Buyout a Partner
A Small Business loan that is partially guaranteed by the government under the Small Business Administration (SBA), which eliminates some of the risks for the financial institution that is issuing the loan. Designed to provide financing for the purchase of fixed assets, which usually means real estate, buildings, and machinery.
Getting an SBA 7(A) Loan to Buy out a Partner
If you run a business with a partner or partners, there may come a day when you want to buy one or more of them out. You might simply have different goals, or the partner may want to retire, move to a new location, or shift their career into a new industry altogether. Whatever the reason, buying out a partner can be expensive proposition and if you don’t have the funds to do it, you might want to look into an SBA 7(a) loan.
Before a Buyout, All Partners Must Agree on the Business’s Value
Before securing financing for a partner buyout, the partners in a business need to agree on how much the business is actually worth and how much the partner(s) being bought out will get. In an ideal world, this would all be written down in the business’s partnership agreement. In reality, many partnership agreements do not include this information. Even if the agreement does stipulate buyout terms, a variety of things can change throughout the years, potentially invalidating the agreement.
One popular method to value a company involves each of the partners sharing what they believe the company is worth, and, if their numbers diverge significantly, calling in a third-party expert to conduct an independent valuation.
Different Forms of Buyouts
In general, there are four major types of buyouts, though these can often be combined to meet a business’s specific needs. The most common types of buyouts include:
Lump-Sum Buyouts: This is usually the fastest type of buyout, as it provides the exiting partner a one-time cash payment for their equity in the firm. However, it can often be difficult for small business owners to come up with enough cash for a lump-sum buyout, which is where SBA 7(a) loans can come in handy.
Earn-Outs: In an earn-out, the exiting partner will receive payments over time, but they must also stay with the firm during a transition period. In many cases, earn-out payments are tied to company performance, so the better the business does, the more cash the partner can leave with.
Buyouts Over Time: Buyouts over time are similar to earn-outs, in the sense that the exiting partner will be paid overtime, but in most cases, they can leave immediately, and will not have to stay on with the company to ‘earn’ their payout.
Equity Buyouts: In this scenario, a new partner will come in, purchasing the existing partner’s stake in the company. In most cases, the other partner(s) will want the new partner to have some kind of expertise or experience in the industry that can help bring value to the business. In some situations, a partial equity buyout could be combined with a lump-sum buyout or earn-out, especially if the new partner has the experience, but doesn’t have the funds to purchase the exiting partner’s entire stake in the firm. However, partial buyouts are not allowed under SBA rules, so a borrower would have to look for non-SBA financing if they wanted to complete a partial buyout transaction.
The Challenges of Getting SBA Financing for Partner Buyouts
While it’s certainly possible to get SBA financing for a partner buyout, doing so can sometimes be difficult. In many cases, lenders will be worried that the absence of a partner will negatively affect the business, borrowers will have to prove that they’re more than capable of running the business themselves, or that they’re going to bring someone new on that can help. That means that a business should make sure that their financials are in tip-top shape and that they have a smart succession/post-exit plan before applying for an SBA loan for a partner buyout.
New SBA Rules Make Partner Buyouts Easier
Despite the challenges of SBA buyout financing, the SBA’s new rules on acquisitions make it much easier for business owners to buy out their partners. In the past, the fact that the partner buyout process left many businesses with negative equity made it extremely difficult to use SBA loans for partner buyouts without contributing a large amount of cash. The new rules state that, for partner buyouts, the borrower does not need to put down any equity, as long as the business has a debt-to-net-worth ratio of 9:1 or less. If the ratio is larger than this, the borrower will put 10% down to qualify for the loan.
Finance a Buyout with Traditional Loans
Some banks offer traditional term loans to pay for the cost of a business buyout. But these can be hard to come by. Companies tend to take a financial hit after a buyout, and many lenders don’t want to take on that risk. Your best bet might be an SBA loan when it comes to a traditional business loan. These are partly backed by the government, offsetting some of the risks and making you a more attractive candidate to lenders.
The SBA recently revised the rules for its 7(a) loan program to make it easier to fund a partnership buyout. Before, you were required to foot 10% of the buyout cost yourself. Now, you might qualify for 100% funding if you’ve been an active participant in the business for the past two years and your company has a high debt-to-worth ratio before the buyout.
If you decide to go with a traditional lender, you’ll have to convince them that the new iteration of your business will continue to grow as strong as it has in the past, if not stronger. Revisit your business plan and financials, and consider hiring an expert to help you navigate the transition. You likely won’t be able to qualify for an SBA or traditional business loan unless your business has been around for a few years, has strong revenue and finances, and you have excellent personal credit.
Finance a Buyout with Alternative Loans
Luckily, there are other options from bank loans when it comes to financing a buyout. Many alternative lenders provide funding specifically for equity financing. Some offer term loans at a higher cost than a bank or SBA loan, which you can use for an equity buyout.
If your business relies on consumer sales, you might also want to consider a merchant cash advance. These are advances on your future credit and debit card sales, which you repay plus a fixed fee with a percentage of your daily revenue. Like alternative business loans, these tend to have more flexible eligibility requirements, though they can be more expensive.
One benefit of applying with an alternative lender is that you can often get your funds faster than if you went with a bank. SBA loans, in particular, are known for taking months to process. Only around half of SBA applications were approved in 2017, according to a study by the Federal Reserve. In contrast, almost 80% of merchant cash advance applications were accepted.
Self-Fund a Buyout
If you’d rather not add to your business’s debts when entering a new, risky phase, you might want to consider self-funding your buyout. There are two ways to do this: You can come up with a payment plan to buy them out or take out a personal loan.
A payment plan is generally the cheapest way to fund a buyout since you might pay less interest than you would with a loan from a lender, if any at all. But you’ll need to be on good terms with your partner and be willing to wait several months or even a few years before you become the full owner.
To speed things up, you might want to consider taking out a personal loan, especially if you have good credit. You can typically borrow up to $100,000 from a personal loan provider at more competitive rates than you’d get with a business lender.
But a personal loan comes with a risk: It’s your responsibility to pay it back. You will be on the hook for those repayments even if your business performs lower than expected after the buyout. If you decide to go this route, set aside some time to shop around and prequalify with several lenders to find the best personal loan you’re eligible for.
Finance a Buyout with Equity
Another option that doesn’t involve any cost is equity funding. This means bringing on another investor, or group of investors, to take over your partner’s share of the business. The downside is that you won’t have complete ownership and may run into the same problems you’ve been having with your current partner. Vet your potential investors as much as they might vet you to make sure you’re bringing on someone who shares your vision. Otherwise, you might find yourself in this same position a few years down the line.
Which Option is Best?
It all depends on where your business is and what you envision for the future. If you’re breaking professional ties with your partner because you want full ownership, you can write off equity funding right away.
Before deciding on a type of financing, you’ll want to compare business loans to see which works best for your business. More established businesses might benefit the most from a low-cost SBA loan. But if you’re new to the game, or just want to make the break sooner than later, alternative business loans or self-funding might be the way to go.