Q: My business partner and I each own 50% of our agency. We are getting along well, but we are thinking about the day when one of us wants to leave the business. What formula would I use to buy out my partner if he wanted to leave? Can we have an oral agreement on the formula, or must we put it in a written agreement? Who would pay him: our corporation or me personally? What would happen if we had no agreement and I were not willing to pay him?
A: You are very smart to plan now for the almost inevitable. Many travel agencies and other companies start with two or more partners, but often only one of them is left after a couple of decades.
What often happens is that, because of personality differences, the partners grow to resent one another after many years together. Because of those bad feelings, the partners can't agree on any buyout. So either the partners stay together unhappily, or the departing partner walks away with little or nothing.
Things get worse when the departed partner decides to set up his own agency in competition with yours. Just because he is still technically a shareholder in your corporation does not mean that he is restricted from competing with you.
So it really pays to negotiate a buyout agreement now, when you are getting along. You probably need a lawyer to draft the agreement and a CPA or tax lawyer to advise about the tax aspects of the various buyout options, as there are tax benefits and traps in every option.
If you both agree that the withdrawing partner should get money equivalent to half the value of the company, there are three options for valuation: a preset formula such as one based on a fixed multiple of profits or revenue, a periodic valuation by an agreed-upon expert or an automatic auction buy-sell arrangement.
An automatic auction is a bit of a gamble and is rarely used. To establish the value of the company, the partner who wants to withdraw names a fixed price for his stock. The other partner must then either accept the price, in which case he is obligated to pay that price, or decline, in which case he is obligated to sell at the named price, with the withdrawing partner becoming the sole owner of the company.
After valuation, the second issue is whether the payments are made by you as the remaining partner or by the corporation in redemption of the other partner's stock. From the remaining partner's point of view, the best course is to have the corporation pay and to characterize the payments as deferred compensation deductible by the corporation or payment for a noncompete, or some of both, rather than a repurchase of stock, which is not deductible.
From the departing partner's viewpoint, deferred compensation or payments for a noncompete are ordinary income, which is taxed at a higher rate than the proceeds of a stock sale. So a successful buyout arrangement may call for a combination of ordinary income and capital gains.
Your agreement needs to be in writing because there will be too many details to remember, and if one partner dies, his estate needs to be able to prove what you agreed.
Mark Pestronk is a Washington-based lawyer specializing in travel law. To submit a question for Legal Briefs, email him at [email protected].