The Basics on Partner Buyouts
Any time you find yourself in a business partnership that has become untenable, a buyout can be the optimal path forward. Understanding how to proceed can make the difference between a buyout that helps all parties and one that just compounds the problems that arose in the first place.
One issue has to do with the best price to offer. Some shareholder agreements contain valuation formulas for buyout purposes, but many do not. At this point, it can be worth getting an expert opinion from outside the company to help you. The offer doesn’t just have to do with value, but also with structure (cash up front as opposed to payments made down the road).
In most cases, companies get their valuation on the basis of expected cash flow in the future. The way that you come up with this number is to look at the performance the company has posted in the past. A lot of times you’ll hear about this valuation in terms of a multiple of current yearly cash flow or EBITDA (earnings before interest, taxes, depreciation and amortization).
This is where your outside expert can help. They look at the financial performance of the company and consider what other companies in the industry have gone for recently. They also consider financing options and the expectations of the partner who is about to be bought out. Remember that if you take on a deal that saddles your company with debt, your growth down the road could suffer.
Once you’ve come up with an offer, it’s time to figure out how to finance the transaction. Sit down with your current banker, because you have the relationship there, and they are likely to support the buyout, unless they look at the partner who is headed out the door as crucial to the success of the business. If the buyout will cost more than what the bank will lend you, then you can look at some other possible sources, such as subordinated debt, payments after closing, private equity or other sources of cash.
Subordinated debt, also known as mezzanine debt, is a loan without any tangible assets backing it up. Instead, lenders extend it simply because of the likelihood that the company will continue to pull in strong cash flows. This debt comes after the bank’s claim on any assets and cash flows, which is why it is called “subordinated.” This can run with interest rates as high as 18% and are frequently tax deductible.
If you pay your partner after closing, you can put together such creative vehicles as royalty payments, payments connected to performance or a vendor note. You can also adjust the equity interest that the partner will hold. This can be a way to meet the gap between what you think your partner’s portion of the company is worth and your partner’s opinion.
Private equity can have a number of sources: Crown corporations, private individuals or private equity funds. These investors come in as your partners but generally want a way out within five years and an internal rate of return of at least 30%. You’ll want to do careful due diligence on any of these sources.
There will be cases where your bank will not support your buyout. After all, your original financing from your lender came from an application that you and your partner both submitted, likely with the two of you on top of the masthead as far as operations would go. However, some banks will see the departure of a partner as a significant form of risk.
If your shareholder agreement does not address a partner buyout, prepare for a difficult conversation – your partner may even offer to buy you out instead. This means that you should be able to enter the conversation knowing what kind of deal you want – which is why talking to an outside party to get a sense of valuation is important. The discussions you have with outside advisors can help keep things from becoming uncomfortable – which means that the deal can go more smoothly. Also (and perhaps most importantly) having that outside advice could indicate to you whether the buyout is the best idea in the first place.