What Constitutes a Partner Buyout Agreement?
Essentially, a partner buyout agreement is a document that states in detail the circumstances and the process by which a partner of a business, or partnership, can exit the business, giving the other partners the right to purchase her shares in the business if they want to remain in it in his absence. In this way, it is an out-mutation document that describes in detail the ‘how’ of a partner’s exit, reserving to the remaining partners the right to a mandatory buy-out of the exit-accused partner’s shares should they choose to purchase them, but not requiring them to do so. It should be understood that a partner buyout agreement can be drafted as a collective document for all of the partners in a given partnership, or as an individual side agreement for each partner . The latter is less common since it makes the drafting process a lot more complex if you change your mind about your exit strategy after a year, for example. While some partners leave the partnership without any problems whatsoever, whether by mutual agreement with the remaining partners and/or proper notice (also discussed in this article), others may wish to part company with the remaining partners in an undesirable and/or messy fashion. While it is not going to mitigate all of the risks of departing in this way, a well-drafted partner buyout agreement can help to deal with these eventualities, making it a valuable template to have in place.
Critical Components of a Partner Buyout Agreement
The key elements of a partner buyout agreement include the valuation method, payment terms and timelines. Below are some examples of how these crucial aspects are typically included in a partner buyout agreement.
Valuation Method
The valuation method is one of the most important components of a partner buyout agreement. It is advisable to start with a base in the partnership agreement, which should provide for a valuation method in the event of a buyout. If the partner buyout is initiated by the withdrawing partner, there should be a presumption as to the value of the partnership interest, unless the remaining partner can show good cause.
Bolt v. Bolt, 2 F3d 1191 (7th Cir 1993)
The facts of Bolt are straightforward: the partnership agreement specified the sale price of the withdrawing partner’s partnership interest (two times the annual profit in the year of termination), but did not provide a means for calculating the profits. The withdrawing partner’s estate contended that the withdrawing partner’s interest was worth at least $800 per share of the partnership, based on an accountant’s assessment. The remaining partner argued that the value was less than $150 per share. The court decided that since the partnership agreement did not specify the method of calculating the profits, the provision was unenforceable and summary judgment was improper.
"[T]he district court … exercised authority Congress intended to limit it under ERISA, and did not properly accord due weight to the intention of the parties in their Partnership Agreement…. [T]he court neglected the general principle that contracts should be enforced according to their terms." Bolt at 1194-1195.
Payment Terms
The payment terms should provide time for the individual or entity purchasing the partnership interest to pay for the interest, and the selling partner to get paid. Again, the court in Bolt v. Bolt found that the partnership agreement was unenforceable because it failed to provide a means for calculating the profits.
The Bolton II Partnership Agreement provides that, ‘[t]he value of [the withdrawing partner’s] portion of the Partnership shall be determined as of the last day of the month in which he withdraws from the Partnership. The value of the Partnership shall be determined by the then current book value of the Partnership as shown by the books of the Partnership and loss of the Partnership shall be deducted in the month in which they are incurred.’ Id. at 1195.
"If it had specified a method for determining the partnership’s value, the district court would have been bound by that." Id. at 1194.
Timelines
The timelines should include when the buyout will occur, as well as how the agreement will handle the death of a partner, disability, retirements and other circumstances related to an exit event.
A partnership agreement and a partner buyout should be aligned. If the partnership agreement provides for allowances for the death of a partner, but the partner buyout agreement does not, the partner buyout agreement will ultimately govern. This is particularly important if a partner does not survive the exit in question.
For example, where a partnership agreement provides for the buyout of an interest upon death, but the buyout agreement does not provide for such a buyout, the buyout agreement will control. However, this does not mean the buyout agreement will prevail – the two agreements should be harmonious.
The court in Dattner v. Conforti, 457 A.2d 9 (Del Ch 1982) illustrates the complexity of determining the intersection of a partnership agreement and a buyout agreement. The partners entered into a buyout agreement that provided, "[u]pon death of a party hereto [to] an estate, the surviving parties shall have the right to repurchase decedent’s share of the partnership under the terms herein set forth."
