How Would You Finance a Buyout of Your Partner?
One of my clients has a tough decision to make: Is he willing to use his home as collateral?
By Ami Kassar
My client needs to buy out a partner who owns a third of his business. The business is valued at $3 million dollars, so the total buyout amount is $1 million.
We can offer our client an SBA loan for the transaction. The loan would amortize over 10 years at a variable interest rate of 10 percent. There is a monthly payment of $13,215. Because the loan amount is over $500,000, the lender will require a lien on my client’s home. There is no prepayment penalty.
The thought of this loan paralyzes my client. He is highly risk-averse and has never had debt before. He does not like the idea of owing the bank money, and he is petrified of putting a lien on his house. So, he has come up with another plan. He will propose to his partner that he will pay him over three years at an interest rate of 6 percent. On this basis, his monthly payment would be $30,422.
Does an interest rate of 6 percent sound more appealing than 10 percent? Of course it does! Who in their right mind would want to pay the higher rate? However, the answer to this question may not be as obvious as it seems.
When you take out a loan, you add an obligation to your balance sheet. When you think about a balance-sheet strategy, it’s best to think as if you were coaching a football team. To be successful, you need both a good defensive strategy and a good offensive strategy. In other words, you want to be structured flexibly to deal with unexpected crises and opportunities.
In this case, my client has to decide between a monthly payment of $13,215 or $30,421. That’s a considerable difference. We all have short memories. When things are going well, the larger payment might seem fine. But if the world changes, as it so often does, the bigger payment could become a challenge. Is it worth this risk to avoid a lien on your house? Remember that his partner will most likely require him to sign a promissory note, meaning he would still have a lien on all of his assets.
I asked my client if his partner would take a 10-year note at the full 10-percent interest. That way, the economic terms between the two offers would be the same. If he can’t get there with his partner, he will have to evaluate the risk of the increased cash flow pressure versus the risk of losing his house.
I don’t think there’s a right answer, but if you were in his situation, what would you do? And why?
Ami Kassar is CEO of MultiFunding.
