Steps to buying out a business partner

[Clara S.]

One year ago I bought a 4plex, my partner did the renovations in exchange for 40%, he did great work.

I am 60%, he is 40%. The title is in my name, I put 20% down. We have an LLC, we operate medium term rentals in the building.

Unfortunately, it’s becoming increasingly difficult to work with him. He’s becoming unprofessional and toxic. He’s mentioned being open to getting bought out and now I am seriously considering it since I can’t imagine this going on for more years.

Where do I start? This I my first investment with an partner and my second investment ever. I would prefer to keep the building.

[Eliott Elias]

Get with an attorney on this. Keep emotions to the side and focus on the task at hand, it may not be in your best interest to buy him out 

[Mitchell Zoll]

Start with your Operating Agreement (Company Agreement if you are in Texas).  That should have provisions for how one party will buy the interests of another.  One component you will likely need to have will be a valuation of the company.  If your books and assets lists are up to date this should be pretty easy for your CPA to provide.  Look to your annual/quarterly meeting minutes to assess any prior discussions or decision about assets or their valuations and your business plans. You will want to make sure you document the transfer, update any vendors/contracts to let them know the new owner is no longer part of the company, and update state records to show the new ownership. 

[Chris Seveney]

@Clara Settje

As Mitchell mentioned, start with the operating agreement. Hopefully that has language on how to buy out the other, typically if a buyout is not recognized then your best bet would be to sell the asset.

If the OA is silent, First question is, have you asked him what it would take to buy him out? If he has not given a number, try and agree on how to figure out the price? Is it through an appraisal, a BPO, realtor.

Sometimes it may be best to have a third party involved to mediate if it gets ugly

[Scott Mac]

What the other have said, plus I will give a little example.

For instance:

Property current market value = $100,000

Clara = 60% owner value of her ownership = $60,000

Mr. X = 40% owner value of his ownership = $40,000

In super simple terms, Clara writes a check to Mr. X for $40,000 (or whatever he holds out for if allowed to do this by the Operating agreement = $50,000,000).

The way to do buy him out, and to figure the amounts (should be) set forward in the Operating Agreement (if you have one), as well as how to handle any printed Certificates (shares, units memberships, etc..).

If you have no Operating agreement it might boil down to state law and case law of the LLC state or your state.

The problem might not be how much to pay (the valuation), but what else needs to be done red tape wise to make it happen--legally.

Good Luck!

[Basit Siddiqi]

Go to the operating agreement and read what the exit plans are.

I would also ask him first what he is expecting to be brought out before going to the attorney's. It may be cheaper that way.

Also, the fact that the property is held in your name is a huge no-no when structuring partnerships.
What would happen if something were to happen to you.
Your partner would have a difficult time getting any of the value of the real estate.

Better to hold property within an entity.

[Scott Mac]

Another note to my formula, you need to factor in the amount owed on the structure.

The formula assumes 100% free and clear.

The amount owed may be split in a different percentage in your agreement than the asset value.

You will also have profits and losses and depreciation to split up.

As the others have said...attorney.

[Allan C.]

@Clara Settje I suspect that your OA doesn’t have many exit clauses written in, if you even have an OA. Since this is a business you cannot simply look at the property value to determine how much the buy-out is. Most businesses are valued on future cash flows that are discounted back to today dollars.

For example, if his share of the business creates $10k/yr earnings before tax, he may ask for a 6x to 10x multiple…. meaning his buy-out is $60k to $100k. He may ask for a 20x multiple, and this is where the negotiation gets complex. Each person will value future cash flow differently so you’ll need to come to a fair compromise.

[Clara S.]

Thank you for the responses! 

If the person is not holding up their end of the agreement per the LLC, does that give you more negotiating power?

[Ryan Seib]

The operating agreement (OA) is the most important factor. If it is silent on anything, the state has default rules for how to do this.

Usually, the partners need to vote to dissolve and wind up the LLC per state law. The law and OAs have a rough formula for how to do this. If you have a good OA, it might even have buy-sell provisions in it. For your next partnership, have a robust buy-sell negotiated with your partner from the start.
Another option is one of you to buy out the other. If you wind up the LLC under default or vague LLC provisions, it may trigger a sale of the LLC's property (your real estate). You probably want to keep it.

[Mitchell Zoll]

Quote from @Clara S.:

Thank you for the responses! 

If the person is not holding up their end of the agreement per the LLC, does that give you more negotiating power?

Depends on how they are failing in the agreement. If it is managerial or “employee” type roles, the LLC can “fire” them but it doesn’t forfeit or void their ownership interests. And now you have a member that doesn’t have to work but can expect 40% of the profits from your efforts