Starting your private practice was probably one of the most important business decisions you ever made. But equally high on the list was the decision to bring on a partner. Whether it was a friend, family member or a coworker, you took the time to ensure the relationship would work – functionally and financially.
But what happens when a partner suddenly leaves? Even worse, what happens if a partner unexpectedly dies or becomes disabled? If you’re not prepared for any of these events, your business could be financially devastated. To ensure that you and your partners are prepared to handle these disruptive situations, consider incorporating a buy-sell agreement.
Simply put, a buy-sell agreement is a critical component of your business. Anytime there’s more than one owner in a practice, a written buy-sell agreement should be in place. It provides a sensible transition plan if a partner dies, retires or becomes disabled. In most cases, a buy-sell agreement is among all of the partners, although, at times, the interests of certain partners may take precedence over those of others.
For example, when an older partner in a practice takes on a much younger partner, the primary focus of the agreement would be on planning for the death, retirement or disability of the older partner. Particular emphasis would be placed on addressing funding issues when one of these events occurs.
Obviously, the terms of a buy-sell agreement will vary, depending on the specific circumstances of the partnership, but typical agreements cover the three major trigger events: death, disability and retirement. Each event will require a different funding solution.
Death of a partner. From a funding standpoint, the death of a partner is one of the easiest events to plan for. Partners will usually purchase life insurance policies on each other. But in some cases – such as when one partner owns a very small interest in the practice – an insurance policy may only be needed on the life of the majority partner. In either case, the surviving partner can cost-effectively fund the purchase of the deceased partner’s interest through life insurance. Having adequate life insurance provides immediate cash flow to the deceased partner’s estate and supplemental cash flow to the business to offset the loss of the partner. It also enables partnership interests to be transferred without creating a financial crisis for the practice.
Retirement or disability of a partner. When a partner sustains a disability that prevents him from actively contributing to the business, and such disability continues for an extended time, the disabled partner’s interest in the business may need to be bought out. Similarly, a partner’s interest will need to be purchased upon his retirement from the practice.
A properly structured buy-sell agreement should include provisions for buying out a partner’s interests under both situations. For disability buy-out purposes, the agreement should:
- Clearly define the term “permanently disabled.”
- State how long the disabling condition must last before the buy-out is triggered.
- Address using disability buy-out insurance as a funding source. (Disability buy-out insurance is different from regular disability insurance; it pays a lump-sum benefit when a partner becomes “permanently disabled.” Whereby regular disability is used to replace the income of the disabled partner by providing a monthly income benefit.)
For retirement and disability buy-out purposes, the agreement should provide a formula for valuing each partner’s interest in the practice. It also should address how the buy-out will be funded, with particular emphasis on financing arrangements.
Financing the Buy-Out
It’s rare that the remaining partners have sufficient independent resources to buy the retiring or disabled partner’s interest with out-of-pocket funds. Therefore, when a partner retires or becomes permanently disabled (without insurance), the remaining partners probably would have to finance the buy-out over a period of years, with the seller holding a promissory note on the balance owed. This section of the buy-sell agreement should state the term of the payment period (often five to 10 years), when payments are due (i.e., monthly or yearly) and the interest rate to be applied to the unpaid balance.
The buying partners usually will rely on the cash flow of the business to cover their buy-out payments. If that cash flow is not sufficient to support the cost of running the practice and the buy-out payments, a financial crisis may occur. This may be alleviated if the selling partner can be flexible with the payment plan, perhaps by extending the payment period or reducing the interest rate. Too often, though, the selling partner will rely heavily on the buy-out proceeds, particularly in a disability situation. By extending the payment terms, the seller will simply transfer the financial crisis from the business to himself. Planning early is the best way to avoid potential funding problems in a buy-out. Here are a few suggestions.
Make sure the buy-sell agreement is flexible to permit the partners to modify financing terms, if necessary, on the retirement of a partner.
Purchase a sufficient amount of life and buy-out disability insurance coverage on each partner (assuming they’re insurable at a reasonable cost). If permanent life insurance is part of the buy-sell arrangement, it may be possible to use the accumulated cash-value to partially fund the buy-out obligation upon disability or retirement, although it generally won’t provide all of the cash needed.
If you purchase disability buy-out insurance, be sure that the language in the agreement matches the terms and conditions of the policy. For example, if the policy states that the person must be disabled for two years before benefits are paid, be sure you don’t have language in the agreement stating that a partner will be considered permanently disabled after one year.
Create a savings plan that will allow you to retire with little or no reliance on receiving any proceeds from the sale of your partnership interest.
If a new partner will be brought in to replace a retiring partner, then begin looking for that new partner several years ahead of the anticipated retirement date.
Valuing Your Practice
One of the major components of a buy-sell agreement is the valuation formula. The formula used will vary, depending on the dynamics of each practice, although it’s usually based on a revenue percentage. A revenue-based formula doesn’t consider the value of any real or personal property owned by the partnership. If the partnership owns the physical property on which the practice is situated, then it may be a good idea to have that property owned either individually or in a separate partnership. The property could then be leased to the partnership, which operates the practice. A separate buy-sell agreement would be needed to deal solely with the real estate.
A revenue-based formula will generally be based on a percentage of either the gross revenue or the net profit of the business over a one-year period. A gross revenue formula often will be based on one to 1.5 times the total annual collections of the practice. A net profit formula will often be based on three to four times the annual net profit. The decision to base the formula on revenue or profit will depend on how your practice is structured.
If the practice has a high profit-to-revenue ratio, then using net profit may be the better solution. If revenues are high, but profits are low, then using gross revenue may be a fairer way of appraising the value. If a great disparity exists in how much revenue is generated by each partner, then you may want to factor that into the formula as well. For example, if one partner generates 70 percent of the revenue while the other partner only generates 30 percent, then you’ll need to address this disparity. The partners will need to determine whether the buyout will be based on the revenue generated by each partner or by the total revenue of the business.
A buy-sell agreement is a critical component of your business plan. With such an agreement, your practice can survive the death, permanent disability or retirement of a partner. You can’t afford to do without one.
Mark Papalia, CLU, ChFC, CFP, is president and founder of Papalia Financial in Danville, Pa.