How To Buyout A Business Partner (Part 2)

In Part One of our Buying Out a Business Partner series, we covered the signs it’s time for a buyout, how to prepare for negotiations, and key terms to address. In this second installment, we dive deep into the mechanics of the transaction itself. You’ll learn the pros and cons of different buyout structures, strategies for securing financing, and how to protect your business from risks during and after the buyout. Whether you’re navigating a 50/50 split or consolidating ownership among several partners, these insights will help you structure your buyout with confidence and clarity. Let’s dive in where the rubber meets the road: structuring the buyout.

There’s more than one way to buy out a business partner, and the optimal structure can depend on your business entity type, tax considerations, and financing method. Broadly, here are the common structures and considerations.

Direct Purchase vs. Company Redemption

If your business is a corporation or LLC, decide whether the remaining owner(s) will personally purchase the departing partner’s interest, or the company will redeem (buy back) the interest. In a direct purchase, you (or the other continuing owners) pay the selling partner and end up owning their shares or membership units proportionally. In a redemption, the company itself pays for the partner’s shares and cancels them, which in effect increases the percentage ownership of the remaining owners.

Each approach has legal and tax implications. The choice can affect how the transaction is taxed; a redemption might be treated as a distribution by the company for tax purposes, whereas a cross-purchase might be a capital asset sale between individuals. This is certainly a topic best suited for discussion with your CPA or tax advisor.

For LLCs taxed as partnerships, a purchase of a membership interest might trigger a termination of the partnership for tax purposes if a majority interest changes hands. If the business has or can borrow the funds, many small companies opt for a redemption to keep things simpler with one buyer instead of multiple. However, if the remaining owner is the one with financing, a cross-purchase might be necessary. Either way, paper it properly so that ownership records and tax reporting follow the chosen path.

Asset Transfer vs. Equity Only 

The ultimate goal is for your partner to give up their ownership and in exchange receive compensation in one or more forms. While most of that value might be cash or a note, consider if any specific assets should be carved out. We touched on this in Part One’s terms: sometimes carving out assets can be win-win in that the exiting partner takes something they want and that you don’t need.

If you decide to transfer assets as part of the deal, figure out how to do it efficiently. Small assets can be transferred at closing with a simple bill of sale. Titled assets, such as vehicles or real estate, will require formal title transfers and maybe government filings. Be mindful of taxes because transferring real estate could incur transfer taxes, for example, or removing an asset from the company could have a tax effect if its value exceeds its basis.

One creative structure we established on one buyout deal is for the company agreeing to pay off a truck that it was leasing, which the partner was driving for personal use, then post-buyout, agreeing to transfer ownership of that truck to the partner for free. Essentially, the business cleared the debt on that asset and gave the asset to the partner, which became part of his payout package.

This illustrates how you can mix debt assumption and asset transfer into the deal structure. If you go this route, clearly state who is responsible for what and always clarify timing (e.g., “within X days after closing, Company will do Y.”) As mentioned before in Part One, include “as-is” language and releases for any assets the partner takes, to prevent future squabbles about their condition or liabilities.

Financing Arrangements and Third-Party Approvals

If the buyout requires outside financing, such as a loan from a bank or investor, build that into the structure timeline. However, is the closing of the buyout contingent on the buyer securing a loan? If so, the agreement might contain a contingency clause.

Be cautious about signing a binding agreement to buy out your partner without a financing out, unless you’re absolutely sure the financing is lined up. Otherwise, you could be on the hook personally if the loan falls through. Alternatively, you might sign the agreement, but delay the actual closing date to a future date to give time for financing.

Also, consider any third-party consents that might be structurally required. For instance, if your business has an operating line of credit or investor agreements, they might require lender or investor approval for a change in ownership. In heavily regulated businesses, like some franchises or licensed operations, the franchisor or licensing board might need to approve an ownership change.

Make sure to conduct due diligence by reviewing loan agreements for any clause about “change of control” or share transfers, major contracts for assignment restrictions, and so on. Structurally, you may need to obtain these consents or waivers as a condition to closing the buyout. In one scenario, if a required consent can’t be obtained in time, the structure might involve keeping the departing partner on in name only, with an agreement to transfer ownership once consent comes. However, this is complex and ideally avoided. It’s much cleaner to gather necessary approvals in advance if at all possible.

