Leveraged Buyout: Protecting Your Practice with a Mandatory Buyout Clause

Imagine you’re a partner in a CPA firm, and you’ve noticed that one of the founders has started making uncharacteristic mistakes. Even worse, they missed an important filing deadline that cost a long-time client a lot of money. You and the other partners don’t know if the founder is suffering from cognitive decline, is distracted by personal problems, or has simply lost interest in staying as involved in the practice as they’ve been in the past.

You and the other partners have decided to talk with the founder about the situation and encourage them to sell their part of the practice. But what if they aren’t willing to go? You don’t want them to harm the practice any further, and you expect it will only get worse, now that you’ve let it be known you want them to leave. If your partnership agreement has a mandatory buyout clause, you’d have a lot more protection. A simple way for partners to finance such a purchase is through a leveraged buyout (LBO), in which the majority of the purchase price (in this case, the founder’s share) is paid for with borrowed funds. The future cash flow of the practice serves as collateral for the loan, and that cash flow supports the payments on the debt.

→ Learn More: CPA Financing

What situations can force a buyout?

Mandatory buyout agreements can be standalone contracts or can be part of a wider partnership agreement. In general, they outline specific circumstances that would trigger the mandatory sale of a partner’s stake in the practice. Failure to meet practice standards, attaining a previously agreed upon mandatory retirement age, or losing the cognitive ability to practice are just a few examples of events that could prompt a forced sale. 

Because a mandatory buyout is almost by definition an emotionally fraught situation, it’s a good idea to set up the agreement early in the partnership when potential triggering events are likely to be years away. Trying to force a new leveraged buyout provision on a partner close to retirement age may be taken as a personal attack.

Benefits of a mandatory buyout agreement

The primary benefit of a mandatory buyout agreement is that it removes much of the emotion from a potentially difficult situation. It provides a set of conditions that all the partners have agreed upon in the past in the best interests of the practice. By keeping the focus on what is best for the practice, the agreement takes some of the sting out of requiring a partner to exit.

A partner who doesn’t want to leave – perhaps because their ego is highly tied up in the success of the practice or they don’t want to give up relationships with long-term clients – can drag down a practice if they are asked to leave in the absence of a mandatory buyout clause. They may damage relationships with clients or staff and ultimately cut into the practice’s earnings.

How can buyouts be financed?

Leveraged buyouts are a common form of financing. In this scenario, the remaining partners would take out a CPA loan to cover most of the purchase price of the departing partner’s share. The practice would take on debt (become leveraged), paying back the loan through future revenues. In a forced sale situation, it would be expected that the practice would increase its cash flows with more invigorated management following the departure of the problematic partner. If the practice’s financial performance does not meet expectations, however, the debt burden could become a significant risk to its stability and future success.

How is a buyout different from a merger or acquisition?

In a merger, two companies combine to form a new or larger entity; in an acquisition, one company is fully purchased by another. In a leveraged buyout, the remaining partners aren’t creating a new or larger company. They are simply increasing their equity stake in the practice, for example, going from a 1/5 share of the practice to 1/4. 

Buyouts do have some similarities with mergers and acquisitions. In an M&A deal, it’s crucial to plan for changes in management and the effects on staff and clients. Going forward with big changes without considering the needs and emotions of those stakeholders can significantly undermine the company’s success and future profitability. In a buyout situation, the changes may be less dramatic, but they must not be underestimated. Clients and key staff may be very attached to a certain partner, and having that person leave – especially if it wasn’t entirely on their own terms – can cause hard feelings. This situation can lead to client and staff turnover and can hurt revenues.

How can Oak Street Funding help?

Oak Street has been providing CPA loans for over 21 years, and we have the expertise to create loan products to meet the needs of nearly every practice situation. We understand how CPA practices work and can lend based on practice income rather than fixed assets. Not all lenders are alike; Oak Street has the expertise and the experience to provide the capital your practice needs. Contact us today for more information.