But the partnership agreement stated that upon the death of a general partner, the partnership would terminate unless there was consensus for it to continue, otherwise the buyout agreement would not accomplish its intended effect.
The partners ultimately decided not to adhere to the buyout agreement, which they signed a year earlier when the partnership agreement was amended. The terms of the buyout agreement were a disappointment and embarrassment because it did not provide for a buyout in the event of a partner’s death. The court held that the partners should have known a buyout agreement limited in such a way would be undesirable.
Methods of Valuation in Partner Buyout Agreements
Valuation methods in partner buyout agreements can be allocated in a number of ways. While most buyout agreements provide that one partner is obligated to purchase the withdrawing partner’s interest at the time of his or her withdrawal, the method of determining how to value that purchase may differ among the buyout agreements.
Some agreements state that the value of what the withdrawing partner has invested in the business, also know as book value, is how the purchase price will be determined. That value is the value of the withdrawing partner’s capital account, less any distributions paid out of the account, or withdrawals made from the account by the withdrawing partner. It does not take into consideration whether goodwill was built up in the business during the partners’ tenure together.
Some buyout agreements provide a more favorable valuation for a partner who has amassed a loyal following in the business when the business, or the withdrawing partner, has a personal services component. In this case, the buyout agreement may provide that the value of the business is determined using the future earnings of the business. While some buyout agreements provide that the withdrawing partner will be purchased out of the business using the approach that another approach may be used if it’s determined that the withdrawing partner has a loyal following and an increased value in the business. A loyal following may increase the value of the business since clients or customers may continue to return because they are comfortable with the withdrawing partner.
Some buyout agreements provide a fair market value for the business. In terms of a business, it is generally defined as the price at which an asset would sell in an arm’s length transaction between a willing buyer and a willing seller, both of whom have reasonable knowledge of the relevant facts. It is the actual value of the business, regardless of what the partners, or the person valuating the business, believe the value of the business is. A fair market value does not, however, take into account the potential future income of the business.
Legal and Regulatory Considerations
Beyond the business terms that govern a partner buyout agreement, there are legal considerations that must be taken into account.
State Laws
The most important — particularly for minority owners — are state laws. While the Delaware Court of Chancery, for example, has recognized that a minority partner who is disadvantaged by a forced buyout in the absence of a clear term in the partnership agreement may have a claim for damages, relying on that decision is risky. The precedential value of a Delaware case such as this is limited to other cases arising within the Third Circuit, and because it is contrary to the Uniform Partnership Act (UPA), it may not be persuasive in other circuits that are not bound by the precedents of the Third Circuit. Additionally, the Court of Chancery has acknowledged that its ruling is a mere indication of how it may be able to decide a future case. The Delaware legislature and courts are not bound by the rules of stare decisis.
Federal Tax Law
In addition to state or local law issues, a partner buyout must comply with federal tax law. For example, the Internal Revenue Code (IRC) requires capital gains taxes if the transaction qualifies as a "distribution" to the seller or transferring partner. A distribution occurs when a partner sells his or her interest in the company to the remaining partners or to a third party. In the case of a partial buyout, this could result in a shareholder or partner being taxed twice on the same income. It is not the lawyers who have to determine how the transaction is taxed, but they must be mindful of how its structure could impact this.
Getting Legal Help Early Is Crucial
Early legal help is important to ensure that an outsider purchaser does not get a full partnership’s value, instead of a fraction of what it is worth as a minority partner. Having an experienced business and partnership lawyer involved in the planning will help you deal with internal and external threats that could put your business at risk. Depending upon the structure of the company, a buyout and shareholder agreement may need to be drafted in order to provide the parties with certainty about how to proceed with the buyout of a partner’s interest. The agreement should cover a number of topics, including: In many respects, a Partnership Agreement is similar to a Buy-Sell Agreement, which is often found in closely held corporations. The major difference is that a Partnership Agreement deals with the winding up of a partnership business, whereas a Buy-Sell Agreement concerns itself more with the dissolution of an entire business.
