Overview of Partnership Buyouts
A partnership buyout is a situation that occurs when one or more partners in a small business leaves the business and the ownership structure is realigned among existing, but remaining partners. There are a number of circumstances that can lead to the need for a buyout including:
Each of these scenarios showcases the importance of understanding how a small business partnership buyout will work between the partners. The specific terms of how a buyout works will, in large part, depend on what has been agreed upon with a buyout agreement as described above. Otherwise, when no agreement is in place, the buyout may be governed by state law.
The biggest implication for partners who are not being bought out as a result of a buyout is that , unless otherwise agreed, it is possible that the departing partner will be entitled to the value of the company as of the time of that partner’s departure. Depending on how a business is performing, this could create a rather large hit to the business. As such, many enter into a buyout agreement before a buyout ever becomes necessary so that both parties have an incentive to keep the business doing well.
Additionally, if a business has multiple owners, a buyout agreement can limit which owners are allowed to exit the business at any given time to ensure the overall stability of the business.
Key Parts of a Buyout Agreement
The essential components in creating a buyout agreement template are as follows:
Establish Valuation Method:
It is necessary to define how a valuation will be determined upon an event that triggers the buyout agreement. Will it be an appraisal, an agreed upon amount between the parties or some other basis? A provision might read as follows:
The Company shall be valued as a going concern as of the Valuation Date in accordance with GAAP. The Fair Value of the Company shall be determined by subtracting from the then-current business value the sum of (a) any outstanding debts and liabilities of the Company, whether or not then due and payable and (b) the aggregate amount of capital contributions made by any person other than the Members…
Ownership Transfer:
The provision should definitively explain the procedures for transferring for ownership of all or part of the business. It may even go so far as to explain how the business will operate during the transition. A sample clause would read as follows:
In the event that a Member withdraws or is forced to withdraw from membership, the remaining members may, at their option, continue the business of the Company. During any period that the Members disagree as to the continuation of the business of the Company, however, they shall operate the Company by complying with the Operating Agreement and performing only those activities which are necessary for the preservation of the business.
Terms of payment:
If the business’s income is not sufficient to cover or loan payments or make other required payments and the parties do not have sufficient liquid capital available, it may be in the company’s best interest for one or all of the parties to take a loan or mortgage on business income or assets. Sample clause:
If the payment of any payment pursuant to this Agreement may render the Company insolvent, or if the payment cannot be paid from funds legally available therefor, each Member to this Agreement shall make a capital contribution to the Company in the amount of such Member’s proportionate share of the distribution and each Member agrees and represents that he is legally committed and will be legally committed to make such a contribution in any such instance or instances.
Other conditions that may be outlined:
The party who will be purchasing the other’s interest; any rights of first refusal; buyout terms for circumstances such as divorce, bankruptcy or death; non-competition clauses; or specific procedures for reaching agreement on all terms of the buyout agreement.
Legal Issues in Partnership Agreements
Legal considerations in drafting the agreement
Even with a small business that may be run by family, friends, or even individuals you do not know that well, certain legal considerations should be observed.
First, both parties should consider using an attorney to draft the buyout agreement. Like other contracts and business arrangements, there are many pitfalls an inexperienced person could fall into, which can even lead to unintended consequences if not properly considered. There is a lot at stake if the buyout of an ownership or partnership interest to a small business with all of its obligations is not properly considered ahead of time.
The buyout agreement should be reviewed by everyone involved, and they all should have their attorneys review it as well. Finally, it should be signed with all parties present to fully execute the buyout agreement. And when that happens, it should be signed in such a way (and properly witnessed and notarized as necessary) to ensure that no one can later claim that they did not sign it. Not properly addressing legal considerations in drafting the buyout agreement could very likely lead to family, marital, partnership, or other litigation contracted on the cheap. That’s not worth the money saved.
Large businesses in particular usually hire specialized business counsel to help them navigate and address many potential issues in this complicated situation. This is also true when a buyout involves real estate as part of the agreement or involves the use of stock in a corporation to be purchased, and even more so when a pension, IRA, or 401(k) benefits plan is involved as a part of the buyout.
