The Associate Buy-In: Issues for Buyers and Sellers
Edward J. Guiducci, J.D.
The negotiations and contracts involved with an associate buying into a veterinary practice cannot be taken lightly. Associates and Owners must address key issues to ensure that the buy-in is a sound decision and the transition from employee to owner will be seamless.
Find the right match between Owner, Associate and Practice
Veterinary practice ownership is not for everyone. Many associate veterinarians have no desire to subject themselves and their families to the financial risk and the management responsibilities that come with veterinary practice ownership. However, if an associate’s ultimate goal is to be an owner of a veterinary practice then the associate should be thinking about co-ownership opportunities when evaluating associate positions. An associate’s goal should be to join a veterinary practice that he or she wants to own an interest in – and one that will give the associate the chance to buy in. The associate is ahead of the game if he or she has already found such an opportunity. If the associate hasn’t found a practice that he or she would want to be a co-owner in then the associate needs to continue to evaluate co-ownership opportunities.
Once an associate is employed by the practice, the associate will have the most valuable reference point of all: experience as an employee. The associate will learn whether the practice staff is efficient and conducive to maximizing revenues and whether the veterinarians in the practice work well as a team. And the associate will know the practice’s reputation within the community and among other veterinarians. The financial position and realities of the practice will become clearer as the length of the associate’s employment increases and a buy-in becomes more likely.
The associate will learn if the owner is someone that he or she could work with as a co-owner. The associate will learn whether veterinarians have come and gone or whether they have tended to stay. The associate may also learn if any associates left because the owner ultimately refused to let them buy-in as co-owners.
Owners should also be very careful in selecting an associate to buy-in. Many owners view associates that are interested in a buy-in as their veterinary practice exit strategy. These owners are sometimes in a rush to find the associate to buy them out because of their age, health or desire to quit practicing and do not consider what it will be like to be a co-owner with their associate. Owners need to keep in mind that having a co-owner is like a marriage and a practice ownership split can be emotionally and financially devastating similar to a divorce. It is important that owners are comfortable that they can work with the associate to resolve some times difficult ownership issues.
What should the original Associate Employment Agreement say
about an Associate buy-in?
Although the initial associate employment agreement may discuss the potential for co-ownership, it will almost never guarantee future ownership. The owners do not want to lock themselves into adding an associate as a co-owner until they are comfortable that the associate will make a good co-owner. In a rare situation, some practices may be willing to guarantee to sell an ownership interest if certain conditions are met, but the vast majority will not want to be so specific. The reason? Any guarantee of future co-ownership may limit the practice's ability to terminate the associate under the employment agreement.
Owners that are willing to commit to sell an associate an ownership interest after a period of time may be willing to establish the formula upon which the purchase price will be based but it is very rare owner that will commit to a specific buy-in price until the associate has worked for the practice for a period of time.
Associates should also be cautious in agreeing to lock into a formula to purchase an ownership interest. Unless the associate is confident that he or she is getting a real deal, he or she shouldn’t lock in a purchase price formula.
How do you value the practice for the buy-in?
Determining the value of the practice for a buy-in is a major hurdle that the associate and the owners must work through and overcome. It is important that practice owners understand that it is reasonable for an associate to expect the owners to pay for an initial buy-in valuation. However, even when the owners volunteer to have the practice appraised, we frequently hear from the associate that is considering buying-in that he or she is uncomfortable with the appraiser that the seller selected to value the practice, or is uncomfortable with the results of the appraisal.
It is extremely important that owners include the associate in the process of researching and selecting an appraiser. Associates are more likely to accept the appraisal as being valid if they conduct research on appraisal options and are involved in the selection of the appraiser. This is not a guaranty because I have seen many transactions where the associate is still unhappy and distrusting of the final valuation of the practice, but it certainly increases the likelihood that the associate will have a comfort level with the analysis conducted by the selected appraiser.
Owners and associates should be cautious about agreeing upon a purchase price based upon a “rule of thumb” methodology. It is extremely important that associates not overpay when they buy their ownership interest and that owners receive a fair market value for the ownership interest that they sell.
Should an associate who has worked for the practice for a number of years be entitled to a “sweat equity” purchase price reduction?
Associates that have worked with a practice for an extended period of time will sometimes ask for a reduction in the ownership buy-in purchase price to be compensated for increasing the value of the practice. Associates in this position tend to believe that it is inequitable that they have to pay more for their ownership interest because their personal efforts have helped to increase the value of the practice.
Associates that believe that they have a right to a “sweat equity” reduction in an ownership interest purchase price are misguided. The associate has accepted employment with the practice at an agreed upon salary or percentage of his or her personal production. The owners have undertaken the risks of ownership during the associate’s period of employment and are entitled to benefit from the increase in value of their ownership interest.
