Partner buyout financing refers to the process of obtaining funds to purchase the equity stake of a business partner. This financial tool is often used when one partner wishes to exit the business due to strategic, personal, or financial reasons, and the remaining partner(s) wish to buy out their share to gain full control or redistribute shares among existing members.
The financing can come in various forms, including bank loans, private lenders, or seller financing. Successful partner buyouts require careful negotiation, clear valuation of the business, and a thorough understanding of the legal implications to ensure a smooth transition and maintain the business’s operations. This article will address some of the common pathways for financing a buyout and will highlight some of the benefits and challenges of each approach.
How to Fund the Buyout as the Remaining Partner?
As the remaining partner, funding a partner buyout can be achieved through several financial strategies. Here are a few options to consider:
- Equity Financing: This involves raising capital by selling shares of the business to private investors or venture capital firms. By bringing in new investors, you can acquire the necessary funds to buy out your partner’s share. However, this will result in sharing future profits and often entails losing some control over the business.
- Debt Financing: This is a common option where you take out loans from a bank, credit union, or private lender to facilitate the buyout. While this option avoids dilution of ownership, it does add a debt obligation that requires regular repayments and interest costs.
- Mezzanine Financing: Mezzanine financing is a blend of debt and equity financing. If the borrower (who, in a buy out, is typically the remaining partner in the business) defaults on the loan, the mezzanine lender has the option to convert their debt into an equity stake in the company.
- SBA Loans: Leveraging SBA loans to facilitate a partner buyout is one specific form of debt financing. While not all SBA loans can be used for buyout scenarios, an SBA 7(a) loan can be used for a partner buyout. This government program often offers longer loan terms and more lenient underwriting guidelines than companies would otherwise find with a traditional bank loan.
- Refinancing Assets: Another unique variation of debt financing is refinancing the company’s current assets. For example, a company may have equity in its real estate, equipment, or inventory. Through refinancing, the partners can turn this equity into cash that can then be used to buy out a partner.
Selecting the most appropriate financing method depends on factors such as the business’s financial health, the urgency of the buyout, and your long-term business goals. Each option carries its own set of advantages and trade-offs, so careful consideration and possibly consulting with financial advisors are recommended to determine the best fit for your specific situation.
How to Choose the Right Financing Option for Your Buyout
When narrowing in on the right financing option for your partner buyout scenario begin by assessing the financial position and goals of your company, with a particular focus on long-term strategic objectives post-buyout. Consider the cost of capital, repayment terms, and the degree of control over the business operations that each option entails. Let’s look at each financing type in more detail.
Equity Financing
Equity financing is a permanent relationship with a new set of co-owners. The business receives an infusion of new capital, but gives up permanent ownership of shares in the business. The upside is that your business receives an infusion of capital that can positively impact performance and growth.
These new co-owners can be silent partners, allowing you to run your business so long as their annual returns from the business meet their goals. Others may be operating partners who take an active role in operating the business.
Some equity investors will be interested in quickly increasing the value of the business so they can sell their shares to another investor at a profit. When equity partners are not aligned in their growth and exit objectives, it can destabilize the business, serving some partners over others.
Additionally, the business will now owe a percent of earnings to the new investors. It can be paid as dividends, but investors may also want a relationship wherein their percentage is reinvested in the business, expanding their equity until such time as they want to cash out. A sudden exit of equity partners can hurt the business as much as the equity infusion helped at the beginning of the relationship, requiring the remaining partners to find new equity partners or choose another option to refinance the exit.
For many equity investors, the end goal is to grow your business to the point that it is acquired by a larger corporation. Many businesses that take equity, especially from venture funds, find themselves on a treadmill they can’t get off. The goal becomes to find more and more equity, growing the business until it is acquired or can go public. When that is a shared goal, it can be a wonderful match. But if the remaining partners simply want a closely held small to medium-sized business, they have to consider carefully with whom they enter an equity relationship.
Debt Financing
Securing debt financing can be a daunting task for businesses due to stringent lending criteria imposed by banks and other traditional lenders. These institutions often require a strong credit history, substantial collateral, and detailed financial documentation, making it difficult for many businesses to qualify. These criteria can be particularly prohibitive for startups and small businesses that may not yet have a long track record of financial stability.
On the other hand, private lenders, although more flexible than banks, present their own set of challenges. They are often niche-oriented, each specializing in specific industries or sectors, which can make the process of finding a suitable lender overwhelming. It is not uncommon for businesses to spend considerable time and resources in seeking the right lender—akin to searching for a needle in a haystack. This intricate and time-consuming process can delay essential funding and pose significant obstacles in capitalizing on timely growth opportunities.
