In this challenging era, and any time important decisions need to be made, the certainty of a partnership agreement takes on greater importance. A well-founded agreement sets the culture of the firm. It spells out the decision-making process and sets forth each partner’s rights and responsibilities. Perhaps most significantly for today, it lets partners know how decisions will be made and how much influence they have in making those decisions. It limits the potential for discord when resolving big issues. Here are essential points that should be addressed in a partnership agreement.
One of the key provisions of any partnership agreement addresses how issues are resolved and by whom. Many firms are run by an executive committee, so your agreement should designate the number of members that will comprise the committee and how they are chosen. They might be selected by the managing partner, other executive committee members, or by a vote of the entire partnership. Further establish if committee members will have term limits. If there is a sole managing partner, include details on the scope of his powers and authority.
Address how both major and day-to-day decisions are reached. Most major decisions, e.g., a merger or seeking a loan, may be determined by a supermajority vote of 66% or 75% of the partners. Setting staffing requirements and other day-to-day decisions are typically left to the executive committee or a subcommittee appointed by the executive committee. In establishing these management rules, partners must be willing to give up some rights as owners for the firm to function efficiently. The time spent in democratically debating inconsequential issues is much better spent servicing clients or pursuing new ones. In the current economy, setting the decision- making rules on issues is particularly important: such as increased bank borrowing; space needs; associate, paralegal, and administrative compensation; staff requirements; mergers or lateral hires and capital requirements.
A good partnership agreement eliminates uncertainty over how compensation is determined. This is valuable in all circumstances and particularly if you need to reduce compensation or want to reward exemplary performance. In your agreement, specify the method used for compensating partners and allocating the firm’s income. Firms typically allocate income based either on predetermined percentages or by a points system that incorporates such factors as fees originated, hours billed, and fees collected. Ensure that the agreement states who makes the final decision on compensation – the managing partner, executive committee, or compensation committee.
In many agreements, the amount a partner can draw is based on a percentage of prior year income. Language should clearly spell out how often a partner can draw – whether it is weekly, monthly, or some other period. Include provisions for the executive committee to adjust distributions based on cash flow. If the executive committee decides to reduce distributions, communicate this to the partnership without delay.
Partners prefer to know in advance what their capital contribution obligation will be, so it is best to have an established formula in the agreement and include a provision for capital calls. There may be times when a call for additional capital cannot be met by all partners, so the agreement should allow for loans. Any partner that advances funds in excess of the required capital obligation should have that advance treated as loan, with interest and repayment terms.
This is one of the most difficult decisions for any firm. Sometimes it may involve a partner who is well-liked or has been with the firm for quite some time. For these and many other reasons, the agreement must be very specific in this area. Establish when a partner can be terminated with or without cause and specify who makes the decision – executive committee or a vote of the partners. The agreement should detail what constitutes cause. At a minimum, cause typically occurs upon the withdrawal or suspension of the partner’s license to practice law, the partner being held guilty of professional misconduct or the bankruptcy of the partner. In many agreements, a partner terminated with cause receives no more than his capital account. A partner who is terminated without cause is typically treated the same as a retired partner and receives some form of termination payment in addition to the return of his capital.
Retirement is often a sensitive issue, so it is important to clarify the firm’s retirement age. There are times when, for the financial security of the firm, partners at or near retirement age are asked to retire earlier than anticipated. Whatever the circumstances, in retirement, partners are generally paid back their capital and receive retirement compensation based on either their share of the firm’s billed and unbilled receivables at the date of retirement or a multiple of their earnings. Structure these payments over a period of time so that they do to not adversely affect the firm’s cash flow. In addition, the total of payments to all retired partners should be limited to a set percentage, 20 to 25%, of the firm’s net income.
Liquidating The Firm
As difficult as it is to face, your agreement needs to contain provisions in the event the firm decides to liquidate. Language should give guidance as to how the liquidation will be carried out. Address who will oversee the liquidation, the priority of payments to be made, and the allocation of excess funds, if any, among the partners.
Though there may be reasons for not implementing a partnership agreement, they are not good ones. The time you spend in preparing a comprehensive agreement now will save the far greater time you will spend resolving the issues you will eventually confront. Moreover, a good agreement enables the firm to function more efficiently and frees partners to concentrate on professional issues and on meeting with and seeking clients. Most importantly, when it comes to partnership agreements, ask yourself this question: “What advice would I give to my client?”
Tony Cucci is an audit partner and Lisa Knee is a tax partner and attorney with the CPA and advisory firm Berdon LLP with offices in Jericho and New York City. They bring decades of experience advising professional services firms of all types and sizes on practice management issues and on ways to operate efficiently with greater profitability.
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