What percentage of the ownership interest will the Associate
be permitted to buy?
The owners and associate must address what percentage of the ownership interest that the associate will be permitted to purchase and when. This will vary to a great extent based upon the number of owners in the practice, when the owners want to retire, the value of the practice and the personal financial needs of the associate.
Many associates are unwilling to buy-in unless they are permitted to initially buy 50% of the ownership interest or a percentage equal to the other owners. Although I understand the desire to be an equal owner, the value of the practice ownership interest and the personal financial needs of an associate will frequently make it difficult for an associate to initially buy that much of the ownership interest.
If the associate’s primary concern with buying less than 50% of the ownership interest is that as a minority owner he or she would be subject to the decisions of the majority owner, there are alternatives that the owners and associate can explore to resolve this concern. One option is for the ownership agreement to require that the parties submit disputes to mediation. It is important that majority owners be aware that they may have the legal right to out vote a minority owner, but that the co-ownership relationship will not last if the majority owners exercise this right very frequently. The use of mediation will assist the co-owners in resolving their disputes. Another option that is sometimes agreed upon by majority owners is to give the minority co-owner veto power on certain economic issues i.e. change of ownership compensation, profit distributions etc.
Many owners are not interested in selling more than a 49% ownership interest in their practice until they are ready to retire when they will sell their remaining ownership interest. These owners are frequently interested in selling their ownership interest to associates in multiple small percentage sales or “stair steps” over a number of years. These owners are normally willing to act as the associate’s lender and provide very flexible financial terms so that the associate can afford to buy-in and maintain his or her standard of living. At the time that the owners retire the associate will be able to pledge the practice assets to obtain financing to buy the remaining ownership interest.
Owners are sometimes unhappy with associate buy-in structures because the initial sale of ownership interest to the associate will not give the owners much of a perceived financial benefit. Although the owners are receiving a monthly promissory note payment for the initial ownership purchase, the owners are giving up the profit distribution for the percentage of ownership interest that is sold to the associate. This is why many owners feel like they are “giving” the associate the initial ownership interest. It is important that owners recognize that this is a short-term situation because this type of a structure is a true “win-win” for the parties. The associate benefits by receiving the opportunity to buy-in on flexible terms and being guaranteed the right to buy additional ownership interest within a certain number of years while the owner is benefiting by contractually locking a quality doctor into buying his or her ownership interests and providing the owners with an “exit plan”.
How do you structure the buy-in?
Once you have agreed upon the purchase price and the percentage of ownership interest that the associate can buy, the parties must agree on a structure for the ownership interest purchase. In many instances, the associate will pay a portion of the initial stair-step purchase price up front and pay the remainder over time pursuant to the terms of a promissory note. The associate will generally make these payments to the co-owners with after-tax dollars. The associate will then be permitted to purchase additional stair steps up to a maximum percentage prior to the owners retiring at which time the associate will purchase the remaining ownership interest.
In some instances, the associate pays part of the purchase price up front, in after-tax dollars, and pays the remainder over time by way of an income differential. For example, assume that you have agreed that the purchase price will be $100,000 for 10% of the ownership interest. The owners may propose that $10,000 be paid up front and the remaining $90,000 will be shifted from the associate’s income to the owners’ income over a two-year. The buy-in term can be extended to give the associate more flexibility, thereby reducing the amount by which the associate’s income will be reduced during each year of the stair-step buy-in.
Obviously, the purchase price and the payment structure will have tax consequences for each co-owner. The associate gets a tax break if he or she can pay for part of the practice with pre-tax dollars, but the co-owners do not get taxed at the lower capital gains rate on this portion of the purchase price because it is classified as ordinary income to them. Be aware that in an audit the Internal Revenue Service could re-characterize any income differential as payment of the purchase price for an interest in the practice. Under that circumstance, the associate might have the amount of the differential taxed as part of his or her annual income, even though he or she did not receive it as additional income.
Owners’ Compensation
Ownership compensation is a very important issue that needs to be negotiated and resolved very early in the buy-in process. The key to an associate negotiating compensation is to attempt to be treated the same as everyone else -- aside from the income differential that pays for your stake in the practice if it is structured as an income shift. Before agreeing to a compensation formula, apply the income division formula to the numbers from the last several years to see how the formula would affect your earnings and whether the amount you would be paid is adequate. For example, many veterinary practices will either divide net income equally once an associate becomes a co-owner or establish a salary formula based upon the level of personal production of each co-owner. There are several basic structures that are frequently utilized and modified for the needs of each practice. Common structures include the following:
Designated Monthly Compensation Formula
This is a formula that pays the co-owners a set monthly draw or salary. It does not distinguish between a co-owner that is producing or that is taking time off. This structure works well when you have two or more co-owners that have similar work ethics and levels of production. It gives the co-owners the flexibility of knowing that they will have the same level of compensation during periods of time that they take personal leave time. The contract terms will then provide for a distribution of profits to co-owners based on their percentage of ownership on a monthly, quarterly or bi-annual basis (this is also commonly referred to as ROI or return on investment). Although some practices recalculate and distribute profits on a monthly basis, it is more common that practices make the distributions on a quarterly or bi-annual basis to avoid the amount of administrative time spent on calculating the profits.
