From Employee to Partner: Three Options to Finance Your Partner Buy In
Companies are always looking for ways to grow. A great way to do this and to ensure that they retain the best and brightest talent is to bring an employee on as a partner in the business. For employees, it’s an opportunity to move up in the company and take on a more central role.
If you are offered the opportunity to buy in as a partner, there are various ways that the buy in can happen. In almost every case, though, the employee’s buy in will need be financed, and there are three financing options available. Which option is best depends on the type of business and the amount of cash available to the employee.
Commercial Bank Loan
First, a general commercial bank will be the least expensive lender option. This path will require the employee to put a significant amount of cash into the deal. However, these lenders generally require hard assets to account for a significant portion of the value of the business. Commercial banks will avoid businesses whose value is based disproportionately on goodwill, such as professional services business.
Commercial financing may be problematic for the purchase of a minority interest in a going concern business unless the bank understands and has an appetite for these types of transactions. It will likely have to be a portfolio loan and, therefore, have a short amortization period and higher interest rate. In some cases, the other partners or the company will be asked to guarantee the loan. In any event, a valuation of the business will have to be undertaken.
SBA Guaranteed Loan
The second financing option is an SBA guaranteed loan. This path is better when there is less buyer cash and the seller is willing to hold back a portion of the purchase or the value is based in large part on goodwill. An SBA loan will, however, have higher upfront costs and has an involved application process.
There are really good lenders working with the SBA, though, and they will work with companies and employees to get deals working. Some SBA guaranteed lenders have appetites for these transactions, particularly where the business is a professional practice. Again, a valuation will be required.
Finally, the company or shareholders could provide the financing by holding paper. This can manifest in a number of ways, which should be determined by the company or shareholders in the partnership, operating, or shareholders agreement. The buy in could be in the form of a restricted stock grant or a stock option, for example.
Risks and Rewards of a Partner Buy-In
A partner buy-in can be a very financially risky transaction if it is not done correctly. It’s a mix of buying a business and creating a partnership, both of which require their own risk mitigation techniques. There are three critical factors that will make or break this transaction for an employee.
- First, the price of the ownership interest must be based on the fair market value of the business and the equity of the business in light of the business value and the rights of the buyer. Very often, the original equity holders have an inflated view of the value of the business in the context of the partner buy in that simply doesn’t hold up under scrutiny. A third-party valuation (by someone other than a generic business broker) fixes this problem by removing the valuation from the environment of a business negotiation.
- Second, the employee must undertake a due diligence review of the business, including its finances and major contracts. The sole source of funding to pay the loan he received to finance the buy in will be the cash flow that the business will generate in the future. If that cash flow isn’t sufficient to cover the debt service, nothing will make the transaction work.
- Finally, the shareholders or operating agreement is vital to protecting the employee after she’s become a partner in the business. The provisions within the agreement will protect the employee who’s buying into the company from the majority owners taking advantage of her. For example, it should limit the majority’s ability to change the compensation arrangements, require distributions so she can pay the investment loan, and require tax distributions (if it is a pass through entity). The agreement should also deal with partner exits, both voluntary and involuntary, so the employee doesn’t end up partners with someone unknown to her.
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