Installment Buy-in to a Business
By Matt Dickstein
Click on a heading for more articles ⇒
There are two basic elements to a buy-in: the amount of the buy-in price, and the time over which the price is paid. In this article, I discuss the latter element– buy-in to a business in installments over time. I leave the first element, the amount of the buy-in price, to certified appraisers and the like.
The new shareholder can pay the buy-in price all up-front, or in installments over time. Payment up-front is the easiest structure. If the purchase price is low, paying it in one lump sum isn’t a problem. If the purchase price is high, the shareholder can try to get financing. A bank’s willingness to lend depends on the industry, for example, banks love medical, dental and veterinary practices. If financing is available, I prefer up-front payment of the buy-in price. Simple is good.
That said, most businesses structure buy-ins over time, in installments. Usually the rationale is to make things easier for the new shareholder. Other times it’s to build in a probationary period during which the business can easier buy-back the new shareholder’s shares if things don’t work out.
There are two ways to structure an installment buy-in. The first is a simple installment purchase, almost like buying sharers based on a vesting schedule. The second is for the new shareholder to buy all of the shares with a promissory note, but subject to a “reverse” vesting schedule if the new shareholder doesn’t pay on the note. I’ll discuss both below.
Here the new shareholder purchases shares in installments over a term of years. The business retains the right to take back the shares if the new shareholder doesn’t complete the entire installment purchase. The buy-back purchase price likely will be the new shareholder’s original price paid plus market interest. Once the new shareholder completes the entire installment purchase, the business’s Shareholders Agreement governs the buy-back of the new shareholder’s shares, and here the new shareholder is treated the same as the old shareholders, with the buy-back price likely being some variant on fair market value.
Small businesses usually put the new shareholder on the board of directors from day one, even though it will take the new shareholder a few years to get to full ownership. Small businesses do this to bring the new shareholder into the team faster.
Consider the following example. The new shareholder purchases 25 shares each year, for 4 years, for a total of 100 shares at a total purchase price of $100,000. If the new shareholder fails to complete the total purchase of 100 shares for whatever reason, the business takes back those shares that the new shareholder actually purchased by returning the purchase price plus interest, thereby rewinding the parties back to the beginning.
|Year||Payment||Shares Bought||Shares Owned||Buy-Back if New Shareholder Fails to Pay an Installment|
|1||$25,000||25||25||After year 1, all 25 shares bought back|
|2||25,000||25||50||After year 2, all 50 shares bought back|
|3||25,000||25||75||After year 3, all 75 shares bought back|
|4||25,000||25||100||After year 4, all 100 shares bought back|
Purchase with Promissory Note
Here the new shareholder uses a promissory note to pay the purchase price for all shares. Because the new shareholder “pays” the entire purchase price up-front (by virtue of the note), the new shareholder gets ownership of all shares. But because the new shareholder actually pays cash for the shares over time under the note, the business retains a buy-back right in case the new shareholder doesn’t complete payment. Again, for shares that the new shareholder actually bought under the promissory note, the buy-back purchase price can be the new shareholder’s paid-in price paid plus interest. Shares that the new shareholder didn’t buy under the note are washed out, that is, the business returns the money actually paid, which is $0. Once the new shareholder has completely paid her note, the Shareholders Agreement governs, as I explain above.
If we use my same example above, it would look like this:
|Year||Payment||Shares Paid for thru Note||Shares Owned||Buy-Back if New Shareholder Fails to Pay Note|
|1||$25,000||25||100||After year 1, all 100 shares bought back, but cash payment only made for 25 shares|
|2||25,000||50||100||After year 2, all 100 shares bought back, but cash payment only made for 50 shares|
|3||25,000||75||100||After year 3, all 100 shares bought back, but cash payment only made for 75 shares|
|4||25,000||100||100||After year 4, all 100 shares bought back and paid for in cash|
There are many variations on the above structures, but enough said already.