Bringing in a New Partner – Long Version
By Matt Dickstein
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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. [Note — this is a long article. For the short version, read How to Bring in a New Partner.]
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).
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.
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 prerequisite?
How important is equity to the existing partners and to the new partner? Some incoming partners take a hard economic view and discount the value of equity. Others want equity to be a real partner and to have some control over the business.
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 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.
Buying into the Group.
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. For more on this topic, read Buy-in and Buy-out of Physicians to a Medical Group.
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.
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.
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.
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?
The existing partners and the incoming partner all need to have an exit strategy in mind. The most common exit is the termination of the partner’s employment plus the buy-back of the partner’s equity.
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.
Buy / Sell Agreement — 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. Read also this article, Buy-Sell Agreements.
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.
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.
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.
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. Also read Non-Competition Agreements at 100 mph.
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.