Buying a Business with a Partner (Part 1)
This is the first of a two-part series on partnerships.
Buying a business is a big undertaking. It takes significant resources. There’s substantial risks involved. Yet despite this, self-funded searchers largely choose to proceed alone. In contrast to the traditional searcher, who forgoes a majority equity stake in exchange for investor capital, self-funded searchers are focused on ownership. They are willing to personally guarantee a multimillion-dollar loan in return for control.
Yet for some self-funded searchers, it makes sense to partner with a like-minded soul. That way, they can share the burden of buying and operating a business.
For this reason, it's worth thinking through the issues raised by a partnership. Who gets to control what and when? What happens if there is a dispute? Let’s look at those issues and more.
Why Buy a Business with a Partner?
Resources
Buying a business requires capital. To secure an SBA loan, the buyer must bring 10% of the purchase price to the deal. Under current SBA Standard Operating Procedures (SOPs), a seller note can count towards 5%, but only if it's on full standby (no payments towards interest or principal) for the duration of the loan (usually 10 years).
Ten percent is a lot. If you want to buy a $2,000,000 business, you need $200,000 in liquid assets. If you only have $100,000, a partner could help.
Additionally, buying a business requires time. I regularly speak with searchers who have just gone under LOI. Most say the same thing: I didn’t think it would take this long.
Reviewing a never-ending list of businesses for sale. Cultivating relationships with brokers. Cold calling to generate off-market leads. These are no small tasks. You will be able to complete them quicker with a partner than if working alone.
Expertise and Networking
Sir Richard Branson is one of the most successful entrepreneurs of his generation. But he is terrible with numbers. And for that reason, he always has a strong numbers guy on his team.
You too have strengths. You also have weaknesses. Working with a partner who brings different strengths to the table can be an advantage, particularly if those strengthens match your weaknesses.
You and your partner will also have different professional networks. By combining those networks, you'll have more people to turn to when you need advice or money. And that can only be a good thing.
Structuring Considerations
As stated above, buying a business is a big undertaking. To close a deal, you'll have to resolve many issues. And one of the biggest issues you'll face is what sources of funds to use to buy your business (often referred to as your capital stack).
I've written about this before.
One option is to ask the seller to retain a minority stake in the business. By buying less than 100%, you'll reduce the purchase price. Moreover, you'll end up with perhaps the most qualified partner of all. After all, no other potential partner knows as much about the target business as the seller.
Partnering with the seller reduces transition risk. The seller has a vested interest in your success (to maintain the value of her minority stake). She can also stay involved in the business in the years ahead (otherwise, SBA SOPs prevent the seller from staying involved for more than a year). These are good things.
Just note that because of recent changes to the SBA SOPs, having the seller retain equity is harder than before. The seller can only retain equity as part of a stock deal; the seller cannot roll equity as part of an asset deal. And the seller must guarantee the SBA loan for two years.
There are other considerations. The seller cannot help you with the search or the 10% equity injection. But for some, partnering with the seller can be a smart move.
What Type of Partnership to Pursue?
So you’ve decided to buy a business with a partner. The next step is to decide how to partner.
Don't worry. It's not as complicated as it sounds. In essence, partnerships take one of two forms.
Equal Partnerships
Majority-Minority Partnerships.
1. Equal Partnerships
In an equal partnership, each partner hold the same amount of equity. If there are two partners, as if often the case in the context of a self-funded search, each holds 50% of the equity.
Accordingly, control over the partnership is also equally split. No one partner holds a decisive vote. Consensus drives decision making. Things don't get done unless both partners agree.
The advantage of this setup is that you can avoid an awkward question: Who gets to be in charge? But that is where the advantages stop.
After all, while decision making via consensus sounds great in theory, the reality is it's great until it's not.
When consensus fails, you have a dispute. And if that dispute hardens into a deadlock, you have a problem.
I have a friend who started a business with a partner on an equal basis several years ago. A year in, they disagreed on direction and vision. They couldn’t resolve their differences. Lawyers inevitably got involved.
Suffice to say that one of the partners eventually lost out. And that happens more often than you think.
Deadlocks can occur in other situations--any time there is the possibility of an equal split between partners, there is a chance that a deadlock can occur-for example, where, in a larger partnership, a combination of partners holds 50% of the equity. But this risk is particularly acute in an equal partnership with two partners.
So when venturing into an equal partnership, be aware of this risk. There are ways to resolve deadlocks. But many are heavy handed. We'll look at those mechanisms in Part 2.
2. Majority-Minority Partnerships
In majority-minority partnerships one partner holds a majority of the equity. For example, the major partner holds 60% of the equity to the minor partner's 40%. The majority partner therefore holds decisive control over the partnership.
The minority partner is not necessarily (or even often) a silent partner. But no decision-by-consensus here. It's majority rule.
This structure avoids the risk of a deadlock. But it raises a different issue: What prevents the major partner from taking actions that harm the minor partner's interests?
How does the minority protect itself against the tyranny of the majority (does this remind you of civics)?
First, minority partners have certain statutory rights (rights provided by law).
It depends on the jurisdiction in which the partnership is formed, but these rights generally include: access to information (the right to inspect company books and records); voting rights (the ability to veto certain big decisions like the sale of the partnership); and dissenting rights (the right to demand that the company purchase shares at fair market value in the event of a forced sale).
Partners are also bound by a fiduciary duty towards the partnership. No partner can act in her self-interest if it causes harm to the interests of the partnership as a whole.
Second, minority partners can negotiate minority rights into a written partnership agreement.
In fact, because most statutory rights can be waived or modified, the partnership agreement is often the main source of those rights. And depending on the split of equity, the minority partner may have significant room to negotiate. For instance, a minority partner may want a veto over large spending decisions or the ability of the partnership to take on more debt.
Conversely, the smaller the minority partner's stake in the partnership, the less leverage that partner has to insist on broad protections. In situations where the majority partner holds 80% or more of the equity, the minority partner can expect basic minority protections but not much else. This is often the situation when the seller retains equity as part of the transaction (typically between 5%-20%).
We'll look at minority rights in greater detail in Part 2.
The Partnership Agreement
However you decide to partner, you will need a written partnership agreement.
A written agreement sets expectations. It outlines the roles and responsibilities of the partners and provides for eventualities like death, disability, and disagreement.
In short, a written agreement makes it less likely that your partnership will end in legal strife.
We will turn to partnership agreements in Part 2, including a review of key terms and a discussion of common pitfalls to avoid. But before I go, I want to clarify two points:
First, in this series on partnerships, I am using the term partnership broadly, not in the sense of a legal or tax partnership. Two shareholders of a corporation are partners. Two members of an limited liability company are partners. And so on.
Second, I want to draw a distinction between partnerships in the sense of working with another searcher to buy and operate a business, and seeking money from investors to do the same. The latter scenario raises some of the same issues as a partnership. But it also involves separate issues. I will address investments in a separate article.