Bringing in a New Partner
- Long Version
You need to know how to bring in a new shareholder or partner to help run
your business. If you're the new partner, you need to know what's at stake when
you step into the business.
When I speak of a "partner," I mean a partner in the non-legal sense, that
is, the incoming doctor, dentist, chiropractor, software writer or other
professional who will directly service clients on a full-time basis. I use the
terms "company" and "group" interchangeably, and both could mean a corporation,
professional corporation, LLC or partnership (depending on your profession).
1. What’s at Stake. You bring in a new partner to expand your business
and to build up revenues. The risk is that your existing group and the new
partner might not fit well together. For example, you and the new partner might
differ on the group’s guiding principles or work ethic, or the new partner’s
skills might not be a good fit.
The primary legal issues at stake in bringing in the new partner are: (i)
setting a level of compensation that is fair to the new partner and the existing
partners; (ii) deciding whether and how much equity the new partner will
receive; (iii) setting a buy-in price and whether it will be paid in
installments and/or through salary reduction; (iv) deciding whether the new
partner will guaranty company liabilities; (v) thinking through exit strategies
for the new partner (including termination of employment and other buy/sell
events); (vi) setting the price to be paid to the departing partner; and (vii)
determining whether to lock up the departing partner with a covenant not to
compete. I will try to give you some guidance on each of these issues.
2. Compensating the New Partner. The hardest thing to get right and
keep right is a group’s compensation structure. There are two guiding principles
in compensating partners -- you will need to (i) enhance the group’s ability to
achieve its long term goals, and (ii) fairly distribute available cash to the
partners.
Compensation is usually salary + bonus. The bonus could be a percentage of
collected receivables, gross income or even net income. You should avoid basing
bonuses on net income, however, because it can be difficult to distinguish real
company expenses from individual perquisites, e.g. what part of a professional
conference in Hawaii is a perquisite?
3. Equity. How important is equity to the existing partners and to the
new partner? You will need to know the answer to this question. Some incoming
partners might take a hard economic view and discount the value of equity.
Others might want equity to be a real partner and to have some control over the
business.
3.1. Minority Stake. A minority equity stake in a small
business has little economic value except for a payoff if ever the
company is sold. There are few (if any) buyers for a minority holding.
This is especially true for physicians, dentists, accountants and
certain other licensed professions, because all purchasers of equity
must be licensed in the profession. The primary benefit of a minority
stake is psychological, because it makes the partner feel more like a
real team member.
3.2. Controlling Stake.
A controlling equity stake has real
economic value, however, because the partner can participate in basic
operational decisions, including the setting of compensation and
distributions.
4. Buying into the Group.
4.1. Coordinate the Buy-In with the Buy-Out.
People come and
go, so the key is to coordinate buy-ins with later buy-outs. One
disadvantage of equity is that the incoming partner must actually pay
for it. Another disadvantage is that where there is a buy-in, there must
be a buy-out. Liquidity will be needed to buy-out departing partners.
Existing Partners Want a High Buy-In Price. Existing
partners want a high buy-in price for three reasons: (i)
existing partners obviously would like as much cash as
possible from the newcomer; (ii) a high buy-in price
increases the company’s cash reserves available for the
buy-out of the existing partners; and (iii) the buy-in price
can be used to set a later buy-out price. Concerning this
last point, the company can use a low buy-in price to
argue that the value of the equity for buy-out purposes
should also be low, and therefore pay less to the existing
partners upon their buy-out.
4.2. Purchase Price / Valuation. Base the purchase price on a
valuation of the company and on the required buy-out price for existing
partners. Value = [hard assets + A/R + goodwill] X an appropriate
multiple. For professional practices, I have sometimes seen a valuation
of 60-90% of one year’s gross collections. Different industries weigh
the factors in different ways, however.
4.3. Payment Terms. Consider how the new partner will pay for
and receive the equity, including vesting and salary reduction.
Vesting. The company can consider using options or
restricted stock for the buy-in, to vest the partner’s
ownership of equity and to permit payment for equity in
installments.
