Buying out a partner

In short

A friend of mine once bought out his business partner over a cup of cold coffee, and both men still say they wish they had written more down first. You can do better than that, and it starts with a plain question. What is the whole business worth, and who says so? Get a written value, from a source you both trust, before you talk about price. Then decide how the money will be paid, because the terms matter as much as the number. Check your partnership agreement for a buy sell clause, since it may already tell you how this works. Bring in an attorney and a tax professional before you sign anything, because each one sees a piece of the picture that you cannot.

The whole of it

What it is

I once watched two brothers argue over a lawn mower for an hour, and neither of them wanted it. Business partners can get like that too, only with more at stake. A buyout happens when one owner sells their share to the other owner or to the company itself, and then leaves. You have probably felt the pull of it, either the wish to run things your own way or the wish to finally rest.

There are two main shapes. In one, you buy the partner's share with your own money. In the other, the company buys that share back and cancels it. Lawyers call the first a cross purchase and the second a redemption, which just means the company buys its own ownership back. Both end the same way. One person owns what two people owned before.

The reason to do it right is simple. This is likely the biggest deal you and your partner will ever make with each other. It deserves the same care you gave to signing your first lease.

How it works

If you are holding a partnership agreement, start there. Many of them contain a buy sell clause, which is a set of rules for what happens when an owner leaves, retires, or passes away. It may fix the price, name a method for finding the price, or set the payment schedule. If yours does, follow it, or agree in writing to change it.

If yours is silent, you will have to build the deal yourselves. The first step is value. Owners often use one of three approaches. One looks at what the business earns each year and applies a multiple. Another adds up what the business owns and subtracts what it owes. A third compares your business to similar ones that recently sold. A business appraiser can do this work and explain the reasoning, and a written report gives both of you something fair to point to.

The second step is the price for the share. If your partner owns half, the starting point is half of the agreed value. Some deals then adjust that number, for instance if the departing partner has a loan owed to the company or has been taking more cash out than the other. Put every adjustment on paper.

The third step is payment. Some buyers pay cash at closing. Many pay part at closing and the rest over time through a promissory note, which is a written promise to pay a set amount on a set schedule. Others borrow from a bank or use a loan backed by the Small Business Administration. The SBA publishes its loan programs and their rules on its website, sba.gov, and you should read the current terms yourself rather than trust a memory of them.

The fourth step is the paperwork. That means a purchase agreement, a release so the departing partner is freed from future company debts or the company is freed from claims, and updated ownership records with your state. Your attorney will know what your state asks for.

The numbers, and where to find yours

Some figures in this deal are set by law, and they change. The tax rate on a gain from selling a business interest depends on how long the seller held it and on their income. The seller should look at the IRS page on capital gains and losses, and at Publication 544, Sales and Other Dispositions of Assets, which is a real IRS publication. For the seller, the current long term capital gains rate that could apply is the current figure, which the official source publishes each year. That is a rule set by law, and the site will show the verified figure and its date.

The seller's tax bill also depends on their basis, which is roughly what they paid in plus what they have left in over the years. A gain is the sale price minus that basis. Your partner's accountant can tell them their basis, and it is often on old tax returns and in the owner's capital account in the company books.

If part of the price is paid over several years, the seller may be able to spread the tax across those years through what the IRS calls the installment method. Publication 537, Installment Sales, explains it. Ask a tax professional whether it fits your deal.

The numbers that belong to you are different. You will need the business value from your appraisal, your partner's ownership percentage from your agreement, and your partner's basis from their records. Gather these three before you sit down together. Nothing else moves a negotiation forward faster.

A worked example

Let me tell you about Maria and Dan, who run a small print shop together. Each owns half. Dan wants to retire, and Maria wants to keep the shop going. They hire an appraiser, and the written report values the whole business at 400,000 dollars.

Dan's half is 400,000 dollars times 50 percent, which is 200,000 dollars. Maria checks the books and sees that Dan owes the company 10,000 dollars from an old draw. They agree to subtract that. So 200,000 minus 10,000 leaves a price of 190,000 dollars.

Maria has 40,000 dollars in savings she is willing to use. She wants to pay Dan 40,000 dollars at closing and the rest over five years. The rest is 190,000 minus 40,000, which is 150,000 dollars. Spread evenly over five years, that is 150,000 divided by 5, or 30,000 dollars a year before any interest. They agree to add interest, and they put the rate in the note.

Now look at Dan's side. Suppose his basis in the shop is 60,000 dollars. His gain is 190,000 minus 60,000, which is 130,000 dollars. Whether the gain is taxed all at once or spread over the payment years is a question for his accountant. Maria asks a different question of hers, which is how the purchase changes what she reports going forward.

They also write down that Dan will help train Maria's new manager for three months, and that he will not open a competing print shop nearby for two years. Lawyers call that second promise a noncompete. Their attorney drafts it, and both sign.

Nothing about this deal was fancy. It was fair, and it was written down. That is the whole trick.

Where it goes wrong

I have seen more friendships strained by a handshake deal than by a hard bargain. The first mistake is skipping the written value. Without it, each person carries a private number in their head, and the two numbers rarely match.

The second mistake is ignoring the payment terms. A price that looks fair can become a heavy load if the yearly payments are more than the business can carry. Run the payment against your real cash flow, and leave room for a slow season.

Third is forgetting the debts. If you and your partner both signed a bank loan or a lease, the bank may still hold both of you to it after the buyout. Ask the lender in writing whether it will release the departing owner. Do not assume.

Fourth is the tax surprise. How the deal is built changes who pays what. A purchase by the owner and a purchase by the company can be taxed differently. Talk to a tax professional before you pick the shape, not after.

Last is the human part. A partner leaving is a loss, even a welcome one. Say thank you. Name what they built. People sign more willingly when they feel respected, and the goodwill you keep may matter to your customers and staff too.

Questions to answer before you leave this page

Does your partnership agreement already contain a buy sell clause, and have you read it lately? Who will value the business, and will you both accept that person's written report? What is your partner's ownership share, and what adjustments, if any, belong in the price? How much can you pay at closing, and can the business afford the yearly payments after that? Will a bank or the SBA be involved, and have you read their current terms yourself? Do any loans or leases carry both names, and has the lender agreed in writing to a release? Have you talked with an attorney and a tax professional about how the deal should be built? And finally, have you told your partner, in your own words, what their work has meant to you?