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What should go into a shareholder agreement

By Mark A. Master, CPA & Joshua Zissman

Physician practices can have a number of different legal structures: sole proprietorship, partnership, professional corporation (designated either a “c” or “s” corporation), and in many states, limited liability corporation (an “LLC”). Each of these legal arrangements has particular advantages and disadvantages. However, common to all of them—except sole proprietorship—is the need to specifically delineate the legal, operational and financial relationhip(s) among the principals, in addition to the definition of the legal arrangement itself.

If your practice is organized as a Professional Corporation (PC), you can protect your individual interest and minimize the potential for conflict by creating a shareholder agreement. A shareholder agreement typically covers three major areas:

• The financial relationship among the shareholders.

• The process of decision-making within the firm.

• The mechanism for transferring and selling shares.

Practices organized as PCs must file articles of incorporation with the secretary of state, or appropriate office of the state government of the state in which you practice. In addition to the articles of incorporation, the completion of a shareholder agreement can provide additional protection. Articles of incorporation, for the most part, can be revised if shareholders with at least 51 percent of the shares vote to do so. But the “standard” shareholder agreement cannot be amended unless all of the shareholders so agree. In addition, while the articles of incorporation are a matter of public record, a shareholder agreement is a private document.

To ensure the smooth running of your practice, and to avoid possible litigation, consider drafting a shareholder agreement to cover the various concerns of the shareholders. By committing these concerns to a written document, potential problems are anticipated and dealt with according to this shareholder agreement as designated in advance by the involved parties.

Stock Ownership

The initial investment. Generally, your percentage of ownership depends on your capital contributions—but not always. A shareholder agreement should spell out just how much money each shareholder will contribute, as well as the number of shares he or she is to receive in return. These ownership issues can be resolved in a number of ways: different classes of stock; ownership based on capital contribution; shares allotted according to a combination of capital contribution, seniority and other factors deemed relevant by the partners, etc.

Additional investments. As a shareholder, you cannot be forced to contribute capital beyond what you agreed to initially. Nevertheless, if other shareholders put additional money into the PC, they will probably receive additional shares, which would dilute your voting interest. Conversely, if a shareholder, or group of shareholders decides to buy additional stock in the PC and the rest of the shareholders are willing to sell, you may not have the right to participate in the stock purchase, unless it is a specified right in the articles of incorporation or the shareholder agreement. A shareholder agreement, however, can also specify that no such sales could take place unless there is unanimous agreement among the shareholders. Also, a typical PC issues a set amount of shares to be distributed among the founding partners, with a remaining balance to be distributed among new partners as they are brought into the practice.

Leaving the Firm

Termination of employment. If you quit or are fired, what happens to your stock? Does the PC have an option (or is it required) to buy it back, or have you lost your investment? These issues, as well as the price at which the stock will be repurchased, should be addressed in a shareholder agreement. Without one, if you are terminated, you may not have the right to require that the PC buy you out and/or the PC may not have the right to buy you out.

In most physician practices, the typically desired outcome when a shareholder or partner leaves is that he or she gives up all claims to rights within the practice (except for those financial considerations specifically delineated).

Retirement. You might assume that the PC is obligated to buy you out when you retire because you are no longer practicing as part of the PC. As long as you maintain your license, some states permit you to be a shareholder of a PC, whether or not you are actively practicing.

However, the remaining members of the PC may not want to share ongoing profits with you after you have retired. Therefore, even without a shareholder agreement, the PC would probably want to buy you out. Without an agreement in place you could get back nothing more than your initial capital investment, or even a lesser amount. Without such an agreement, there is no obligation to pay you the fair market value of your stock—assuming you and the other shareholders can agree on what that is.

A shareholder agreement, therefore, should contain one or more processes for determining the fair market value of your stock and, ideally, provide a method for ensuring that when you retire, the PC has the necessary funds to buy you out.

