While getting into a partnership is easy, getting out can be a nightmare. It doesn’t have to be that way. This blog will explain how to use a buy-sell agreement to your advantage.
Let’s face it, for most surgeons and other professionals, a buy-sell agreement is an afterthought. They are not thinking of getting out, just getting in… and as fast as they can so they can capitalize on the opportunity that lies ahead.
But is jumping in so quickly wise?
What if there is a dispute?
What if there is a disability, divorce or death?
While these are things few consider on their way in, in this blog I will explain why this is important, why you should insist on a buy-sell agreement, and how you can use a buy-sell agreement to stabilize your partnership and its profits.
Just so we are all on the same page, a buy-sell agreement can be used for the benefit of shareholders of a corporation, members of a limited liability company, and partners of a partnership, but in this blog, and for the sake of simplicity, I will only address its use in a partnership.
We should also clarify that while writing this blog I was primarily thinking about the importance of buy-sell agreements for surgeons, it’s equally applicable to other professionals such as attorneys, CPAs and architects. For that reason, I have discussed buy-sell agreements for not just surgeons, but the entire group of professionals.
With that said, let’s get started!
What is a Buy-Sell Agreement?
When you enter into a partnership with one or more other partners, you typically sign an agreement that sets forth key information regarding the terms of your partnership.
For instance, some of the terms typically included in the agreement may be: the names of the partners, the amount of money each partner will contribute to the partnership, a description of any property that any of the partners will contribute to the partnership, the services each partner will provide to the partnership, the nature of the partnership business, and when and how profits will be distributed to the partners.
These are all important things to know when starting or getting into a partnership, but what about getting out of the partnership? What if you want to get out of the partnership? What if one of your partners wants to get out? How does that work? How will the partners and the partnership survive that transition?
These questions are typically answered in a buy-sell agreement, a written agreement between the partners and the partnership setting forth how the partners can get out of the partnership and how new partners can get in.
Perhaps no partnership can benefit more from a buy-sell agreement than a professional partnership. Why is that you ask? The short answer is because professionals desire to get in and out of partnership more than any other occupation.
Think about it. If you are a surgeon, how many other surgeons do you know that have already been in more than one partnership?
If you are an attorney, how many attorneys do you know that have jumped ship more than once already? I have read that business partnerships fail 70% of the time.
Here are some of the more common reasons:
- Lack of Communication – In any relationship, regular communication keeps the connection healthy. If a partner has taken the lead but fails to communicate with others, this will deteriorate the relationship.
- Lack of Shared Goals and Business Vision – Partners in a business are running a relay race with one another. If one partner is interested in other ventures, has other commitments, or is not on board with the direction of the business, this can result in needing to part ways.
- Undefined Roles of Partners – Some organizations adopt a flat structure, which can lead to an overlapping of responsibilities and confusion about who has the lead on each aspect of the business.
- Unequal Perceived Contributions – If one partner is contributing significantly more or less than the other partners, this can lead to disparagement or resentment in the professional relationship. Contributions can be made in the form of time, money, network, etc.
- Personal Issues with a Partner – If a partner has personal issues such as a drinking or drug problem, it may be time to discuss a business divorce with that partner.
- Unresolved Issues – The longer a disagreement lasts, the deeper the damage to the relationship it can cause. When partners have a difference of opinion, it’s helpful to have a buy-sell agreement that outlines the course of action to take in resolving the business dispute.
- Hiring Family or Friends – In any business, finding good talent that is trustworthy is no small task. Often, we look to the people closest to us to fill these positions. This can cause an unequal alliance between that new-hire and the partner that is family, not to mention the perceived special treatment that will receive.
- Lack of Transparency – Hidden agendas eventually come out with time. If a partner has been untruthful with money or motives, it can be near impossible to mend the relationship.
- Too Many Skills in the Kitchen – Without having clearly defined roles, partners with similar skill sets may have different opinions about professional issues. This can cause unrest between partners and break the unified front they present to the client.
So, now that we know what a buy-sell agreement is, and why professionals need it the most, let’s first discuss the common pitfalls of a typical buy-sell agreement, and then discuss how you can use a buy-sell agreement to your advantage.
Common Pitfalls of a Typical Buy-Sell Agreement
Can you imagine a business that could not get the wrong employees out and the right employees in? How would that business grow? How would it become more successful?
Of course, this would never be the case because we know that you can fire the employees that are not the right fit and you can hire the employees who are. But what about a professional partnership? Can it get partners who are not the right fit out? Can it get partners who are the right fit in?
Let’s spend just a bit more time on “right fit” and “wrong fit”.
First, with respect to employees, it goes both ways. In other words, it may not be the company that wants to part with the employee, it may be the employee who wants to part with the company. If you have an otherwise “right fit” employee who no longer wants to be there, then that employee is now a “wrong fit” as he is no longer passionate about his position with the firm. This lack of passion will show in his performance which will decline while he tries to figure out how to transition to another employer. There are many reasons why this employee may want to part with the company. For one, he may have developed as far as he can within the organization and need to transition to another organization where the opportunity to further develop exists. It may also be a matter of compensation. He may be able to earn more money or receive more benefits with another employer. Suffice it to say, the employee wants out and until the company gets him out and replaces him with a better choice, the company will be weak in this position.
How is it any different for a partner? Do partners not want to transition to another opportunity? Perhaps the partner is not happy with the manner in which the partnership is administered? Maybe the partner believes the overhead is too high and he is not receiving enough of his revenues? Or Maybe the partner has an opportunity to make more money somewhere else?