Negotiation of a Partner Buyout Agreement
Negotiating a partner buyout agreement is a critical stage in the process of a partner exit. Like any negotiation, the way the partner buys out or is bought out can have long-term parting effects. Potential issues between partners that may have existed well before the decision to exit are likely to be exacerbated by the exit process.
In a successful negotiation, both parties get what they want, and the exit process is much easier to handle. When negotiations are not well-handled, they frequently devolve into inter-partner disputes even before the exit begins. Every partner needs to understand how avoiding certain behaviors and activities during the negotiation can save time and money.
There is no way to completely avoid conflict among partners. However, partners should handle the exit negotiation process with a view toward avoiding future problems. Partner buyouts are often contentious because the parties each have reasonable, yet entirely different, interests, ends, and ways to get there. The negotiations often reflect these differences in a very negative way.
If a partner’s financial condition is poor, that partner might try to use its financial condition to negotiate with the partner that wants to leave. The exiting partner will probably suggest the only way he or she can afford the buyout is on an installment basis over a period of years or over a specified term of years. "Even though it might make more financial sense to pay now, your company can afford it; I cannot."
Another contentious issue involves the analysis and determination of value . The retiring partner might propose using a third party business valuation expert. The other partner might disagree with that and suggest that the whole process should take place without the expertise of a valuation expert. This often leads to throwing around numbers and basing value entirely on emotion.
It is important for the parties to recognize that whatever tension there is in the process should be contained in the negotiations. Involving third parties or outside experts and advisors in the negotiations seems to serve only to escalate the tenor of the negotiations. They almost always lead to increased costs without resulting in a good faith effort to resolve the issues. These added costs can delay the time frames for a settlement and might even make the exit difficult or impossible. Partners who behave in this manner in the early stages of the process have difficulty with other partners in the future.
It is a good, albeit sometimes difficult, practice to negotiate with the intent of keeping everything within the four corners of the agreement itself and not to involve outsiders. Even the introduction of a family member or friend as a negotiator can increase the cost and difficulty in resolving issues.
The process of negotiating in good faith in the context of an exit of a partner from a partnership should be a high priority. It is important because it helps reinforce the expectations including the end result of the process. An additional benefit is that it often helps maintain the common ground that is needed for the business to operate during the balance of the partner’s career with the company.
Challenges and Common Solutions
One of the most common challenges we see during a partner buyout is disagreement over the value of the business. One key to resolving this issue is to identify the cost of professional fees for the valuation. Let’s face it – some businesses are too small to have their partners spend a week looking at every nook and cranny of the company’s books. On the other hand, some companies are valued so high that the entire purchase price would be eroded by the cost of the valuation if ordered by the parties’ accountants. In such situations, we suggest that the parties agree on the process, rather than the value. These processes can vary from an independent appraisal by a respected national company to a straight calculation based on past earnings. The agreement could also include an enumeration of specific issues to be included in the valuation, such as the valuation of the owner’s claim for goodwill.
Another common source of disagreement is the time period for the buy-out. We have seen situations where the buy-out period is for the sale of inventory in a shareholder buy-out situation. This is generally not desirable for the seller/retiring owner because the selling owner receives no payment for any decrease in inventory and could have to hold out for five years before receiving a lump sum payment. A better approach is a graduated payment plan that takes into consideration the fact that older owners, those in their fifties and older, may not want to be burdened with annual payments. Another factor to consider is the company’s cash flow. A relatively new start-up may not be able to accommodate substantial annual payments for some time. This is especially true where the company is a professional practice with significant retirement benefits. In a typical scenario, a gradual buy-out over five years or less is a reasonable plan.