Death or disability. The same issues that crop up at retirement arise if a shareholder of the practice dies or is permanently disabled and can no longer practice. Often, a deceased’s estate can legally hold his or her stock for a reasonable period of time while the estate is being administered. Because only a licensed professional can be a shareholder in a PC, the stock would have to be returned to the PC. A shareholder agreement should address two issues: the price at which the deceased’s stock will be repurchased, and a method for ensuring that the funds are available.

Decision-making and Control

A corporation ordinarily is governed by a board of directors responsible for the overall conduct of the business. In a PC a managing partner or other manager may exercise such authority. The shareholders elect the board, which in turn chooses the corporation’s (practice’s) officers. The officers run the practice’s day-to-day business at the board’s direction. The board is elected by shareholders holding a defined percentage of the stock. If you are not part of a group that controls that defined percentage, you will have little or no say as to who is elected to the board or how the PC’s business is run, unless you have a shareholder agreement.

Shareholders holding a majority of the stock may elect to merge with or sell to a firm of which you are not a member. They may also amend the articles of incorporation to your detriment although the law does give a shareholder who votes against any of these transactions and who follows certain procedures some protection. As a dissenting shareholder, you have the right to be bought out of the PC at fair market value if certain conditions are met. Ultimately a court will decide the fair market value of a dissenting shareholder’s stock. But the process may require a lengthy, expensive lawsuit.

A minority shareholder (one with less than a controlling interest), or group of such shareholders, can sometimes negotiate a requirement for a “supermajority” vote for certain transactions with the majority shareholders. For example, the shareholder agreement could stipulate that the PC could not be merged without the consent of shareholders holding at least 75 percent of the PC’s stock. This does not give a minority shareholder an absolute right to block a merger, but it does provide some leverage.

A shareholder agreement can protect you as a minority shareholder in another way, by giving you the right to elect one member of the board (yourself, usually). Even though you cannot control board decisions, you’ll be kept informed about transactions involving the PC.

Share Transfers

As a shareholder, you may assume you have the right to determine with which professionals you will practice, as you would in partnership. But this is not true in a PC. Without a shareholder agreement, a shareholder can sell or otherwise transfer his or her stock to another licensed professional without the consent of other shareholders.

As most professionals want to avoid such situations, a shareholder agreement can be used to restrict the ability to transfer stock. The agreement should stipulate, at a minimum, that the other shareholders and the PC have a right of first refusal. In other words, a shareholder cannot sell his or her shares to a third party. Without the shareholder agreement, a shareholder can freely sell his or her shares to a third party whom the remaining shareholders do not like or may not even know.

Physician Practices vs. Other Business Entities

In general it should be noted that there are some substantial differences between physician practices and other business entities. First and most important, is the requirement that all PCs be owned only by physicians. This requirement may vary somewhat from state to state. However, it should be remembered that other business entities can be owned and can hire non-professionals (i.e., “generic” MBAs) to operate and market their business. PCs must have physicians not only providing the service directly, but also in top management positions in order to conduct the business of the practice itself.

Also, in contrast to other business entities, PCs usually have a smaller number of shareholders with a direct operational impact on the performance of the business. Consequently, there is usually more stability and less “trading” of shares. The success of a PC is based on the reputation of the physicians as providers. A continuous turnover of physicians would not only damage the quality of care in the practice, but would most certainly have a negative impact on the management and financial success of the practice.

The success of a group practice is based on many factors: personalities of the principals, financial and operational acumen of each of the individual practices (or physicians) joining the group, the clinical reputations of the principals, and the openness and honesty of the negotiations among the interested parties. All of these characteristics must be embodied in the shareholder agreements, demonstrating a depth and strength to withstand the potential downturns that any business may face.

It is important to realize that once these shareholder agreements are put in place and implemented, the only time they will probably be dusted off and reviewed is when times are “not so good.” If the practice is successful and everyone is happy, for the most part, the shareholder agreements will not see the light of day.

Mark A. Master, CPA, is an accounting and auditing partner, specializing in physician practices, of Goldenberg Rosenthal, LLP in Jenkintown, Pa. Joshua Zissman is a partner of Practical Healthcare Solutions, LLC in Jenkintown, Pa.

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