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Negotiating a co-ownership arrangement

By Jeffrey B. Sansweet, Esq.

Many physicians who join a private practice out of residency or fellowship will not find the negotiation of their initial employment contract too unpleasant or cumbersome. Most contracts that I draft or review require only two drafts to finalize. The key issues are usually salary and benefits, incentive compensation, parameters of the restrictive covenant, type of malpractice insurance and who has the responsibility for the “tail,” if any, and grounds for termination.

Once the “engagement” period is over, usually after two or three years, the fun really begins. The issues that arise when working out a co-ownership arrangement become more significant both in terms of dollars and security. This article will focus on the most important and contentious issues to be addressed when making a doctor a “partner.” Although most medical practices are structured as professional corporations in Pennsylvania, not partnerships or limited liability companies, I will herein refer to the new co-owner as a partner, not a shareholder, since the term partner is more commonly used.

Since negotiating a partnership arrangement is inherently more complicated than an initial employment contract, the negotiations should begin as early as six months prior to the targeted effective date. I have been involved in several deals where the documents are not signed until more than a year after their effective date. Of course, if a detailed Letter of Intent is prepared along with the initial Employment Agreement, the process usually is less time consuming as many of the deal points have already been spelled out. However, such letters of intent are becoming less popular as practices want to be careful not to commit to anything prematurely.

Becoming a partner usually means two things to doctors: more money and security. However, many of my clients are surprised when I review the documents and point out to them they may make less money after factoring in the buy-in and that they have no additional security. Of course, that should not be the case.

In terms of security, at least with small groups, I feel strongly that a partner should not be able to be terminated without cause. Surprisingly, that is not always the case. In groups with less than six partners, at least a unanimous vote should be required to terminate a partner without cause. In larger groups, perhaps a supermajority vote of 80 percent of the partners should be required to terminate a partner without cause. The definition of cause also needs to be spelled out in the documents.

When the partnership will only consist of two physicians, a “senior doctor right” may be appropriate. This typically would allow the senior partner to keep the corporation’s name, tangible assets, location and charts upon a mutually agreed upon split-up for some period of time. It may also give the senior partner the right to make a final decision when there is a deadlock on certain governance issues. The junior partner should attempt to negotiate an end to such rights after a reasonable period of time, perhaps five years. In addition, I do not think it is fair if the senior partner can unilaterally buy-out the junior partner without a mutual agreement to split-up.

Another way for the senior partner in a two physician practice to maintain control is to sell less than 50 percent of the stock. When representing the junior partner, I almost always push for fifty percent. Equal ownership is the norm in medical practices, at least after the buy-in is complete. In larger groups, and even with groups of at least three partners, certain “critical decisions” should probably not be able to be made by a simple majority, but rather with a supermajority of 70 to 80 percent of the partners or even unanimity. Such critical decisions may include the hiring or firing of a physician, adding a partner, selling the practice, acquiring a practice, merging with another practice, opening or closing a location, participation with an insurance company or expenditures in excess of $20,000.

Structuring the buy-in is usually the most important part of the partnership arrangement. Even in today’s marketplace where institutions have stopped buying primary care practices and specialty practices are constantly facing reimbursement cuts, most practices still require a buy-in that includes “goodwill.” In order to minimize the tax burden on the junior partner, the stock price is typically tied to the value of the tangible assets (equipment, furniture, fixtures) less practice debt. The tangible assets may be appraised, but more often, a modified book value approach is used. Pure book value may result in little or no value if a lot of the assets are more than five years old.

Therefore, many times the assets will be valued using straight-line depreciation over 10, 12 or 15 years, perhaps with a floor of 10 to 20 percent of cost. The new partner is either expected to pay the other partners up-front for the stock or allowed to pay over a few years with interest. For tax purposes, the new partner gets “basis” in his stock, but no tax deduction. The selling partners report any gain on the sale of the stock as capital gain.

The remainder of the buy-in, for the accounts receivable and goodwill, is often structured as a percentage reduction in net income over a period of time. This avoids a dispute over the exact value of the intangible assets. It also results in the new partner, in effect, paying more if the practice is more profitable and less if it is less profitable. In addition, it allows the new partner to buy-in to the intangible assets with pre-tax dollars.

As an example, if there are to be two partners and we assume they will otherwise divide the net income of the practice equally (to be discussed further below), the new partner may receive 70 percent of an equal share of the net income in Year One of the partnership (since 70 percent of 50 percent is 35 percent, that means a 65/35 split), 80 percent of an equal share in Year Two (a 60/40 split), 90 percent of an equal share in Year Three (a 55/45 split) and total equality in Year Four.