Pay for Equity through Salary Reduction. Along
with vesting, consider having the incoming partner take a
reduced salary in the first few years (3-8 years is common)
as deferred payment for the equity. The company also would
sell the equity to the partner at a reduced price (e.g.
based solely on hard assets or A/R), so that the reduction
in salary in part pays for the equity. In this way, the
partner avoids a large up-front payment and essentially pays
for the equity in installments with pre-tax dollars. At
buy-out, the sale price for the equity could also be low,
with the balance paid as severance pay.
5. Liabilities. If the existing partners are liable for company debts,
then it is very important to be clear about the liabilities and obligations that
the new partner will assume and become responsible for. For example, will the
new partner guarantee existing loans or leases? Will the new partner step into a
capital call?
6. Exit Strategies. The existing partners and the incoming partner all
need to have an exit strategy in mind. Two common exits are the termination of
the partner’s employment plus the buy-back of the partner’s equity; and the sale
of the company.
Termination of the Employment Relationship.
The employment
agreement will set forth the conditions for the new partner leaving
the company, including termination and retirement. Most of these
conditions are negotiable. The partner’s leaving the company usually
is a trigger event under the buy/sell agreement that permits the
company to buy-back the partner’s equity.
7. Buy/Sell. A buy/sell agreement is essentially an agreement for
exiting a company. The purpose of the buy/sell is to prevent persons who are not
intimately involved with the company from owning equity in the company. A
buy/sell agreement works like this – the agreement names certain trigger events
for buy-back (e.g. termination of employment, death) then it either requires or
permits the buy-back of the partner’s equity on the occurrence of that specific
event. Then the agreement sets a price for the buy-back.
7.1.
Sample Trigger Events for Buy-Back Under a Buy/Sell
Agreement.
Termination of Employment; Reduced Workload. If a partner
disassociates from the company or semi-retires, the company and/or
the remaining partners may purchase all of the terminated
partner's equity at the buy-back price (or a discounted price). Note
that the company has the option to buy-back but is not required to
do so.
Death or Disability. If a partner dies or becomes disabled,
the Company (and/or the remaining partners) must purchase
(and the estate must sell) all of the partner's equity, at
the buy-back price. This provides liquidity to the partner or his or
her estate. Insurance can fund the buy-back.
Disputes. Buy-out is a possible resolution to deadlock or
disputes, using "shotgun" procedures (i.e. I cut, you choose).
Professional Corporations. For a professional practice, a
partner’s loss of his or her license should be a trigger event for
the buy-back of the partner’s equity.
7.2. Buy-Back Price.
Once you determine what triggers the
buy-out, you next need to set a price. The price can be a combination of
the purchase price for the equity plus severance pay. Various methods
exist for setting a buy-back price, including appraisal procedures and
earnings-based formulas.
8. Severance Pay. In addition to the buy-back price for equity, a
departing partner might receive severance pay. Paying off a departing partner
through severance pay can make sense for the company because the company can
deduct the payments. There is no deduction for the buy-back of equity. Therefore
the company might consider allocating more of the payoff amount to severance
pay.
9. No-Competes. During employment, a no-compete is enforceable. After
termination, a no-compete usually is unenforceable, except that a partnership
agreement may prohibit a withdrawing partner’s competition in a limited
geographic area for a limited time. It is safest to have the no-compete only cut
off deferred payment to the departing partner. That is, the company does not
stop the partner from competing, but only stops paying the partner on future
installments of severance pay or the buy-back price upon his or her competition.
10. The Documents. The two documents that handle most of the above
issues are the employment agreement and the buy/sell agreement. The employment
agreement sets forth the new partner’s compensation and the grounds for
termination of the new partner, among other things. The buy/sell agreement
(a.k.a. shareholders agreement, LLC operating agreement, partnership agreement
etc.) is an agreement among partners that sets forth how they will control the
company and the ownership of the company.
11. Get Legal Counsel. This outline only gives a roadmap of the issues
involved with bringing in a new partner. When I sit down with a client, we
usually spend hours analyzing these issues in light of the client's specific
needs. In fact, large treatises are written about the details and considerations
that go into this analysis. The bottom line is that, before starting down the
path of bringing in a new partner, get competent legal counsel to help you.
Thank you for being a part of this seminar.
Call
me to schedule a legal consultation:
510-796-9144
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