Partnership Buyout Agreements

Many new partners neglect to make a buy-sell agreement—also called a "buyout agreement". But these agreements are critical to protecting your investment in a partnership. When you create buyout provisions for your partnership agreement, you and your partners will be prepared if one partner wants to leave the business, or worse, dies, goes bankrupt, or gets divorced.

What Is a Buyout, or Buy-Sell, Agreement?

Contrary to popular belief, a buy-sell agreement isn't about buying and selling companies. A buy-sell agreement is a binding contract between business partners about the future ownership of the company. Because of this confusing terminology, we'll use the term buyout agreement from now on.

A buyout agreement can stand on its own or it can be several provisions in your written partnership agreement. The agreement controls the following business decisions:

• whether a departing partner must be bought out
• what price will be paid for the departing partner's interest in the partnership
• who can buy the departing partner's share of the business (this might include outsiders or be limited to other partners), and
• what other events could trigger a buyout.

You can think of a buyout agreement as a sort of "prenuptial agreement" between you and your partners: Although you might think that your partnership will last as long as you all shall live, the buyout determines what'll happen if things don't go exactly as you planned. (For more information, see our FAQ on partnership buyout agreements.)

Why Do You Need a Buyout Agreement?

Your buyout agreement will instruct you and your partners on how to handle the sale or buyback of an ownership interest when one partner's circumstances change. Without one, if one partner quits to move to another city or leaves to start another business, your partnership might, by law, be dissolved. A dissolution of your partnership could force you to divide any assets and profits among the partners and to decide whether to start a new company with the remaining partners.

Even if your partnership doesn't end, you might still have an argument over whether you should buy out the departing partner's ownership interest, and for how much. If you don't anticipate and plan for circumstances like these, you risk serious personal and business disputes—perhaps even court battles and the loss of your business.

In addition, a buyout agreement can control who can buy into the partnership. Otherwise, you might be stuck sharing control of the company with someone you'd rather not run a business with.

What Are the Terms of a Partnership Buyout Agreement?

Your agreement should address when a partner can or must be bought out of their partnership interest and the procedure to buy out the partner. If you decide on these issues before your partnership faces a buyout, you can feel more comfortable that the process will be reasonably fair and relatively free of any additional hostility or resentment. (For more information on how to manage your partnership, read our article on partnership FAQ.)

Events Covered Under a Buyout Agreement

Typically, the events that trigger a buyout of a partner's interest under a buyout agreement are:

• the retirement or resignation of a partner
• an attractive offer from an outsider to purchase a partner's interest in the company
• a divorce settlement in which a partner's ex-spouse stands to receive a partnership interest in the company
• the foreclosure of a debt secured by a partnership interest
• the personal bankruptcy of a partner, or
• the disability, death, or incapacity of a partner.

Who Can Buy the Partner's Interest

Once a buyout is triggered, you need to know who can buy the departing partner's partnership share. There are typically three potential buyers for a partner's share:

• the partnership itself
• another partner, and
• an outside party.

Your buyout terms can be vague so that anyone can buy the partnership share. Alternatively, your agreement can be restrictive so that only the partnership or other partners can buy the share. A more common option for partnerships is a mix of the two.

Many partnerships allow for anyone to buy the exiting partner's interest but give the partnership or partners the right of first refusal to the partner's interest. The right of first refusal means that the departing partner has to offer their share to the partnership or partners first. If they decline to purchase the share, then the partner can sell their interest to someone outside of the partnership.

For example, suppose Alvin, Simon, and Theodore have a partnership together. Alvin decides to pursue other interests and leaves the partnership. The three partners have an agreement that the other partners have the right of first refusal to a partner's share if a partner decides to leave. So, Alvin offers his share to Simon and Theodore first as required by their buyout agreement. But both refuse to buy Alvin's share. Alvin then sells his share to Brittany, and she becomes the new partner.

The right of first refusal protects everyone's interests. If the remaining partners don't want an outsider buying into the partnership, then they have a way to prevent that scenario by buying the partner's share themselves. But the departing partner also isn't trapped trying to sell their share to partners that don't want to or can't buy them out.

The Value of the Partner's Interest

Once you've determined who can buy the share, you need to settle on a price. You don't have to determine a fixed number right now. It can be hard to throw out a fair number when your partnership is growing and you're not sure what the business's true value will be when a partner leaves.

For example, suppose Donna and Jackie start a partnership where they share equally in the company. At the start of the business, each share is valued at $10,000. But they're already predicting significant growth and they expect that in the next five years, each share will be valued at $50,000. So, in their buyout agreement, Donna and Jackie specify that if one of them leaves, they must sell their share of the partnership to the other for $50,000. Their partnership is extremely successful, and after five years Jackie wants to leave the company to pursue other interests. At the time of Jackie's departure, her share is valued at $80,000. It would be unfair then to make Jackie sell her share back to Donna for $50,000—significantly less than what it's worth.

To avoid landing on an unfair fixed price, many partners decide to opt for a buyout provision that values the partner's share at the time the partner leaves based on a certain calculation method. By using this approach, the departing partner can feel secure knowing that they'll be fairly compensated for their interest.

Usually, the price for a partner's share is determined either by:

• the business's current value (if liquidated)
• the business's equity (or "book") value—that is, its value after subtracting its liabilities from its assets, or
• the present value of a future flow of distributions.

If a partner has died, then their estate or heir will take over the deceased partner's responsibilities. So, if you plan to buy out the deceased partner's share, their estate or heir will need to be compensated based on the terms of the buyout agreement.

Whatever you and your partners decide, it's critical that everyone is satisfied with the choice. The value of a partner's share can be the most contentious part of the buyout process if there's any disagreement over it.

Speaking With a Business Attorney

If you have experience drafting business contracts or forming partnerships, you can probably create a buyout agreement yourself. But if you and your partners can't agree on terms or you're not sure which terms best fit your business's needs, you should talk to a lawyer who has experience working with partnerships. They can help you negotiate with your partners and draft an agreement for you.

If you want to create an agreement yourself but need some direction, check out Business Buyout Agreements: A Step-by-Step Guide for Co-Owners, by Anthony Mancuso and Bethany K. Laurence (Nolo). This book has a fill-in-the-blank buyout agreement and instructions on how to incorporate it into your partnership agreement.