Picture this: after many years of running a successful business, you and your business partner have come to a crossroads in your professional relationship. It’s time to part ways. You’d like to buy your partner’s share of the business, but you’re unsure how to go about it. Securing the funds for a business partner buyout has been a common hurdle — until recently. The Small Business Administration adjusted their business partner buyout financing rule in April 2018, and now offers a loan product with partner buyouts in mind – ultimately benefitting all parties involved in the transaction.
To understand why the SBA’s business partner buyout loan can be advantageous, we need to step back in time for a moment. Before the rule change in 2018, financing a partner buyout with an SBA 7(a) loan was difficult. The old SBA rule said that to qualify for a loan to buy out a partner’s interest in the business, the balance sheet must have a minimum of 10% equity based on the business’ total assets after the sale. Partner buyouts had been accomplished through a stock purchase, which would be applied to the balance sheet often resulting in negative equity. This made securing an SBA loan improbable without the buyer investing personal funds to meet the post-transaction equity requirement, an obstacle for many.
Now, a partner can qualify for an SBA 7(a) loan without an equity injection as long as the following criteria are met: 1) the buying partner has been an active partner and has held the same or higher ownership percentage for more than two years and 2) the business has a debt-to-net-worth ratio at or below nine to one at fiscal year-end and the most recent period.
How is debt-to-net worth calculated? In simplest terms, this is total liabilities divided by total equity.
Debt-to-net worth ratio: 0.80x
In this example above, the debt-to-net-worth ratio is below nine to one, eliminating the need for an equity injection. Instead of the buyer putting down cash, they can leverage the equity of the balance sheet. This can be hugely beneficial to both the buying partner and the selling partner, as it removes one of the largest barriers in the transaction. If the previously mentioned requirements are not met, then the buying partner will have to inject 10% of the purchase price in equity to qualify for the loan.
Regardless of the reason for parting ways, no one wants a partner buyout to drag out and have negative consequences on the health of the business. Business partner buyouts are historically complicated but with the SBA’s revised rule, existing partners can purchase the business in a straightforward transaction. There are a few things to consider when using an SBA loan for a buyout: 1) the seller cannot remain involved with the company as an owner, officer, director or employee and 2) if a transitional period is needed after the sale, the seller may serve as a paid consultant for up to 12 months post-sale.
Let’s consider a likely partner buyout scenario. Married couple Arthur and Elizabeth have owned and operated a successful manufacturing business for five years. The couple has decided to divorce and since Elizabeth is leaving the business operation altogether, Arthur needs a loan to purchase her share of the business. The business has $1,000,000 in assets and $325,000 in liabilities, so the debt-to-net worth ratio is 0.48. Because Arthur has been active in the business and has held the same ownership position for more than two years and his debt-to-net worth ratio is less than nine to one, Arthur can leverage the equity of the balance sheet instead of putting cash down to buy Elizabeth’s 50% share. In other words, he does not have to contribute any cash towards the loan. After mutually deciding on a purchase price and securing an SBA loan, Arthur is now the sole owner of the business and each party can move on with their life.
If you’re considering a business partner buyout and want to pursue an SBA 7(a) loan, the SBA will require a comprehensive business plan which demonstrates how the business will benefit from the transaction. These are typically considered lower-risk transactions when compared to complete changes of ownership, as the buyer is already deeply familiar with the business at hand. Consult with your CPA or attorney to discuss all your options and determine if a partner buyout is suitable for your situation. Our experienced lending team at Live Oak can help determine the best path forward for your partner buyout – from valuations to structuring the deal and ultimately, making the transition of ownership possible. For more information about partner buyout financing, reach out to one of our loan experts today.