The following excerpt is from Mark J. Kohler and Randall A. Luebke’s book The Business Owner’s Guide to Financial Freedom.
Selling your business to a partner is probably the most common ownership transfer among small businesses. The reason is, your partners have a clear picture as to the value of the business, its potential, and what they need to do in order to replace you in the operations.
Selling to a partner is often one of the easier transfers to handle legally — not that partners don’t have their battles and disagreements — but most buying partners want to make the transition smooth and get the selling partner out quickly and painlessly. Many times, I feel that partners are amenable and anxious to define the transaction and process so that they themselves can utilize the same method with a good conscience in the future.
The document that typically lays the groundwork for a partnership sale like this is called the “Buy-Sell Agreement.” These types of agreements are drafted daily by law firms around the country and are actually implemented for more reasons than a partner wanting to sell.
In a more elaborate Buy-Sell Agreement for a more mature or established partnership, the document will cover issues of divorce, death, disability and a requested departure or exit. I call these the “Four Ds,” and each is important to address with predefined terms.
The primary purpose of the Buy-Sell Agreement is to define the procedure for the transfer of ownership, price, terms and transition well in advance of any event causing a transfer. This is a powerful tool because it prevents a partner from holding another partner hostage at a price or process in the heat of emotions when the transfer is needed.
For example, if all partners understand the process to determine the value well in advance, then they can work more clearly toward increasing the value of the business. Each party also knows that they’re all held to the same equation and process no matter what side they’re on. This way, it will be fair when the time comes for each partner to leave the partnership (at least, that’s the goal of the document and can certainly minimize the chance of a lawsuit). Following are some details you need to know about the Buy-Sell Agreement.
Determining the value.Most Buy-Sell Agreements require the partners to agree to the value of the company on an annual basis and record it in the annual partnership meeting. This may seem arbitrary, but if everybody agrees (typically requiring a unanimous vote) and everyone knows the value applies to everyone, then who cares what anyone from the outside thinks? If the partners can’t agree, then a third-party appraiser is brought in to do a formal valuation if a buyout is triggered during the upcoming year.
Terms. Oftentimes, the terms are based on a note, with interest, paid out over five to 10 years. This can obviously create the retirement income a partner is looking for, and over the period of payments, it will spread out the tax bill as well. Some Buy-Sell Agreements require the remaining partners to obtain a loan for a good portion of the purchase price and then finish off the rest with a Note. This allows the departing partner to invest the initial money received wisely to create additional cash flow and prepare for when the payments under the Note end.
First right of refusal. Typically, there’s a first right of refusal that must be given to the remaining partner(s) when a partner wants to leave or sell. This means that before a partner can run out into the open market and look for another buyer, they first have to offer their ownership interest to the other partners. This obviously can create some hurdles for the partner wanting to sell because they first have to find a third party willing to buy into a partnership where they may not be welcomed with open arms, probably be in a minority position, and then have to wait around for the other partners to exercise their first right of refusal. But, again, it’s a protection mechanism that “cuts both ways” and protects all the partners.
Security. To protect both parties, there can be a provision requiring the departing partner to sign a noncompete, and also the remaining partner or partners to “pledge” the partnership interest they purchased as security or collateral for the Note they’re paying off. Thus, if the buying partner(s) defaults, the selling partner can come back into the company as an equity partner to try to recover the remaining sales price or value sold in the original agreement.
It’s OK for a partnership not to have a Buy-Sell Agreement in place, but it can increase the tension in the case of a partner selling when the remaining partners didn’t foresee the situation and don’t have the wherewithal to buy out their partner. In these situations, I tell the partners to turn immediately to their partnership agreement (typically an LLC Operating Agreement) to understand what the governing document allows for when it comes to a partner who wants to get out or sell.
If you’re in a partnership and you have the slightest thought that you might want to sell in the next 10 years, and your partner might just be the buyer, then implement a Buy-Sell Agreement immediately. Don’t mess around with the disaster that can be created in a partnership when it becomes volatile or a partner up and decides they want out.