There could be any number of reasons why a partner no longer wants to be in the partnership, but can he get out? Does the partnership or the other partners really want him to remain a partner when he wants out?
The biggest concern I have with buy-sell agreements is that they do not address these issues. They do not provide a simple and easy way for partners to get out and for new partners to get in. There is often a budget of $5,000 – $15,000 and this is typically not enough for the level of customization that is needed to ensure a smooth transition for departing or incoming partners. There is also too often a rush to get the buy-sell agreement completed by a certain deadline and the partners do not understand the importance of the agreement and therefore, do not commit the amount of time necessary to develop a really good agreement.
It is my hope that by writing this blog, professional partners will “see the light” and spend the time and money necessary to get their buy-sell agreement done right so they can easily withstand a partner transition. With that said, let’s move on to our next point of discussion.
How to Make a Buy-Sell Agreement Work for Your Partnership
The key to making a buy-sell agreement work for your partnership is putting the team first. When the team wins, everyone wins the most. One individual partner may not win as much as if he put his own interests ahead of the team, and one individual partner may win a bit more than he otherwise would have, but no one can anticipate beforehand what situation he will be in. But if all partners put the team first, then we know that collectively the partners will win more than if they don’t.
To be in a really good partnership, you need to get everyone on board with this “team first” concept and ensure they have all bought in to this philosophy. Once you have everyone’s buy in, then you can focus on the one crucial part of the buy-sell agreement that is rarely dialed in tight: valuation.
Typically, a buy-sell agreement will provide for a method or process for determining the value of a partner’s interest. A common structure would be for the two sides to first attempt to agree on a valuation and if unsuccessful, then to agree on a business appraiser who can then determine the value. If they cannot agree on a business appraiser, then each side picks his own business appraiser and then the two business appraisers agree on a third business appraiser. The three appraisers then value the business and the value that diverges most from the other two is discarded and the remaining two are averaged together to arrive at a value.
This is a very complicated structure and what ends up happening is each side wants to get the best price. A future partner who is buying into the partnership wants to put a low value on the interest so he can buy in at a good price. That same partner, years later when he wants to get out of the partnership, will then want to put a high value on the interest so he can get more money. But if someone else is getting out, that same partner will want to put a low value on the interest so he and/or the partnership will pay less money.
This desire to always get a good price does not fit into the “team first” philosophy because it makes partners getting in and out of a partnership an adversarial process that gets extended for a year or more, or sometimes many years as some partners who want out will indefinitely delay getting out until they are able to “get more” for their interest. Likewise, other partners or the partnership will delay getting someone out until they can “pay less” for the interest.
In a “team first” environment, the partners recognize that the value to the partnership in being able to get the right people in and the wrong people out is more important to their collective interest than any one of them “getting more” or “paying less”. For this reason, they structure the valuation not as a process for determining a value, but as a formula for determining the value. As an example, the buy-sell agreement might provide that the value of partnership interests is always 5 times the previous calendar year’s profits. So, whether a partner is coming in or getting out, the value is always known as all partners know what the total profits were for the preceding calendar year and can simply multiply that figure by 5. For instance, suppose the previous year’s profits were $1,000,000. The value of the partnership would be $5,000,000. If the amount of partnership interest being bought or sold is 10%, then the value of that interest would be 10% of $5,000,000 or $500,000.
In addition to valuation, there should be a predetermined plan for payment of the value. For instance, there should be a promissory note attached to the buy-sell agreement and the agreement should state that the promissory note is to be used and the terms will already be set forth in that promissory note. As an example, it might say monthly payments at 8% interest and amortized over 6 years. With these terms, the partners can quickly turn to an amortization calculator and determine that a $500,000 promissory note would include [INSERT NUMBER OF MONTHLY PAYMENTS] monthly payments of $[INSERT AMOUNT OF MONTHLY PAYMENTS].
Owned Real Property
Many professional partnerships extend beyond the business of the partnership to the business premises on which the partnership conducts its operations. This can make getting the right partners in and the wrong partners out even more challenging if being a partner also includes an equitable ownership position in the business real property. But this can be made simple too.
If your partnership owns its business real property, you can extend the terms of your buy-sell agreement to include the real property and you can also include a simple formula for determining the value of the real property, just as you do for the business partnership.
Stories from My Experiences
I have been involved in both situations. I can tell you about one surgeon who very badly wanted to leave his partnership for a better opportunity. At that point, it was in everyone’s interest that he got out. But the buy-sell agreement was so confusing and had a process instead of a formula. Due to the uncertainty, he stayed with this partnership for 1.5 years longer than he wanted to. This hurt him and the other partners.
I can also share with you another experience where a very well written buy-sell agreement was in play and it included a formula, not a process. In that situation, a deal was struck with the exiting partner in one week and within two weeks the documents were drafted and signed.
The difference between these two situations is bottom line profit. When you operate a professional practice, you want to focus on marketing, sales and production. You want to develop, refine and execute your system every single day. You do not want to be distracted and you need everyone on the team rowing the boat in the same direction. Not being able to get the right people in or the wrong people out is more than just a distraction, it can sabotage your efforts.
What To Do Now
Investing in a partnership can be a money maker for you, but it also can be a money loser. Take the time to get your buy-sell agreement dialed in tight so you can make the most of your professional partnership, but get out when you need to, or get other partners out when it’s time for them to go.
At Sollertis, we work with professionals to craft solutions that fit your business relationships. We take a preventative approach to you business health to ensure you have the smoothest path to creating the impact you want with your business.
If you want to learn more about your options, call our office today at (858) 771-8400.