A primary risk of debt financing is that of securing more funding than your business can repay. Should the market shift and your business experience a significant shortfall in revenue, your business could go into default. For this reason, managing your company’s debt service coverage ratio and putting capital into profit-generating activities is paramount.
In assembling projections for a buyout scenario, the remaining partner should also realistically account for the income generated by the exiting partner. This allows a continuation plan that practically addresses potential changes to revenue following the buyout. To remain stable, the business must be profitable even after losing revenue from the partner’s departure and increasing costs from new debt.
There is a flip side to this coin. The greatest benefit of debt financing is that the remaining partners or sole proprietor can grow the business and retain ownership without the influence of other partners. This means more control over the business and the ability to retain an increased percentage of the company’s profits.
Mezzanine Financing
Similarly, mezzanine financing, with its hybrid nature that splits the difference between equity and debt, can impose significant financial burdens due to its higher interest rates and complex terms. The terms and conditions of mezzanine financing may include covenants that restrict the company’s operational flexibility, potentially limiting its ability to respond to market changes swiftly.
Companies often opt for mezzanine financing when they cannot qualify for the needed capital through banks or other traditional lenders.
A common clause in mezzanine financing is that the debt reverts to equity under certain performance conditions specified in the agreement. Should the company go into default or otherwise underperform, mezzanine investors may be able to overtake control of the company. These factors can heighten the risk exposure of the remaining partners, necessitating a thorough understanding and careful negotiation of terms to balance immediate capital needs with the long-term strategic integrity of the business.
The benefit of mezzanine funding, especially in the real estate sector, is that equity partners can reduce their exposure and realize high long-term gains. By putting in less capital upfront, the partners rely on cash flow to pay down the debt while property appreciation increases the value of their shares in the enterprise. When the property is paid off, they increase cashflow, and in the instance the building is sold, they realize any gain as a lump-sum increase in value over the money they initially put in.
SBA-Backed Financing
SBA loans can be an excellent option for those whose operations qualify as a small business under the criteria set for their industry. With an SBA 7(a) loan, businesses often qualify for more capital, longer repayment terms, and sometimes equal or lower rates as compared to their conventional or alternative counterparts. SBA loan repayment terms can extend to 20 or 25 years, making monthly payments quite reasonable. SBA loans can also be applied to a broad array of business costs, from real estate and equipment to a line of credit and working capital funds.
The downside? The cost of debt may ultimately be higher than other types of financing. Additionally, SBA loans come with some added fees upfront to cover the validation processes required prior to loan approval.
SBA loans can be approved for partner buyouts, but there is close scrutiny on business valuations and the business categories approved for such funding. SBA loan applications are notoriously detailed, and some businesses are denied simply because they don’t gather all of the right information. Brokers, such as our team, can assist in proper packaging and vetting of a loan application prior to submittal, significantly increasing success rates on behalf of applicants.
Refinancing
When refinancing a business as part of a buyout, both partners need to be thoughtful about how the loan is structured. Usually, to be approved, all partners need to sign to guarantee the loan. This means that if the business fails to repay the debt on time, the lender can come after all of the partners personally in order to get repaid. In a situation where one partner is exiting the business, they don’t want to be on the hook if the remaining partner makes bad decisions and goes belly up.
In this case, alternative lenders are needed who will fund the business without all partners guaranteeing the loan. It can be a hunt to find the right lender, which is why a broker can be extremely helpful in preparing a successful package and matching with the right lender. Often the transfer of assets, leverage of those assets, and buyout of the ownership stake in the business will all need to take place at the closing table.
Working with a Financing Broker
When preparing for a partner buyout, securing the right financial arrangement is crucial to ensure a smooth and equitable transition. Engaging the services of a capital broker, such as our firm, can help you navigate this complex landscape of a partner buyout.
Our team of experienced brokers will leverage our industry knowledge and extensive network to find the most suitable capital source for your unique scenario. By collaborating with a broker, partners streamline the financing search and gain access to competitive terms and rates.
Brokers will also help ensure that the financing structure aligns not only with the company’s immediate needs, but also with its long-term business strategies. Partnering with a financing broker can save time and resources while mitigating the risks of high-cost capital and financing delays
Initiating a free, no obligation conversation with our team can provide insights into the best financing strategies for you, whether through leveraged buyouts, mezzanine financing, or other creative capital structures. We’re here to support you in the next step in your business journey.