plus: how to account for partners’ capital.
by marc rosenberg
how to bring in new partners
what do new partners “get” for their buy-in?
this is a question asked, justifiably, by many new partners when they are informed of the buy-in requirement. firms should be prepared to respond.
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- first and foremost, new partners essentially get to be a member of the “club.” they get to become an owner of an organization that operates a highly profitable, growing firm that will provide them with a substantial income stream for 20-40 years that is well above what most people earn in other jobs.
- they get interest on their investment as part of a layer of the partner compensation system, usually at prime plus 3-5 percent. this, of course, only applies in cases where the firm’s compensation system has a tier for interest on capital.
- they get their capital back if they leave the firm.
- they share in the value of the firm and its increase in value over time. when they retire, they will receive a stream of payments that may equate to as much as three times their compensation.
- they get the recognition of being a partner, and along with it, a say in how the firm is run and a vote on decisions.
ownership percentage
a fundamental and critical tactic in bringing in new partners is to sever, as much as possible, the link between ownership percentage and any of the following:
- allocating partner compensation: partner compensation allocation should be based mostly on the performance of each partner, relative to one another, and not on ownership percentage.
- accumulating retirement benefits: partners’ retirement benefits should be based on what each partner contributes to building up the value of the firm, not on ownership
- determining the buy-in amount.
- allocating cash/credit for the value of the firm upon a sale or merger: if the firm is sold or merges out of existence, the amount each partner receives should be determined in the same way that retirement benefits are determined, not by ownership percentage.
- voting: regardless of the ownership percentage disparity, voting should be one person, one vote for routine decisions. important decisions such as changing the partner agreement, determining how to allocate income, admitting a new partner, merging, etc., may need to be voted on by ownership percentage to avoid having the biggest producers ousted by a group of the firm’s lower producers.
if the buy-in is made over a period of years, the new partner’s ownership percentage should only increase as the money is paid in.
partners’ capital
regardless of whether it is a corporation or a partnership, there is a substantial amount of accrual basis capital in a firm. all the partners “own” some portion of that capital.
there are several methods for determining how much capital each individual partner “owns.”
- the old-fashioned partnership accounting method. if you are a partnership, this is self-explanatory. if you are a corporation, then “off the books” you should maintain a schedule that emulates partnership accounting – partner’s capital account increases with his/her capital contributions and allocations of income and decreases when cash distributions are made.
- each partner’s share of capital is in the ratio of their partner compensation. two important caveats:
- the firm must have a performance-based partner compensation system, not a pay-equal system or a system based on ownership percentage.
- the partners must feel that the system and the results are reasonably fair (not perfect!).
- each partner’s share of capital is in the ratio of their ownership percentage. this is inherently unfair because over time, ownership percentage ratios rarely correspond to how each partner performs relative to the others.
we prefer either no. 1 or no. 2. some firms feel no. 1 is cumbersome, so they opt for no. 2.
at no time should a partner be allowed to withdraw capital other than for purposes of death, disability, withdrawal or expulsion from the firm.
the percentage of the relative accrual basis income allocations should be used to determine the actual cash distributions, including regular draw or salary checks. in other words, don’t let partners overdraw because “they need the money.”