Installment Payment Structure and Security

We discussed promissory notes in Part One. Now in the execution phase, if your partner buyout is being paid over time, consider securing the arrangement to avoid future defaults.

Structurally, this could mean the buyer giving the seller a security interest in some business assets until the note is paid in full, or the buyer personally guaranteeing the payments. This effectively collateralizes the “business partner payout.” The selling partner may sleep easier knowing the payment is secured, and the buying partner might negotiate a lower price or interest in exchange for offering security.

All of this would be documented in a security agreement or UCC filing at closing, alongside the note.

From a structural view, if the company is paying, ensure that the board and shareholders approve the company incurring this debt. If you’re the one buying individually, make sure you can actually fulfill the payments from your salary or distributions of anticipated profits.

If the company will essentially fund the payout from future cashflows, the seller, as a protection for itself, may want to insist upon a clause in the agreement restricting certain financial actions until the seller is paid off. An example of such a restriction could be no substantial bonuses to remaining owners or no new debt until the seller is paid off. Conversely, the buyer may want the right to accelerate payment and save interest if things go well.

Tax Considerations of Structure

It’s worth another reminder to plan for taxes in how you structure the deal. The structure can affect whether the departing partner’s payout is taxed as a capital gain, or as ordinary income or a dividend.

It can also affect the company’s taxes. For example, interest on a promissory note is tax-deductible to the payer, but principal payments are not. If the company redeems stock, in some cases it could be treated as a dividend distribution to the seller if certain IRS criteria aren’t met for sale treatment).

The specifics are beyond the scope of this article, but a consultation with a tax professional on the front end can save thousands of dollars later or prevent an unintended tax hit. Structure the transaction in a way that’s efficient: sometimes slightly adjusting whether the company or an individual serves as the buyer, or the payment timetable can change the tax outcome. Also consider sales tax on any asset transfers, and if the partner is transferring shares, whether any state stock transfer taxes apply. (Such taxes are rare, but a few local jurisdictions and states have them.)

If your company is an LLC, you might need to issue a final K-1 to the departing member for the year of sale and allocate income properly between pre-sale and post-sale. Basically, involve your CPA to make sure Uncle Sam’s cut is minimized and no filing obligations are missed.

In summary, choose a structure that aligns with your financial capabilities and legal requirements. Document clearly in the buyout agreement who is buying, what is being transferred, and how everything will happen. This is another area where your attorney’s input is invaluable because they can draft the agreement to reflect the exact structure and include fallback provisions if any structural element, like a needed consent, is pending. A well-structured deal sets the foundation for a clean execution. Now let’s look at how to protect the business as you implement it.

A partner buyout can introduce a variety of risks, some existing and some new. Part of your planning must include steps to mitigate those risks and shield the business (and yourself) from liabilities as you transition. Let’s break down key risk areas and how to handle them:

Restrictive Covenants to Protect the Business

In Part One, we covered non-compete and non-solicitation provisions as key terms. Now, at this execution stage, ensure these provisions are properly executed and enforceable. The risk here is the ex-partner competing or raiding your employees and/or clients, thereby damaging the business you just paid for.

To mitigate: keep the non-compete restrictions reasonable to avoid the risk of a court ruling it unenforceable due to being overly broad). For example, a one-year or two-year non-compete in a defined territory related to your service area is more likely to hold up than, say, a 5-year worldwide ban.

The agreement should explicitly give you the right to seek an injunction if the covenant is breached in order to make it easier to go to court and stop competitive behavior without proving monetary damages that can be hard to quantify. Also, include an acknowledgment by the seller that the restrictions are reasonable and necessary to protect legitimate business interests. Such acknowledgments, often with an option for a court to modify the covenant rather than void it, strengthen your hand if there’s a dispute. 

Confidential Information Security

Make sure that as your partner exits, they return or securely dispose of any confidential business information in their possession. This could be client lists, trade secrets, strategic plans, login credentials, etc. The buyout agreement can require that all company documents and data be returned at closing, and that any remaining access to email accounts, shared drives, and the like be terminated. Change passwords on sensitive accounts and systems the partner used.

