Partnership Agreement Buyouts Explained
Partnership buyouts are a structured process wherein a partner buys out the ownership of another partner in a partnership. The buying partner determines a value for the ownership and distributes the buyout amount to the selling partner. These may be well-defined and structured in a partnership agreement or may be an ad hoc transaction among the partners. Partnership buyouts may be the easiest way to remove an unwanted partner and establish an ownership level that can be an appropriate return on investment for existing partners. Many large companies have been able to work through a buyout of a shareholder only to turn around and have that shareholder come back to them after the separation to then demand greater compensation or seek a greater stake of ownership.
In the context of a larger ownership group , often partners will agree to divide their business based on asset and liability information. Partners can create a business or family entity agreement with provisions stating that if the business is dissolved for any amount of time, assets and liabilities are split evenly and partners can keep the cash value from liquidated assets. Assets can be valued at the time of dissolution or based on an appointed valuation company. Liabilities include everything from office equipment to accounts payable.
The Basics of a Partnership Buyout Agreement
An essential element to any business is its contract with its owners. Agreements among the owners of an enterprise provide clarity with respect to ownership and the value of an owner’s interest through a buy-sell mechanism. The buy-sell mechanism may vary the treatment of an owner’s interest upon termination of the owner based upon the triggering event. The triggering events can include the owner’s voluntary departure or forcing termination of the owner for "good cause", certain disability events, and death or incapacity upon the owner’s death.
In a buy-out agreement, the owners will seek to identify the valuation mechanism that will be used to value the terminated owner’s business interest. Depending upon the event, the valuation may use a multiple of EBITDA, an appraisal, or another pricing mechanism. SBA generally will not consent to a transaction where the buyer and seller have agreed on the purchase price. SBA’s only acceptable methods are those provided in the regulations (without regard to any provisions in any other document). In the most typical arrangement, the buy-sell agreement will set forth the valuation method to be used upon a termination event. SBA’s recent memo suggests that any other valuation method will be presumed unacceptable.
The purchase price is problematical as it requires some form of financing and cash is not always available at the time of the buyout. Financing could be through a loan or seller financing, or some other means. The terms and conditions will need to be spelled out in the operating agreement itself to assure that it can be enforced and that the funds are on deposit. SBA has recently stated that a non-competitor could be used to make the required deposits. But, in any event, there must be funds available for the payment. The parties will need to ensure sufficient funds are available for the purchase (unless the parties agree to a more delayed means for repayment). In other words, there must be some practical reality that money paid into escrow or lockbox can be obtained when needed to fund the purchase.
There also should be some mechanism to encumber the buyout provisions to assure the buyer’s obligations. That could be in the form of additional security for the seller, and may likely require financing on the purchase price. SBA’s recent memo noted that security interests in the business assets was the appropriate remedy for performance. Although, SBA will not require that the seller take a security interest in the business of the company. The SBA has stated that blanket security interests over the business assets is not required if the seller is also contributing equity capital up to the amount of the purchase price.
The remaining issues usually deal with transition of ownership to the surviving partner or entity. That includes restrictions on competition, non-solicitation of customers and employees, as well as nondisparagement clauses. There may be restrictions on incentive payments that would be applicable to employees or related to the amount paid to the owner. There is little change here from years past. However, parties could view these provisions more carefully in light of new caselaw under the Dodd-Frank financial reform law to limit the application of certain restrictive covenants. Under the law, a company cannot enforce a non-competition clause against a loan officer.
Determining a Partner’s Value
The terms of a partnership agreement can also make a difference when it comes to determining the value of an owner’s share in a buyout situation. For instance, does the agreement call for book value, fair market value or some other approach?
Book value
One common method of valuing a practice for a buyout is its book value — what the business would be worth based on its financial statements. Typically, this involves valuing the company’s fixed or depreciable assets at their book value and treating goodwill as zero. As a result, this approach generally yields a lower valuation than alternatives might, especially if the business relies heavily on such intangible assets as customer lists or management expertise. Due to the low valuation that book value often generates, courts may be reluctant to approve the use of this method when the buying and selling owners have unequal interests in the equity. In addition, book value doesn’t account for the buying partner’s investment in improving the practice after the buyout.
Fair market value
Another approach is the fair market value (FMV) method, which aims to provide a fair price for a business transaction. In an FMV method, valuators consider various factors including market conditions, industry conditions and the practice’s financial condition. This method may be more appropriate if the partnership agreement requires it to set the company’s initial value and doesn’t provide a procedure for valuing the company after the initial contribution. It also might be appropriate if the two partners’ ownership interests require valuation to be based on identical factors.
Income approach
Some agreements require that value be set using the income approach — capitalizing the business’s earnings. According to the Consolidated Appropriations Act, 2018, this approach is appropriate only when determining fair market value for an interest that has to be included under Internal Revenue Code (IRC) Section 318(a)(2)(C) and isn’t covered under the valuation safe harbors in IRC Section 2701 or IRC Section 2703.
