A partner buyout funded by the business or funded by you

When one owner leaves, the money can come from two places: the company borrows and buys back the departing owner's interest, or the remaining owner borrows personally and buys it. The price is the same. Almost nothing else is.

The two structures

There are tax consequences to each — basis treatment, the character of the payment to the departing owner, and how any seller note is treated — that turn on facts a general article cannot see. Get them from a CPA before signing. What follows is the cash and credit arithmetic, which is usually decided badly and is usually decidable.

The cash arithmetic

Financed at an illustrative 9 per cent over seven years, the payment on 640,000 is 10,297.01 a month, or 123,564 a year.

The extra pre-tax cost is 58,148 a year, or 47 per cent more, for the identical purchase. Over seven years that is roughly 407,000 of additional pre-tax cash out of the same business.

That arithmetic is why lenders and buyers reach for redemption first. It is not the only consideration, and the tax basis you acquire in a cross-purchase is a real asset. It is, however, the number to put on the other side of the scale.

What redemption does to the balance sheet

A redemption reduces equity by the purchase price. On a company with 640,000 of book equity, buying back half the ownership for 640,000 can leave equity at or below zero while adding 640,000 of debt.

That matters in three concrete ways:

• Covenants. Any existing loan with a tangible net worth, gearing or debt-to-equity covenant may be breached on the day of closing. Read them before you structure the deal.
• Bonding and prequalification. Contractors and anyone who needs a surety are assessed on balance sheet strength. Negative equity can reduce a bonding line at exactly the moment you need it — see how business debt affects your bonding capacity.
• Future borrowing. The next lender reads the same balance sheet. A redemption that leaves the company technically insolvent on book values makes everything after it harder, even when cash flow is fine.

A cross-purchase leaves company equity untouched, because the transaction happens between the owners. The debt appears on your personal financial statement instead, where it affects your guarantee capacity for every future company obligation.

What the lender will require either way

• A full buy-sell or redemption agreement, not a handshake and a wire.
• The departing partner released from guarantees — and this is the step most often missed. Paying someone for their interest does not remove their name from the guarantees they signed, and it does not remove yours from anything. Every lender, lessor, landlord and supplier with a guarantee needs a written release, one at a time.
• A non-compete and non-solicit from the departing owner, with a term the lender considers adequate.
• Key person life insurance on the remaining owner, frequently assigned to the lender.
• Evidence the departing partner is actually leaving. A "partner" who stays on as a consultant at similar money has not been bought out in any way that improves cash flow.
• Interim financials showing the business runs without the departing partner's function, or a hiring plan that shows who will do it.

The decision procedure

1. Compute both structures on pre-tax cash using your actual marginal rate, not a rule of thumb.
2. Check every existing loan covenant against the pro-forma balance sheet after a redemption. If one breaks, ask that lender for a waiver before you commit, not after.
3. Ask your CPA what basis you get under each structure and what it is worth if you sell in five to ten years. That value is the counterweight to the pre-tax cost of a cross-purchase.
4. Decide who guarantees what. In a redemption the company borrows and you guarantee; in a cross-purchase you borrow and the company may have to guarantee upward, which needs consent from existing lenders.
5. Price a hybrid. Company debt for part, a seller note on standby for part, your cash for the rest. Partners are frequently willing to carry paper on their own exit because they know the business better than any lender does.
6. Get the guarantee releases in writing before funds move. List every obligation the departing owner signed, and tick them off one by one.

The failure mode is not paying too much. It is closing with a payment sized for a good year, a balance sheet that no longer supports a line of credit, and a departing partner still on three guarantees.