Purchasing a spouse is never simple. Sometimes the working relationship has degraded to the point that you both want to terminate it immediately. Buying out your partner’s ownership might be extremely costly for you and the company.
Without proof that the business will continue to develop and be able to handle more debt following the partner’s exit, banks are renowned for refusing partner buyout financing. There are several ways to accomplish a partner buyout, each with advantages and disadvantages.
No matter how you go about it, partner buyouts are expensive. If you and the departing partner are the only owners, your partner is hoping to walk away with half of the business’ capital. To buy them out, you need to make up the difference. There are several strategies for doing this, and most involve you taking on a significant amount of debt. These are some of the most common methods for financing a buyout.
Utilize Equity Financing
If your partner wants to leave the company and you’re not especially interested in becoming its sole owner, you can sell your partner’s shares to another investor. If an investor buys your partner’s equity, they are now a legal partner in your business.
Unfortunately, this can be detrimental to your business’ independence; all decisions must be made with the new partner’s consent. This is why most partnerships are dissolved with the remaining partner using debt financing to become the business’ sole owner.
Financing with an SBA 7(a) Loan
In the not-so-distant past, the government was almost universally opposed to guaranteeing loans for partner buyouts as they result in substantial negative equity for a business. To guard against default, SBA 7(a) loans required 20-25% buyer equity. However, a few years ago, the Small Business Administration altered that position to extend loans for partner buyouts if a business has at least a 9:1 debt-to-net-worth ratio and the buyer equity requirement was reduced to 10%. SBA 7(a) loans have relatively low-interest rates (though they are variable), long repayment terms (10-25 years), and can provide up to $5 million in capital.
Using an SBA 504 Loan To Buy Into a Partnership
SBA 7(a) loans are the financing of choice for partner buyouts, however, an SBA 504 loan is another good option in certain circumstances. The 504 loan can’t be used to purchase a business directly, but it can be used to purchase certain tangible assets within a business: real estate, equipment, etc.
Unlike SBA 7(a) loans, 504s have fixed interest rates in addition to having low buyer equity requirements and generous repayment periods. The catch is that the loan can only be used for tangible assets that could be sold in the event of a default.
An SBA 7(a) loan can be used to purchase intangibles like business patents, client lists, and name recognition. You could combine the two types of government-backed financing though, purchasing real estate and equipment with a fixed-rate SBA 504 loan and then using a variable rate SBA 7(a) to buy out the remainder of your partner’s equity.
Banks can be reliable providers of financing for partner buyouts, but many SMBs cannot access them. Smaller businesses with strong credit and consistent revenues can look to alternative funding for choices that traditional banking institutions might not provide.
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.
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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.
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.
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.