A successful professional partnership, whether doctors or lawyers, accountants or architects, requires more than a group of skilled service providers practicing their craft together. A robust partnership agreement will protect your partnership’s financial position, maximize operational efficiencies and establish a path to longevity. This article addresses 5 key provisions for inclusion in a partnership agreement.
- Governance
Your agreement should establish clear governance procedures that are uniformly applied to resolve potential conflicts.
Depending on the size and composition of your partnership, it may not be efficient to require that all partners be consulted and/or vote on all matters affecting the partnership. Identify decision-makers in your agreement. These are not necessarily “rain makers” focused on generating business, but those partners who have demonstrated their ability to thoughtfully evaluate complex issues and act decisively to execute difficult decisions in the best interest of the partnership at large.
Once decision-makers have been identified, meeting and voting procedures should be established. Your agreement should bind all partners to the decisions of your manager group, but also create processes to enable non-managerial partners to call and attend special meetings to address emerging issues in a timely manner.
If partners are reluctant to cede complete control to a designated group of managers, consider identifying a subset of decisions that are so fundamental to the business that unanimous or supermajority partner approval should be required. These decisions may include:
- the admission or removal of a partner,
- hiring or firing key non-partner employees,
- entering into material contracts over a specified dollar value,
- establishing an annual operating budget,
- capital calls and securing third-party financing,
- capital expenditures,
- liquidity events, and
- dissolution.
Finally, to encourage transparency and build trust amongst partners, your agreement should identify how and when information and decisions are communicated with non-managerial partners.
- Capital
Your agreement must address capital needs: how and when partners may be required to commit capital to fund the partnership’s business operations and the consequence of a partner’s failure or refusal to fund.
Even though many partnerships will not require partners to contribute additional capital, those partnerships still need to address in your agreement what happens if the business needs additional capital. One option is to treat voluntary capital contributions as a loan by the contributing partner. The loan will typically accrue interest, be repaid out of operating cash prior to making distributions, and accelerate on certain qualifying events (upon the sale or dissolution of the partnership or the contributing partner’s exit). Alternatively, additional capital can dilute the non-contributing partners (depending on the circumstances under which the capital is contributed and risk of repayment, dilution can be proportionate or disproportionate to incentivize participation).
If all partners are unwilling or unable to fund business operations, then the partnership must look to third-party financing sources. Here again your agreement must identify who has the right to source and secure financing.
- Distributions
Your agreement should specify rules and procedures for cash distribution while ensuring that the partnership maintains adequate cash to cover operational costs and reinvestment needs. Be mindful of debt obligations and financing covenants that could restrict distribution payments. At minimum, provide for regular partner draws (typically paid monthly or quarterly) and tax distributions (typically paid quarterly or annually).
- Transfer Restrictions
Limiting the transferability of partnership interests maintains the identity of your partner base and ensures new partners do not enter the partnership without consensus. Note that most states require equity in professional partnerships to be held by duly licensed and actively practicing professionals, which is already a significant restriction on ownership. Consider including the following provisions in your agreement to further limit transferability:
- Right of First Refusal: This provision grants the partnership, and then the remaining partners, the right to purchase a departing partner's interest on the same terms and conditions as the departing partner would receive from a third-party purchaser.
- Tag-Along Rights: This provision grants the remaining partners the ability to sell a pro rata portion of their interests to a third-party purchaser, proportionately reducing the amount of equity the departing partner would otherwise transfer. This ensures all partners have an equal opportunity for liquidity.
- Lock-Up Periods: This provision imposes a complete restriction on transfers for a set period of time.
- Non-Compete and Non-Solicitation Clauses: These clauses prevent a departing partner from directly competing with the partnership or soliciting clients and employees for a specified period after departure. Note, however, that many jurisdictions limit or prohibit restrictive covenants on certain professionals, including lawyers and medical professionals, as a matter of public policy.
- Succession Planning
Succession planning enables existing partners to extend their personal legacy while incentivizing the next generation for retention and commitment to the business. Succession planning can also provide an income stream to retiring partners as books of business are transferred.
Your agreement should establish guidelines for transitioning both managerial control and economic value to young partners. Consider an equity structure that includes both capital equity, whereby partners share in the existing capital value of the partnership, as well as profits-based equity, which shares only in future growth. Profits interest partners can transition to capital partners over time.
Define triggers for partner withdrawal in your agreement, as well as parameters for valuing a partner’s stake upon exit, including:
- A/R (particularly recurring revenue streams),
- client demographics and engagement fee structure,
- proprietary systems or infrastructure, and
- goodwill.
Consider whether valuation should be discounted to reflect factors surrounding a partner’s exit (death or retirement vs. continued service with a competing business). Finally, your agreement should establish payment terms for buyout. Will departing partners require cash upfront or will they accept deferred payment? Can a buyout payment be financed using third-party loans or seller-provided financing or will the partnership require personal funds?
By establishing governance procedures, addressing capital needs, creating mechanisms for cash distribution, limiting transferability and managing succession planning in your partnership agreement, you will create a legally binding framework that clearly outlines the rights and responsibilities of each partner, thereby minimizing potential disputes and ensuring partners can focus their efforts on client service to maximize revenue.
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Please contact Jillian Benda Goldberg, Esq. at , or 908-206-4214 for more information on professional partnerships.