Essentially, perform a mini “offboarding” as you would with a key employee departure, but perhaps even more thoroughly. The confidentiality clause we discussed in Part One will obligate them not to use or disclose any of the company’s confidential info post-departure, but you should nevertheless take practical steps to remove their access to that information. This reduces the risk of information leaks or sabotage.

Non-Disparagement & Communication Plan 

Reputation risk is real; you don’t want the departing partner bad-mouthing the business. Likewise, they likely don’t want you to tarnish their name either.

The mutual non-disparagement clause creates a legal deterrent, but equally important is how you handle the messaging of the separation. Discuss and agree on a public narrative: for example, a joint statement or understanding that “Partner X decided to pursue other opportunities, and we parted on amicable terms. We wish each other well.”

Even if that’s not 100% reflective of the behind-the-scenes drama, presenting a united, professional front will protect the company’s image with customers, suppliers, and employees. If one partner suddenly “disappears” without explanation, rumors can start – which can harm morale and client confidence.

To mitigate this, have a plan to communicate the change to key stakeholders. Perhaps send a letter or email to major clients letting them know of the change in ownership, reassuring them of continuity and introducing the point of contact going forward. When you control the message, you reduce the risk of gossip or negative assumptions. Further, by agreeing with your ex-partner that neither of you will disparage the other, you further ensure that the transition isn’t marred by a PR battle.

Removing Former Partner’s Authority and Access

This action is critical for risk management. Once the buyout is effective, immediately update all relevant permissions and authorities. That means: remove the ex-partner as a signer from bank accounts, credit cards, lines of credit; take them off as an authorized person on any company contracts or leases; revoke any powers of attorney they had for the business; and notify key vendors if they used to have ordering or spending authority on accounts.

It might feel awkward to “lock someone out” of what used to be partly their company, but it’s necessary. There are horror stories of ex-partners still being able to incur debt or access funds because paperwork wasn’t updated. Don’t let that happen to you. Work with your bank to get new resolutions or signature cards in place promptly. (Your attorney can often supply a certified board resolution or consent removing the partner and appointing new authorized persons.)

Change alarm codes, building access cards, and so on, if they had physical access to facilities. These actions not only protect you from unauthorized transactions, but it’s also a signal to both of you that the separation is real and final, helping avoid boundary confusion.

Handling Joint or Personal Guarantees

As noted earlier, many small businesses involve personal guarantees. If your ex-partner has guaranteed any company debts, leases, or contracts, you have a continuing risk until those are resolved.

Ideally, the partner is released at closing, with that release confirmed in writing by the creditor. If not, your agreement likely says you’ll try to get them released. Meanwhile, what if something goes wrong and those creditors come knocking on the ex-partner’s door for payment?

To mitigate, your buyout agreement might include an indemnification where the buyer agrees to indemnify the ex-partner if the ex-partner ends up having to pay a company debt that they had guaranteed but which was supposed to be the buyer’s responsibility after the buyout.

In plain English, if your former partner gets stuck paying off a business loan because the business couldn’t, and the bank wouldn’t release them as guarantor, you promise to reimburse them. This kind of indemnity can give the departing partner peace of mind to go along with the deal.

From your perspective as the remaining owner, the real solution is to refinance or eliminate those jointly guaranteed debts as soon as possible so you’re not entangled. Perhaps you plan to refinance the company’s loan in just your name within a certain timeframe. If so, reflect this in the buyout agreement.

One creative approach we have seen some partners utilize is to hold a portion of the buyout price in escrow or structured payments until a guarantor release is obtained, as an incentive to get it done and to have funds to pay off the debt if needed. The key is to actively manage the situation so that, a year later, you’re not still getting calls about a debt. Make it part of your post-closing checklist to revisit all guarantees until they’re resolved.

Unknown Liabilities and Indemnifications

Despite all the reps and warranties a buyer can secure in the buyout agreement, sometimes skeletons come out of the closet after the partner leaves. For example, maybe an audit triggers a tax penalty for a year when your ex-partner was handling finances, or you discover a lawsuit brewing from some claim that arose last year.

