Business is much like any other pursuit. It takes guts, gumption, smarts, and most of all, passion, but unlike the first three of these prerequisites, passion can be fleeting.
It can be tough if you or your business partner lose the drive and hunger to continue pushing the business along, for if a party isn’t 100% focused and dedicated, it’s inevitably going to have a negative effect on progress.
This is for the most part why partners buy each other out. It’s not an aggressive political or power move; it’s more about offering them a chance to move on to different projects or pursuits that do kindle that essential fire within.
However, buying out a partner isn’t an easy task. It’s not like you can just give them whatever you have in your pockets and send them on their way. It can be a pricey engagement, and oftentimes, the only way to afford such a move is to take out a business loan.
Can You Buy Out a Business Partner With an SBA 7(a) Loan?
It’s not that it was impossible to use an SBA 7(a) loan to buy out a business partner in the past, but there were certain rules in place that made it incredibly difficult to do.
To get the green light to use borrowed 7(a) funds to finance a partner buyout, your shared business had to be in tip-top shape. To even qualify for the loan, your balance sheet had to display an absolute minimum of 10% equity based on total assets after sale.
As buying out your partner’s interests in the business had to be done via stock purchase, the business equity would often plummet into minus figures, thereby significantly reducing the chances of securing the 7(a) loan. This meant that short of allocating large sums of personal funds to get the business equity out of the red, a buyout wasn’t really viable.
Well, the good news is that in 2018, the SBA decided to relax the rules on this area of borrowing, so now you can source a 7(a) loan without pricey equity injections, but there are still certain criteria that must be met.
- The partner that wants out has to have been an active partner.
- The partner that wants out has to have owned the same or a greater percentage of the business than you for over two years.
- Your business must have had a debt-to-net worth ratio no higher than 9:1 at the end of the last fiscal year and the latest business period.
What does this last requirement mean? It sounds complicated, but it’s actually not that difficult to grasp. All you need to do is calculate total liabilities, and divide it by your total equity.
Even if your business doesn’t quite qualify due to a poorly weighted ratio, as long as the buyer is willing to put down 10% of the total borrowed amount, they can still secure the 7(a) loan.
Securing a 7(a) SBA Loan to Buy Out a Partner - The Process.
Unfortunately, eligibility isn’t the only hurdle you’ll encounter when trying to secure a 7(a) loan to buy out a partner. There are a few other factors to consider and work through before any money can change hands.
Valuing the Business
To establish what the percentage ownership of the exiting partner is worth, the pair of you first have to come to a decision on what the business is worth altogether.
Sometimes, business value is worked into the initial paperwork of the business partnership agreement from the get-go, but as businesses evolve, value and percentage ownership inevitably shift, thereby invalidating the accord.
Oftentimes, no such figure is worked into the original documentation, which makes the process of valuing the business even more difficult.
A common way of starting this discourse is for both parties to note down what they believe the business is worth, then share their evaluations with one another. If the figures are drastically dissimilar, a neutral, third-party evaluator must be brought into the equation to find the likely value of the business.
Form of the Buyout
There are four ways to go about purchasing your partner’s stake in your business, so you and your partner will need to decide which of them works for both of you.
- Lump-Sum Buyouts
This is a one-time payment that covers a partner’s entire business equity. It’s quick, it’s painless, and everyone can move on with their lives, but it can be mighty expensive.
Earn-outs are a more gradual approach to buying out a partner. Rather than receiving a lump-sum payment, they receive it as incremental payments, and they have to stay with the company for a transition period.
The sum of each payment, and the overall amount the partner can exit with, is tied into the performance of the business. If it does well, they get more. If it does poorly, they get less.
- Gradual Buyouts
You can think of a gradual buyout as a hybrid of the first two methods. Much like the earn-out method, an exiting partner will receive the payment over time, but they can leave the firm immediately as if it were a lump-sum payout.
- Equity Buyouts
This involves a new partner joining your business and buying out the exiting partner for you.
Challenges in Securing an SBA 7(a) Loan for Buying Out a Partner
The exiting of a partner is no small event, one that can have truly seismic consequences, which is why lenders will always be a little hesitant to invest.
To give yourself even the slightest chance of securing a 7(a) loan for buying out your partner, you need to prove to the lender beyond a reasonable doubt that you have what it takes to run the business on your own. Alternatively, bringing in another partner with experience in the relevant fields can help sweeten the deal for lenders.
Whether you decide to go it alone or recruit a new partner, you need to have an airtight succession plan penned out before you even contact the SBA.
As you now know, the SBA is sympathetic when it comes to fracturing business relationships, but even though they changed the rules to make 7(a) acquisition easier in these trying circumstances, securing one is no slim feat.