… and what partner candidates should know before they sign.
by marc rosenberg
how to bring in new partners
what is a partner agreement?
according to nolo.com, “a partner agreement spells out the rights and responsibilities of the firm’s owners. without one, firms will be ill-equipped to settle or avoid conflicts because if certain key passages are missing or written improperly, the courts will intervene in ways that the partners may not like. a partner agreement allows the firm’s partners to structure their business relationships with each other in ways that suit their desires, needs and preferences.”
more: six systems used to determine partners’ goodwill payments | how partner buyouts work | what buying in actually means | how partner and staff actions impact profits | nuts and bolts of mentoring staff | nine ways to measure staff performance on the path to partner | sixteen duties of a partner
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any post on partner agreements will have an obligatory paragraph like that. here is a more in-depth description that may be illuminating.
a partner agreement is a legally binding document that stipulates how the firm will be governed. by signing this agreement, all the partners agree to abide by the document’s terms. the partner agreement essentially contains the rules of the game. this helps the firm minimize problems and disputes such as these:
- one-size-fits-all state laws. in the absence of a signed agreement, state laws, which vary by state, will be used to settle partner disputes. by necessity these state laws are one-size-fits-all rules. it’s much better to have an agreement in which the firm’s partners specify the rules for their firm on their own terms. examples:
- a cpa firm decides not to provide for payment of goodwill-based retirement benefits. without a partner agreement, state law could require the firm to pay these benefits if the departed partner sues the firm for them.
- if the founder or a power partner dies or becomes disabled, the other partners may be legally entitled to a much larger share of the firm than they deserve.
- voting. great example: a four-partner firm asked me to help them with their first-ever partner agreement. the firm was dominated by its founder. he brought in most of the firm’s clients, managed the firm and was the primary driver of virtually everything in the firm, including its success and profits. without a written agreement, the founder was susceptible to the three other partners essentially throwing him out of the firm, with or without valid cause.
- allocating firm income. most firms allocate partner income based on partner performance, as opposed to nonperformance methods such as ownership percentage, pay-equal or seniority. although many firms factor this into the allocation system, in the absence of a written agreement, in the case of a dispute, it’s possible a court could force the income to be allocated on ownership percentage rather than performance.
- expelling partners. specify circumstances that allow the firm to expel a partner. without this, firms may be greatly limited in terminating partners, even for egregious acts.
- other critical issues that partner agreements need to address:
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- admission of new partners
- duties of partners
- duties and authorities of the managing partner
when duties and rules of conduct are documented in a partner agreement and signed by all partners, they are more likely to adhere to these rules than if there is nothing in writing.
critical provisions in a cpa firm partner agreement
there will be two different types of readers of this post, and they will read the text from different perspectives:
- partners of the firm. they should read this post and ask:
- is our partner agreement up to date and does it contain the provisions cited in this post?
- does our agreement provide strong protection of the firm and minimize the possibility of disputes among the partners?
- if we expect partners from merged-in firms and new partners promoted from staff to sign our partner agreement, are we proud to show them our document because we know it’s current, strong, fair and properly written?
- partner candidates. becoming a partner in the firm is a big deal, something you should be proud of. part of being a partner is signing the firm’s partner agreement. is the firm’s agreement current, coherent, fair and properly written? are you comfortable with the restrictive provisions and obligations that go along with becoming a partner? do you understand all the provisions?
here are those critical partner agreement provisions:
- new partner buy-in. the firm should require this because (a) all owners should have a meaningful amount of money invested in the firm that is at risk and (b) new partners should not be allowed to acquire part of a valuable asset without paying for it. the buy-in should be paid to the firm, not individual partners.
- partner capital. addresses how each partner’s capital in the firm is accounted for and calculated. once capital is contributed and built up in the firm, most firms don’t allow partners to withdraw it except as routine partner draws and distributions determined by the firm’s management.
- ownership percentage. this provision defines what ownership percentage means. it usually addresses how ownership percentage impacts (a) compensation, (b) buyout, (c) voting and (d) new partner buy-in and (e) how the proceeds of a firm sale are allocated to the partners. as stated earlier, well-managed firms virtually eliminate the impact of ownership percentage on these five factors.