Guidelines for Making a Tailored Buyout Agreement Template
Steps to create a custom buyout agreement template:
A key initial step in the creation of a buyout agreement template is identifying the particular characteristics of your business and its owners, in relation to one another. A business entity that includes members who have variable ownership interests (for example, via different classes of stock or ownership based on length of service) has a more complex situation to consider than a company with two partners or only one class of stock. You’ll need to determine how your particular situation will impact the content of your buyout agreement.
Next, you’ll need to decide what types of buyouts you need to plan for: death, disability, retirement, or voluntary departure of one or more owners. Your buyout template should include a buyback formula that is appropriate for each of the potential circumstances. A template can include different buyback formulas for owners who have to leave the business, depending on how many years they have owned the company . Because your buyout agreement will spell out the terms of a buyout, you’ll also need to draft those terms. For example, will the buyout amount be determined by an appraisal if no specific price is listed? Will it be paid in installments over time, or as a lump-sum payment?
If you’ve consulted with an attorney in the creation of an initial buyout template, speaking with him or her again as you develop your customized template will help ensure that you haven’t overlooked any considerations. A customized agreement from an experienced business attorney can also include ideas or variations you may not have considered, to ensure that it meets your business’ needs. The assistance of a skilled attorney can save you a great deal of time and effort when creating a customized buyout agreement template, and result in a greater likelihood that your document will be effective and useful.
How to Use a Buyout Agreement Template
Small business owners should avoid relying on buyout agreement templates that are "freely available" on the internet. Although some of these can be used as a rough guide, most will not apply to all of the particulars of each business. The business should then have its attorney develop and customize the document after a thorough review of the needs of the business and the owners. After the document is initially developed, it should be reviewed periodically (e.g., after the entry into or termination of a business contract; after the departure of a principal; after the transferring of voting power, etc.). Also, if there is the addition of new principals, the buyout agreement should be drafted at the same time. Many businesses forget to update their buyout agreements and have serious issues when a triggering event occurs.
Partnership Buyout Agreement FAQs
Gratuitously, this section poses the most common issues and questions we see regarding business partnership buyouts and how to create an acceptable buyout agreement:
How is value determined? "Value" is usually determined by appraisal. However, for simplicity and cost reasons, we recommend that you use an agreed upon formula (e.g. last 3 years’ average profits plus net tangible asset book value plus 75% of intangible value, etc.) or some other quantifiable tool such as trailing twelve (12) months earnings. However, these are only starting points and can be tweaked to fit the specific facts and circumstances. We strongly recommend a cap on paid outside shuffling of professionals.
How are disputes handled? You will likely need to file a lawsuit as a general partner to enforce your rights derived in an agreement with a specific partner. Enforcement actions are generally covered by insurance.
What if a partner refuses to sell? It depends. Most buyout provisions are, by their very nature, self enforcing. Some plans are set up to trigger upon the death of a partner. Others rely on good business practices to cause the reluctant partner to voluntarily sell. A lot turns on company culture , state law, and local business customs.
Will there be negative tax consequences? Probably not, but it depends. For instance, if a partnership is forced to sell, that is a "forced liquidation." A partner cannot have a loss or gain across an involuntary property transfer unless that transfer occurs when the partner is completely "disassociated" from the partnership. In that case, a partner’s pro rata share of the partnership deductions and credits would be suspended by the partner’s discharge from all liabilities and transferred to the extent of liabilities assumed by the transferee. Section 736(b) of the Internal Revenue Code (IRC) 26 U.S. Code § 736) treats payments by the partnership as sale of association interest where the payments are made via liquidation. Conversely, payments to a retiring partner in accordance with 736(a) are considered guaranteed payments that are subject to self-employment tax. Getting this correct is so utterly important that it is worth a deep study of IRC §736 to get fully up-to-speed before attempting to implement a business buy-out. The possible unintended tax consequences could be really significant.
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