Collected Production/Detailed Expense Allocation Formula
This is a formula that distributes compensation to co-owners based upon the co-owners’ individual collected production. The practices that utilize this formula simply identify the total amount of collected personal production (as the practice defines the term) for each co-owner and reduce the total amount by the individual co-owners’ share of the practice’s expenses. The practice expenses in this type of a formula are broken down into three categories: Fixed Overhead Expenses which are expenses that are shared equally; Variable Overhead Expenses which are expense that are shared based upon percentage of total practice production; and Individual Expenses which are expenses that are unique to the individual co-owners and are deducted totally from the co-owners’ production. This formula will frequently minimize the amount of profits that are being disbursed based upon the percentage of ownership because more of the total compensation is being disbursed to the co-owners on a monthly basis based upon production. The benefit to this type of structure is that the detail of the breakdown of Variable Overhead Expenses that are shared based upon the percentage of total production versus individual expenses that the individual co-owners are totally responsible for insures that the co-owners that are producing more will pay for more of the overall expenses.
Percentage of Collected Production/General Percentage
Expense Allocation Formula
This is the same structure as the Collected Production/Detailed Expense Allocation Formula except that it provides for the Fixed Overhead Expenses and the Variable Overhead Expenses to be divided equally with a multi-owner practice as opposed to making the higher producing shareholders be responsible for a higher percentage of the Variable Overhead Expenses. This formula is different from the Collected Production/Detailed Expense Allocation Formula because it divides the non-individual practice expenses equally with two co-owners as opposed to making the higher producer pay a larger percentage of the total practice expenses. The excess will be disbursed as return on investment based on percentage of ownership on a periodic basis
Should an owner be subject to a non-competition/non-solicitation
covenant if he or she leaves?
Restrictive covenants are almost always negotiated as a condition of co-ownership because the co-owners will want to guard against the possibility of a co-owner competing with the practice. Many co-owners view the restrictive covenant as a negative but it is important to remember that a restrictive covenant protects co-owners from other departing co-owner competing with the practice.
In all states, restrictive covenants that arise as part of an ownership agreement are enforceable if reasonable in scope (the geographic radius of the restriction) and reasonable in duration. In many restrictive covenants associated with co-ownership, the restriction does not prohibit you from practicing, but instead imposes liquidated money damages as a remedy for violating the restrictive covenant. In many instances, practices do not want to go to the trouble or expense of enforcing a restrictive covenant, but they will use it to penalize a co-owner if he or she competes with the practice upon leaving.
It is important that the methodologies by which a co-owners interest in a practice will be bought out when the co-owner leaves are consistent with those used to determine a buy-in. Obviously, it would be unfair for a co-owner to pay a large amount on the way into a practice, only to have nothing to show for it
Business Continuation/Exit Strategy Issues
The purpose of business continuation and exit strategy ownership agreement terms is two fold. The co-owners establish under what circumstances a co-owner (or his or her estate if deceased) would be forced to sell their ownership interest and on what terms. Upon the occurrence of certain triggering events the co-owner is required to sell or offer to sell his or her ownership interest to the remaining co-owners. The ownership agreement also identifies a formula to value the ownership interest and provides for payment terms that will either require the owners to buy insurance to fund a purchase i.e. life insurance or lump sum buy-out disability insurance or will specify the length of time for the payment of the purchase price and the rate that the unpaid balance will accrue interest upon. It is designed to be mutually beneficial for all parties in order to permit the seller, or if a death situation, for his or her family to be paid the agreed upon amount over a reasonable period of time. It is also designed to permit the remaining co-owners to continue the practice while paying the seller or his or her family the value of the ownership interest without causing the practice to fail due to cash flow problems.
Closing advice
A properly structured associate buy-in is a complicated endeavor. It is advisable to seek the advice of an attorney, tax advisor or practice management consultant before verbally agreeing on the terms of the purchase. Owners or associates that verbally agree to terms without understanding the tax and legal consequences of such an agreement risk damaging the relationship by having to back out of certain verbal agreements. The failure of either an owner or an associate to properly plan and negotiate the buy-in can lead to an unhappy practice divorce. Knowing what to look out for puts you ahead of the game.