Buying Out a Partner Can Be Tough to Fund
An entrepreneur with a successful ethnic restaurant contacted us about writing a business plan that he intended to use to raise capital so he could buy out his partner. There are often very good reasons to buy out a partner, but this is a very difficult thing for a small business to do, no matter how successful. So, why should this be so difficult? Don’t large, public companies do it all the time? The answer is that while it is more common to see large companies raise capital to buy out existing shareholders, it happens less frequently now than before the 2008 financial market meltdown.
Funding for a buyout will come from one of two kinds of capital: equity or debt. Debt is a much more typical way to fund a buyout. With debt, you are removing an owner and increasing your ownership interest by borrowing money from a source that will not have an ownership interest. If you use equity to fund a buyout, you are simply exchanging one owner for another. It is unlikely that that makes much sense.
So, why is funding a buyout such a difficult thing to do? The reason is that the new money (probably a loan) coming into the company will not financially benefit the company in any way. The new money goes straight into the pocket of the selling shareholder. The new money will not be used to expand the business or pay down debt or for some other useful purpose. In fact, the new money will increase the company’s indebtedness and decrease cash flow. Banks would view this type of loan as non-productive, and for that reason, few lenders would be interested.
One exception might be in the instance of a technology company or similar enterprise with extremely high margins and cash flow that can easily accommodate the repayment that will come from the new debt. Restaurants usually don’t fit that profile. Not many other small businesses do either.
What is the best way to buy out a partner? Self-fund the buyout. In other words, pay the selling partner over time, as if your partner were the lender. In this scenario, you don’t need anyone else’s approval for the transaction other than your partner.
The first step is to agree on a price. Then agree on the terms including how much you will pay immediately and then the number and amount of payments you will make over time, including rate of interest to complete the transaction.
One note of caution: if you already have bank debt on your balance sheet or intend to borrow in the near future, you should structure the loan so that it will be subordinate to a bank.
One more thing: buying out a partner can be a time consuming proposition that can keep you from concentrating on what is really important… running your business. So, go ahead and make a deal with your partner to exchange his ownership for a note and let him receive his money over a period of time that suits both you and the partner.