This is where the indemnity clauses come into play, as well as potentially why you might have a portion of the payout held in escrow or earn-out. If your partner promised “there are no undisclosed liabilities” and then one surfaces, you may need to pursue them to cover it. That’s obviously a last resort. As such, try to minimize this risk beforehand but conducting due diligence.

Even though this isn’t an arms-length acquisition (you already co-own the business) take a moment to inspect all areas that your partner managed. If they handled all the bookkeeping, maybe have an outsider review the books for any irregularities. Check that taxes have been filed and filed correctly, that key vendor accounts are current, and so on. The more you verify now, the less you’ll have to worry about unknowns.

Nevertheless, maintain those indemnity clauses for safety. And consider an insurance angle: if there’s potential liability, such as product liability risk or some other pending legal claim, consider keeping an insurance policy tail or ensuring that coverage continuing is part of your risk mitigation.

Compliance and Licenses 

If your business requires licenses, such as a contracting license, professional license, or any operational permit, and if the departing partner was the license holder or qualifier, manage this proactively. You might need to apply to transfer the license or designate a new qualifying individual.

Think about whether your partner’s exit triggers any such issue. If you’re losing a license or certification, plan to hire a qualified individual that can fill that void, or obtain a license or certification yourself.

Include a covenant in the agreement if you need the partner’s cooperation for a while, like signing off on projects until you’re licensed or remaining the license holder of record. If the partner is not open to such an arrangement, you might need to delay the closing until you sort out the license.

In short, failure to address this kind of regulatory compliance could lead to a nightmare scenario in which you buy the company, but cannot legally run it. So add this to your checklist: review any licenses, permits, or certifications tied to the departing partner.

Employee and Customer Retention

While not a legal risk per se, there’s an operational risk that when your partner leaves, some employees or customers loyal to that partner might leave too. Mitigate this by having a transition plan. For example, maybe the partner can say her goodbyes on good terms, or even introduce you or a new hire to their key clients to reassure them the service will continue. If certain employees of highest value to your company are very close to that partner, talk to them, encourage them to stay, and perhaps offer incentives.

Non-solicit clauses prevent your ex-partner from actively poaching them, but it doesn’t prevent folks from feeling uncertain and leaving on their own. Open communication and a bit of rallying the troops about the company’s future under your sole leadership can go a long way.

You want to project stability and optimism to counteract any jitters. On the customer front, let them know that the business is continuing strong. Consider reframing the departure as “we’ve streamlined our ownership for even more focus on you, the customer” or some other positive spin. By proactively reaching out to your customers, you control the narrative and reduce the risk of losing valuable relationships in the transition.

In essence, addressing risk in a partner buyout is about thoroughness and vigilance. Legally, button up your contracts with non-competes, indemnities, and clear obligations. Practically, take steps to secure finances, information, and people. If you’ve covered these bases, you’ll greatly diminish the “what if” worries and be able to focus on running the business post-buyout rather than fighting fires caused by the buyout. Speaking of post-buyout, let’s talk about how to make that transition as smooth as possible.

Structuring your business partner buyout is a balancing act between protecting your current interests and setting up your company for a strong future. By selecting the right deal structure, securing financing, and building in safeguards against potential risks, you’re laying the groundwork for a clean and successful transition.

Remember, no two buyouts are identical, and the stakes are high. An experienced corporate attorney can help you anticipate legal pitfalls, negotiate favorable terms, and ensure the deal is airtight from both a legal and financial standpoint. The right professional guidance can mean the difference between a smooth transaction and a costly, drawn-out dispute.

In Part 3, the final installment of our “How to Buyout a Business Partner” series, we’ll walk through the crucial steps that follow the buyout: managing the post-buyout transition, updating your operational structure, retaining key clients and employees, and finalizing the legal documentation that cements your new ownership.

If you’re preparing for a partner buyout, or want to explore your options, contact our corporate law team today. We can help you navigate the process with confidence and protect your business at every step. 

 

This publication is provided by Amini & Conant, LLP for educational and informational purposes only and is not intended and should not be construed as legal advice. Should the reader seek further analysis of the subject matter or answers to specific questions about the subject matter, please contact the author at joel@aminiconant.com. This publication is considered advertising under applicable state laws.

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