Retirement Planning via Partner Buyouts
Baby boomers are retiring sooner rather than later. In fact, by 2030, all baby boomers will have turned 65, which adds up to some 75 million potential retirees. Many put their life’s work into building sustainable businesses, including insurance firms. What happens to these businesses? Many owners are thinking ahead and putting plans in place for partner buyouts.
Here’s how it works.
Calculating Buyouts
A significant component of the partner buyout is calculating and obtaining financing to compensate the departing partner for their shares in the company. Often, the partners have a buy-sell agreement to outline procedures and compensation when a partner leaves the business. The intent is to repay the departing partner for the equity initially put into the company and compensate them for the value of the business built from that equity. In other words, the partner buyout purchase price is often equal to the value the business would earn if a third party purchased the selling partner’s percentage.
A partner’s buyout share depends on factors, such as the amount of equity the partner contributed to join the partnership, the company’s value at the time of the buyout, and the number of partners in the company. The Revised Uniform Partnership Act (RUPA) establishes a partner’s share as the value of their percentage of the partnership’s total property less the percentage of any partnership liabilities as of the day the selling partner leaves. This formula determines the percentage of the partnership that belongs to the selling partner, but the price the partner receives for that share varies.
While the RUPA and many buy-sell agreements define the percentage of a partner’s share, determining the company value at the time of sale may be challenging, even in an amicable buyout. The selling partner wants a greater payment, while the remaining partners want to reduce the payments to lower their investments.
One way to determine the buyout price is for each party to present their estimate of the company’s value and choose a value in the middle. Another option that may cause less conflict is for both parties to split the cost of a third-party valuation. Once the company’s value is determined, the selling partner receives their share of the value based on the perimeters outlined in the buy-sell agreement.
Buyout Financing Options
There are three common types of partner buyout financing, each with pros and cons for the buying partner(s) and selling partner. It is imperative that all partners work with legal counsel to draft the agreements for partner buyout financing to ensure a smooth transition.
Lump-Sum. Just as it sounds, a lump-sum is a single large payment to the selling partner for 100% of their share in the business. A lump-sum payment is uncommon and can be difficult for the remaining partner(s) to finance, particularly if the valuation of the business is high. A more common approach is for the buying partners to pay a percentage of the value up front, with the remainder of the payments to be paid in the form of a seller note.
Phased Buyout. In the phased buyout method, the retiring partner sells portions of ownership over a set period. This method eases the financial strain of a lump sum payment for the buying partner(s) and eases the transitionary period as the selling partner takes a decreasing role in the company.
Earnouts. If the selling partner chooses to stay with the company for a transition period, the deal may be financed by an earnout method. The selling partner often receives a percentage of their payment upfront, and the rest of the value is paid out over time when certain performance metrics are met. The belief is that by requiring the departing partner to “have skin in the game,” the company is less likely to suffer financial loss during the transition.
Financing
Some traditional banks avoid partner buyout loans saying a partner buyout can damage the company’s health and may negatively impact viability. Another option is a specialty lending institution that understands the value in funding a partner buyout. Expect the loan to be based on the future cash flow of the business with options to structure it as a one-time event or a multiple-year partner buyout.
Through the entire process, be sure you have a team of trusted advisors to provide guidance. Passing a business to the next generation to prepare for retirement is a very personal decision. Business confidants, including a lender, attorney and accountant, give various perspectives each step of the way to navigate a smooth transition to retirement.