- voting. specifies how formal votes are taken, including what actions require a vote. there are two types of votes: majority votes for most issues and supermajority votes for critical issues such as partner admissions and mergers. the firm’s most productive partners will want to ensure that a group of minority owners are unable to band together to stage a coup. the firm’s new partners will want to ensure that they are not assigned such a low voting percentage as to disenfranchise them.
- overall firm management. the main responsibility for managing the firm should rest with a management team, primarily the managing partner and the executive committee. to be effective, the firm’s managing partner should not have to take a vote every time a decision must be made. the partner agreement specifies what the managing partner’s duties and authorities are. the agreement also specifies the duties and authorities of an executive committee and a compensation committee, if the firm has these committees.
- partner compensation. many people are surprised to hear that cpa firm partner agreements should be very brief on how partner income is allocated. one or two sentences at most, using very general terminology, is all that is needed. this is because compensation systems are changed frequently, and the firm doesn’t want to have to change the agreement every time it makes a modification.
however, just because the partner agreement is short on verbiage for how partner income is allocated doesn’t mean that the system is simple. new partners should thoroughly understand how the system works. ideally, the firm will have prepared a document or policy that explains how its partner income is allocated.
- partner duties. partners must devote 100 percent of their time to the firm; there should be no side businesses or service to boards without the firm’s approval. all income from professional endeavors, even on the side, should go to the firm. performing effectively as partners is a tough, demanding job requiring long hours; firms don’t want their partners distracted by outside pursuits. new partners must read this section carefully because signing the agreement means that they commit to complying with the restrictions. a staffer who aspires to create a burgeoning real estate business on the side will not want to become a partner in a cpa firm.
- partners’ outside activities. certain outside activities usually require partner approval. they include (a) owning other businesses, actively or passively, (b) investing in clients’ businesses, (c) serving as trustees and executors and (d) serving elective civic offices. if you want to become the mayor of your city, this may not be compatible with being a partner.
- prohibitions and expulsion of partners. if you don’t provide for these, the firm may legally be limited in taking disciplinary action, including termination, against partners who commit “bad acts” or fail to meet minimum performance standards. be specific about the retirement benefits that an expelled partner will not receive.
- nonsolicitation covenant. the firm must protect its intellectual property and assets. they were developed over many years at considerable expense to the firm; departing partners shouldn’t be allowed to simply take these assets for free. if partners leave the firm, they should be prohibited from taking clients, prospects and staff, even if they offer to pay for them. if they violate this prohibition, they should be required to pay a significant but not unreasonable amount of liquidated damages for this offense, regardless of whether the clients, prospects and staff were solicited or not.
- non-equity partners. for decades, cpa firms erred in promoting managers directly to equity partners as a retention device, regardless of their ability to function as equity partners. today, 60 percent of firms provide for a position between manager and equity partner, the non-equity partner. the trend these days is for firms to have fewer equity and more non-equity partners.
- mandatory retirement. yes, this is still legally applicable to partners in the vast majority of states. even if the firm wishes to allow partners past retirement age to continue working, it needs a mandatory retirement provision. this way, the firm, not the older partner, decides if an aging partner whose skills have eroded should be allowed to continue working. this provision is a great way to address the retirement issue for a specific partner.
- death and disability. these departures from the firm should be treated the same as a normal retirement. in the case of a disability, clear guidelines are needed for compensating the partner while disabled and determining when the person should be declared retired. disabled partners should not be allowed to be a financial burden on the firm.
- sale of the firm. firms have been known to abandon their partner buyout methodology when the firm is sold. an allocation method is needed to distribute the proceeds of the sale. the allocation should be based on each partner’s relative retirement benefits.
- partner retirement/buyout. firms should either provide for goodwill-based partner benefits or specifically state that there will be none. agreements that are silent on this may result in a court ruling that departed partners are due for goodwill an amount of money well in excess of what they deserve or have earned.