December 4, 2023
Bringing new partners into practice-owned real estate is essential to the long-term viability of a practice. To facilitate those buy-ins, many groups internally finance with attractive terms for incoming partners. Those terms often feature:
• Little to no money down
• Low interest rates
While this approach may be favorable for incoming shareholders, the unseen costs to the existing partners can be quite meaningful. But the dilemma between new and old doesn’t need to prevent your practice’s growth, and with a little planning, you can create buy-in terms that have the same results for the new partners without the drawbacks of internal financing.
Here are three factors to be considered:
- Who’s Paying for the Buy-In?
When you think about it, new partners are buying in with money that would otherwise have gone to the existing shareholders. To put this into perspective, ask yourself the following question:
Would I take my distributions and give it to a new partner such that they could give it right back to me to buy a portion of my shares?
That may seem like a silly question, but that’s exactly what’s happening with internally financed purchases. But wait – you say it’s not free? You’re getting interest? Okay, next question: is the interest at least as great as the return you would be getting in your distributions? If not, some portion of that is still free, and the “free” portion is being paid directly out of the pockets of the existing partners. This is not insignificant.
You can see an example calculation below to understand the full effects, but the bottom line is that partners will typically give up hundreds of thousands of dollars in equity for approximately the same, or even less distributions inclusive of the buy-in payment.
- Who’s Receiving the Equity Gain?
During the internal loan payment, the property should continue to build equity as the group’s debt is repaid and the property appreciates. Under this structure, the existing partners are giving up the appreciation of those shares ahead of receiving the equity from the loan payment to purchase those shares. Depending upon the configuration of the partnership, that difference could amount to hundreds of thousands of dollars and is accompanied by a significant reduction in the internal rate of return (IRR) for existing partners.
- What’s the Opportunity Cost?
If the new partner were to buy in with cash or obtain personal financing from a bank to purchase their shares, that money would typically be distributed to the existing owners to compensate them for their dilution of ownership right away. This money THEY received could be reinvested elsewhere to generate additional wealth.
Using the prior example, where a new buy-in was $729k, each partner should have received approximately $73k for their dilution of ownership. If that was reinvested at just 5%, the partner would be receiving approximately $46k over the duration of the 10-year buy-in period. Thus, internally financing that new partner’s loan could result in a substantial loss of wealth accumulation for the original partners over the duration of the internal loan.
Given these factors, it’s often advantageous for the entity to receive the buy-in for a new partner up front. That said, new buy-ins can be expensive, even after a group has leveraged to reduce the buy-in amount. In these cases, it can often make sense to obtain personal financing from a lender to help fund these buy-ins. This ensures the existing partners are fairly compensated for their equity at the time of the sale or dilution event, while enabling the new partner to use the entity’s distributions to help cover the personal loan payment.
If a group wants to make the personal financing options more attractive for new partners, one alternative option may be to have the practice or real estate entity guarantee the personal loans that new partners receive from the bank, which would improve the personal loan terms for the new partners.
For more information on creating affordable and achievable buy-in options, email email@example.com.