We have also encountered issues regarding a buy-out when one partner wishes to sell and another partner refuses to buy. This situation happens when the buy-out trigger is a removal event such as a divorce settlement, disability or death. Since these are involuntary, there will be a forced buy-out of the interest. In general, the language contained in the agreement should specify how the buy-out is to occur in the event the terms cannot be agreed upon by the parties. Requiring third-party input to the valuation as described above is a way to address this issue.
Case Studies and Examples
The medical industry often uses buy/sell agreements as a part of their partnership formation because it allows for continuity of the business, medical practice in this case, after an owner leaves due to termination or death. We have seen so many instances of physician partners entering into buy/sell agreements only then to be forced to engage in litigation when an event covered by the buy/sell triggers the right of purchase. In this section we will review three cases where physician partners purchased another partner’s interest in the medical practice in which they are owners.
In 2012, Dr. E arrived to our office with a buy/sell agreement that provided for the sale of his ownership interest in the medical practice only if the partners could not agree on the quantity and quality of patients to be transferred to Dr. E. After initially requesting that he be allowed to transfer only certain patients and receive value for the transfer, we negotiated for Dr. E a flat $300,000 closing payment for his 50% interest in the medical practice and an additional $300,000 if a patient transfer could not be agreed upon. In addition to negotiating for the payment structure, we also negotiated terms providing for Dr. E’s continuing employment with the medical practice following the closing.
An orthopedic surgeon (Dr. W) went into partnership in 1999 with three other orthopedic surgeons (the "Partners"). The Partners had a buy/sell agreement stating that if any partner became disabled a sale of the disabled partner’s interest would occur as determined by the disability panel set forth in the buy/sell agreement, i.e. trigger event. In 2010, the Partners were asked if Dr. W was disabled. Dr. W did not believe he was disabled but elected to leave the practice and not trigger the buy/sell provisions. His Partner remained engaged and asked whether there was any protection in the buy/sell agreement regarding future losses of practice due to Dr. W’s anticipated departure. We told the Partners how their practice would be valued under the buy/sell agreement if Dr. W became disabled, i.e. trigger event, and the Partners decided to buy his interest pursuant to the buy/sell agreement. This resulted in the Partners making a payout to Dr. W of $3.4 million within 30 days of the contract date and returning to equity positions. All Partners were relieved as the buy/sell agreement allowed for an orderly adjustment to the remaining partners’ position in the medical practice.
Dr. H, an internal medicine physician in South Florida entered into an oral partnership in 1982 with four other internal medicine physicians providing for each partner to receive two and one half days per week of patient care. Dr. H took his time to build a group of physicians who could cover him during his two and one half days per week. For 27 years, all parties were happy with this arrangement. In 2009, partners began to express dissatisfaction with the oral partnership and took a vote to dissolve the partnership after Dr. H last saw patients on September 30, 2010. On October 1, 2010, Dr. H came our law office because he was without his practice, the patient care agreements and no opportunity -real or perceived- to purchase a practice to continue to see the patients with whom he had treated for more than 28 years. After litigation and several months of settlement conferences, the medical group made a global settlement of $420,000 to Dr. H, more than $120,000 of which were payments for CPT/ICD billing codes monitored by Msippw and just under $300,000 which constituted compensation to essentially purchase Dr. H’s practice. Additionally, the Partners agreed to review Dr. H’s medical records so as to reestablish the relationship with the patients seen by Dr. H, i.e., patients had the opportunity to choose providers within the medical group or terminate the group relationship.
Conclusion: The Necessity of a Well-Constructed Buyout Agreement
The above examples are why it is necessary for any company, large or small, to thoroughly consider, draft and implement a buyout agreement that can be relied upon when the time comes to have the document and the parties’ actions speak for themselves. A well-drafted buyout agreement establishes a clear path of action for both the partners and the entity. The company and its remaining partners can plan and set a new course of action knowing that the rest of the organization is stable thanks to: (1) the financial security of the ongoing entity; (2) a continual partner (whether a current partner , a family member of a current partner or an outside party); (3) the knowledge and skill of a current partner continuing his or her work for the company; and (4) a clear succession plan for how the company will move forward.
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