make sure you’re looking at the big picture.
by marc rosenberg
this post applies only to transactions that are true mergers, which require the sellers to sign the buyer’s partner agreement.
more: partner agreement issues affecting women | mandatory retirement: pros and cons (and is it legal?) | deciding how to allocate partner income | making partner: today’s 15 essential skills and traits | how to specify managing partner duties | when votes must be taken, what are the options? | a crash course in partner retirement/buyout plans | protect your business with a solid partner agreement
in a sale, the owner(s) of the seller don’t sign the buyer’s partner agreement because they won’t become owners of the buyers.
partner agreements govern the firm as it currently exists. the firm’s partners are expected to adhere to all provisions of the agreement. when a firm adds partners via internal promotions or mergers, the new partners are expected to adhere to the firm’s existing partner agreement.
merger agreements are primarily intended to confirm the merger’s deal terms. merger agreements typically address issues in far more detail than partner agreements. examples will be given later.
provisions in the buyer’s partner agreement that may be a problem for sellers
- the retirement/buyout plan. the seller’s partners get paid for the value of their firm when they retire under the terms of the buyer’s partner agreement. therefore, the seller has to feel that the buyer’s retirement plan is fair. example: the seller’s buyout plan values goodwill at 100 percent of revenue. the buyer’s plan is at 80 percent. will the seller accept this reduced valuation?
- vesting. it is common in mergers for the partners of the seller to be grandfathered for vesting in the buyer’s buyout plan. example: if a person was a partner at the seller for 10 years, they will be granted 10 years of vesting in the buyer’s plan.
- capital and capital accounts. the seller’s partners are usually expected to maintain a capital account just as the buyer’s partners do.
- ownership percentage. the ownership in the buyer by the seller’s partners must be acceptable to them.
- how the firm will be managed. this can be a bone of contention in two ways:
- larger firms usually have a much more formal, corporate management structure than smaller firms. one of the biggest differences is the managing partner. at larger firms the mp functions as a ceo, whereas at smaller firms the mp (if they even have one) is more of an admin partner with little decision-making authority. so the partners from the smaller firm must feel comfortable working at a firm where they will have a “boss” who will hold them accountable for their performance and behavior.
- another major difference is the existence of an executive committee at larger firms. depending on the nature of the merger and the size of the smaller firm vs. the larger firm, the two merger parties may need to discuss how much representation the smaller firm will have on the executive committee. in cases where the buyer is many times larger than the seller, it is extremely rare for this issue to ever arise.
- voting. how compatible are the voting rules between buyer and seller? a common scenario is when the seller votes based on wildly varying ownership percentages and the buyer votes one partner, one vote.
another potential point of contention: at small firms it’s common for most decisions, large and small, to be voted on in partner meetings. at larger firms, most decisions are reserved for the firm’s management, primarily the managing partner, the executive committee, the coo and department heads. at larger firms, voting by all partners is usually reserved only for significant issues such as mergers and admission of a new partner.
- mandatory retirement. the vast majority of larger firms have a mandatory retirement provision. they believe that without it, the firm will lose talented, ambitious young staff and the orderly transition of clients from older to younger personnel will be jeopardized. mandatory retirement is an essential part of their firm’s succession plan.
smaller firms often don’t have mandatory retirement provisions. their partners can’t conceive of being forced to retire before they want to. many wish to work well into their late 60s and 70s.
- overwithdrawing compensation. most larger firms do not allow partners to withdraw compensation in excess of their allocated amount. but smaller firms are often quite loose on this. the partners reason that, if they have an urgent cash-flow need such as making quarterly tax payments, paying for college or buying a second home, they should be allowed to withdraw extra cash as long as their capital account balance remains positive. the smaller firm has to be comfortable with the larger firm’s policy on this.
- investing in non-attest clients’ businesses. larger firms tend to have restrictions on such investments but smaller firms usually do not. larger firms often require the firm’s approval, with the caveat that it will not be unreasonably withheld.
- serving on outside boards. the issues are similar to those for investing in non-attest clients’ businesses.
- name of the firm. depending on the size of the seller vs. the buyer, a name change may be up for discussion. if a $20 million firm mergers in a $2 million firm, there is no discussion. but if a $6 million firm merges in a $4 million firm, it’s understandable that one or both parties would consider a name change.
- non-solicitation agreement. this critically important covenant tends to be more strict and formal at larger firms and might not even exist at smaller firms. it’s common at smaller firms for the partners to agree that if one of them is unhappy, the partner is free to leave and take whatever clients he or she wishes. this won’t fly at larger firms. so this is clearly an issue that the smaller firm must be comfortable with.
- non-equity partner. in many mergers, not all of the seller’s partners join the buyer as equity partners. so the two parties have to agree on a title/position for each of the seller’s partners. the most common way to deal with this is to make some of the seller’s partners non-equity partner or similar non-ownership titles or positions. there needs to be a provision for this in the buyer’s partner agreement.
i was involved in a situation where the seller’s owners had to check their egos and titles at the door and focus on the tremendously attractive deal terms that were offered.
sellers: don’t get hung up on titles
in mergers where the seller’s owners are not retirement-minded, it’s natural for them to want to come into the buyer as equity partners. after all, they have been partners at their own firm for 20 or more years. accepting a lesser position feels like a demotion and is insulting and embarrassing.
but sellers need to cast aside their egos and emotions and look at the attractiveness of the basic deal terms. here’s a great example.
a four-partner firm with a great specialty asked me to find a larger merger partner. two of the owners were 45 and two were 58. their average partner income was an unexceptional $250,000. their $3 million of revenue was flat. none of their staff had partner potential. they were skeptical that any buyers would be interested in them.
i found them three buyer candidates. one in particular was a top 20 firm that confirmed their high level of interest at the first meeting. this firm’s internal policy was to maintain a revenue ratio of $1.5 million per equity partner. therefore, only two of the four seller’s partners would become equity partners. the other two would become non-equity partners. the silence was palpable.
the buyer went on to say: “i see you are disappointed that only two will become equity partners. let me see if i can ease your distress. first, we will write you a $3 million check immediately for your clients. last year, our equity partners averaged $800,000. our non-equity partners averaged $400,000. we can’t guarantee that the two of you who will be non-equity partners will make $400,000 in the first year or two. but we are confident that our management model will make your firm way more profitable that it is today. and by the way, we have one partner meeting a year, so even the two equity partners will have virtually no involvement in firm governance. we want our line partners to focus on their clients, growth and developing staff. that’s it. do you still feel disappointed?”
- partner duties, prohibitions and grounds for expulsion. the larger the firm, the more likely it is that their partner agreement will be formal and strict in this area. the partners of the seller need to be comfortable with this section of the buyer’s partner agreement. here are some of the more common items that may disturb the seller:
- failure to perform as a partner, including carrying out the duties specified in the partner agreement, is grounds for expulsion.
- 100 percent of a partner’s time must be devoted to the firm. this means that partners can’t own other businesses without the firm’s approval.
- remuneration and perks provided to partners by clients must flow through the firm and cannot be retained by the partner.
- fees paid directly to the partner for serving clients as a trustee or executor must flow through the firm.