Legalities of Partnership Agreements
Several legal issues must be considered in any partnership buyout. For example, who can buy the equity? If the equity cannot be sold to an outside person, what is the value of the equity, how is the value to be calculated, and can that calculation involve a third-party valuation? Does the value include a clause stating the value is fair and reasonable for purposes of any tax liability, or that the parties have waived the benefits of having a third party prepare the valuation if it is not used? Can the selling partner negotiate to change the values as long as the purchase price does not exceed the stated value? Any of these issues involves significant opportunity for disputes if the issues are not clearly stated and agreed upon in advance.
There are also issues relating to the employment status of the selling partner. Whose light is this, anyway, as the old joke goes. Is the selling partner entitled to a commission for new business? Are unpaid bonuses owed to the selling partner only to the extent actually paid to current partners or to all prior partners? The devil is truly in the details.
Alliance law attorneys can help you solve these issues. We can draft the buyout provisions of the partnership agreement to reflect the intent of the partners. We can also negotiate and draft the buyout provisions to comply with various laws and rules.
Negotiating a Smooth Buyout
The negotiation stage is a critical component of any commercial buyout process. Parties may not engage in negotiations until a partnership agreement has previously been put into writing. However, there is also potential for negotiations to occur preemptively, whether or not a written partnership agreement exists. Negotiation refers to the process through which the parties attempt to agree on terms regarding a purchase/sale of the exiting partner’s ownership interest from a partnership.
There are several benefits to an effective negotiation, which can be defined as a process through which the parties work towards a settlement or an exchange of demands. First, a satisfactory negotiation has the potential to leave each party better off than it would have been had the negotiation failed. This is true where the terms of success would leave all parties with the product of a positive negotiation – i.e., a deal that is worthwhile for each side.
Second, a successful negotiation can also help to avoid or mitigate conflict. Where the parties are unable to reach an agreement, this can lead to a protracted conflict without a resolution. A negotiation may be of critical importance when a buyout is pursued less than amicably , given that disputes can be costly and exhausting.
The ability to smooth over a negotiation can be useful in situations where it is essential to maintain a relationship, preloaded with animosity or not, between the parties. For example, where one partner is exiting a partnership owned by several partners, a negotiation with the other partners may be necessary in order to help ensure that the relationship between the remaining partners is not adversely affected by the existence of a disagreement with the exiting partner.
Further, a negotiation can help demonstrate an appreciation for the partnership and its value, which in turn can help the parties come to a creative solution that can be satisfactory. It is this nature – the recognition of value in the partnership and its carrying forward not only as a business but a relationship – that ties together many of these potential benefits.
The importance of engaging in negotiations cannot be overstated. If a potential deal can be struck before even a contract is signed, then a conflict can be avoided altogether. Even where negotiations are difficult and don’t produce the desired result, remaining calm and exercising patience and understanding toward another party can help alleviate problems in the future.
Common Issues and Their Solutions
Potential Pitfalls and How to Deal with Them
As with most things in business, partnership buyouts are not without their difficulties. Perhaps the biggest hurdle is lack of preparedness: having spent no time considering future buyouts, partners can find themselves unprepared for the process, both psychologically and financially.
Disagreement over valuation is the most commonly-cited dispute. Even clearly-stated buy sell agreement terms are subject to interpretation, and of course we all have our own vision of it. When a third-party valuation is called for, the expert often has to make assumptions about the company that are more favorable to him or her. For example, many business owners are hesitant to share all of their sales figures with third parties. In this case, your buy sell agreement should specify the record-keeping requirements for the financial information needed for disputes.
Keeping extra funds on hand is a good way to deal with any shortage that might occur if a financing plan turns out to be too aggressive. Getting real about the money that you have and how you will finance the buyout can mean the difference between an amicable purchase and a financially impossible one. This alone can sometimes lead to conflict, but it can also mean the difference between a successful purchase and a protracted, destructive struggle.
Post-Buyout Transition and Integration
Transition and Integration Processes
The post-buyout phase is where alignment and integration are critical to the success of the transaction. Those involved in the transition period and process have a unique opportunity to shape the future path of the business. A couple of important areas to focus on are as follows: Business Continuity and Team Morale – What initial steps are to be taken to effectively transition the team including communication considerations. One of the first questions a seller will have is , "how will we be communicating with the employees?" A strong plan that is implemented early is one of the best ways to alleviate initial uncertainties. Alignment on Next Steps – What next steps are expected for the new owners, and if any are needed for the previous owner(s)? This is where owners can utilize their advisors and create a community of experts to help ensure the new era begins on solid footing. Strategic Direction – Is everyone aligned on the general business strategy moving forward? Has the business kept pace with industry standards? A discussion around the strategic plan of the company can lead to very informative ideas and solutions that can positively impact the company for years to come.
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