take out a small business home equity loan to finance a partner buyout. Owners who own their home can borrow against it to buy out a partner instead of using it for home improvements or debt consolidation. However, a home equity loan can be risky because responsibility for the debt rests in the owner, not the business.
Finally, a debenture is a bond that has the backing of the company’s reputation or performance. Because this loan to buyout a business partner is unsecured, many investors are hesitant to provide this type of financing, especially to startups.
Option 2: Equity Financing
Equity financing involves selling shares to raise the capital needed for a buyout. Equity financing can occur either by placing stock privately with investors or publicly through venture capitalists and public stocks.
Option 3: Merchant Cash Advance
A merchant cash advance pays the borrower a lump sum up-front, with the borrower repaying the loan with a percentage of the company’s revenues. Approval for this arrangement typically takes days. On the downside, it tends to be more expensive than other financing options, so it’s best for short-term needs.
Option 4: Mezzanine Financing
The name for this type gets its inspiration from actual mezzanines, which are in-between levels between two floors. This type of debt takes priority over a typical loan to buyout business partners because it can be converted to stock, depending on the loan terms.
Conclusion
Flexibility, lender reputation, and ease of borrowing should factor in any choice of partner buyout loan. Alternative lending can provide SMBs with affordable, accessible financing to smooth out any transition involving a partnership change.
Businesses facing a partner buyout can look at Saratoga’s investment profile to see if their company is a good fit for securing partner buyout financing.