I have seen these formulae start as low as 60 percent of an equal share in Year One. If that is the case, one should project what that means in terms of salary as compared to the salary prior to becoming a partner. The new partner should not go down in salary in the first year of partnership even after factoring in the buy-in. If that is a distinct possibility, I feel that the buy-in price is too high and thus the formula should be adjusted.

Some groups prefer to use a specific value for the receivables and goodwill, as opposed to a percentage income reduction. In that case, the face value of the receivables should be reduced by a reasonable collectibility factor based upon historical data, and any accounts with no charge or payment for a six-month period should not be counted.

Goodwill is much more subjective. Although there are several methods of determining goodwill values, most practices use a percentage of collections. Such percentage can be anywhere between 20 and 80 percent of a year’s gross collections. Others use a percentage of the average collections over a two year period. A key issue that also arises is whether to use the gross from the year prior to the associate joining the practice or the year prior to the associate becoming a partner, as the associate has certainly contributed to the gross and goodwill.

As an example, let us assume the goodwill and receivables of a two-doctor practice are valued at $450,000 and the net income to split in each of the first four years of partnership is $500,000. The new partner, assuming 50/50 ownership and an otherwise equal split of net income, would make $175,000 each year and the senior partner $325,000 each year, calculated as follows:

The new partner’s buy-in would be $225,000 (50 percent of $450,000), which is “paid” by taking $75,000 less in income each year for three years. An equal split in net income would be $250,000 less $75,000, which equals $175,000. The $75,000 foregone in each year would go instead to the senior partner. In Year Four each partner would make $250,000.

If we instead use the percentage approach outlined above, the new partner would make $175,000 in Year One (35 percent of $500,000), $200,000 in Year Two (40 percent of $500,000), $225,000 in Year Three (45 percent of $500,000), and $250,000 in Year Four.

In addition to the buy-in methodology, the division of net income is also a critical economic consideration. Some practices divide the pie equally and are not concerned with keeping track of relative productivity and time spent on the job. This promotes a team approach, does not penalize someone who may do less lucrative procedures than others, and does not penalize someone who spends a lot of time on administrative matters.

Other practices prefer dividing everything based upon relative productivity, usually by collections, not charges. Of course, if that is the case, the buy-in reductions start from the productivity figures, not from an equal share of net income. If a productivity-based formula is used, many practices simply divide the net income using relative collections, which results in the overhead of the practice also being “paid for” based upon relative productivity. Other practices allocate some of the overhead equally among the partners and some by relative productivity, as some of the overhead may be more fixed than variable.

Other practices use a combination of equality and productivity. For example, 50 percent of the net income may be divided equally, and 50 percent by relative productivity. Others may set equal base salaries for all partners, with any bonuses based upon relative productivity.

Of course, when structuring any productivity-based formula, one must be careful to avoid violating the Stark laws and not compensate the partners based upon certain services not personally performed by them.

When structuring the buy-in, many new partners do not focus on the buy-out. If the senior partner is going to retire shortly, the buy-out is just as important as the buy-in. The buy-out is typically structured similar to the buy-in. The stock would be valued based upon the tangible asset value less debt. The bulk of the buy-out would be structured as deferred compensation or separation pay, which is tax deductible by the corporation. If the percentage reduction method was used for the buy-in, as opposed to the specific valuation of the intangible assets, typically the deferred compensation would be a set percentage of the departing doctor’s salary and bonus for the 12 months prior to termination. That percentage varies anywhere from 25 to 100 percent. Typically, the deferred compensation would be payable over 24 to 60 months in order not to overburden the corporation.

The deferred compensation entitlement is usually subject to forfeiture or reduction if the departing doctor leaves and competes, does not give sufficient notice or is terminated for cause. The new partner is typically not entitled to a full share of deferred compensation until the buy-in is complete. Assuming the buy-out is substantial, I feel there is no need for a restrictive covenant for partners, as long as at least the intangible asset portion of the buy-out would be forfeited upon leaving and competing.

Finally, a new partner should be asked to sign on as a guarantor on any existing debt that the partners have personally guaranteed. However, I feel a new partner should be indemnified against any financial responsibility for a tax or billing audit that results from actions prior to becoming a shareholder.

These are some of the key issues to be addressed in negotiating a fair partnership arrangement. Each deal and each practice is unique, so you cannot always compare your deal to others. It is important to engage an experienced health care attorney who is familiar with the marketplace and the issues to guide you through this important process.

Jeffrey B. Sansweet, Esq., is an attorney with Kalogredis, Tsoules and Sweeney, Ltd. in Wayne, Pa.

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