Partners In Sync

Whether a practice is organized as a corporation, limited liability corporation, or partnership, physicians commonly refer to their co-owners as "partners." This is an important distinction because it reflects the relationship between the practice's owners.

In creating a successful partnership arrangement, it is important to do all you can to preserve the relationship among the partners. You can have the best-drafted, ironclad legal documents in the world, but if they are one-sided you will be starting your partnership off on the wrong foot. And resentment can develop among the partners, especially toward the person who appears to have gained the advantage.

When recruiting a new physician whom you hope will someday become a partner, you should spell out the basic parameters of the ownership arrangement up-front, reducing the possibility of disagreements about partnership terms and enhancing the long-term success of your relationship with the new associate.

Figuring practice value

One of the thorniest issues in developing a partnership arrangement is determining the amount the new physician must pay to become a partner.  The realities of today's medical practice economics -- fewer buyers of medical practices, declining reimbursements, and rising overhead costs (especially malpractice insurance) --  have led to a re-evaluation of medical practice values.

You know how much time and money you invested in building your practice, but step back for a minute and look at the valuation issue from an outsider's viewpoint. Compare the value of your new associate's current compensation and benefits package with what partnership would bring.

Let's say a new physician receives $200,000 a year in compensation from the practice and up to four weeks of vacation or continuing medical education leave. As a partner, this associate would make approximately $225,000 a year and receive five weeks of leave. Considering the less-than-rosy outlook for the growth of practice values, you'd have a hard time convincing this person to pay hundreds of thousands of dollars to buy into your practice just to gain a one-time 12.5 percent compensation increase and an extra week of vacation.

To develop a more accurate picture of what it should cost to buy into your practice, first figure the depreciated value of the practice's hard assets. This will be the original cost of all equipment, supplies on hand, buildings you own and so on, minus depreciation and liabilities. Many practices use a modified net book value for hard asset valuation. This method spreads the depreciation of assets over a longer time period (usually three to 12 years, depending on the type of asset), with a minimum floor value (typically no more than 20 percent of the original cost) for the functioning hard tangible assets.

The practice's accounts receivable should be valued according to its estimated collectible value. You should also consider how income is divided among the partners. Your potential partner should not be expected to buy into a greater share of the accounts receivable than he or she will likely receive once a partner. If you divide income and expenses on an equal share basis, then the equation is easy: three partners each own one-third of the accounts receivable.

If the practice intends to divide partnership net income on the basis of productivity and the productivity levels between the two partner physicians differ, then the new associate should only be expected to buy into his or her productivity share of the collectible value of the practice's accounts receivable.

Goodwill --  the value of the practice based on its reputation or strength in the community --  is the giant variable in many partnership arrangements. It is an intangible asset and, unlike hard assets and accounts receivable, it is difficult to place a value on.
You will likely find most new associates reluctant to pay a large amount for goodwill. If you intend to include goodwill in your buy-in agreement, be prepared to explain to your new partner why goodwill is appropriate.

Once the value of your practice is determined, you need to appropriately structure the buy-in. Tax planning is essential. Practices commonly include only the depreciated hard assets in the value of the practice's stock. Buy-in agreements often deal with accounts receivable and goodwill through income adjustments. Many practices use a salary differential method in which a new partner who is on salary agrees to reduce that salary by a set amount or a set percentage for a defined period of time.

Dividing income

The essential components of partnership agreements usually include several documents, including agreements for: income division, purchase-of-ownership interest, and shareholder employment; the promissory note for the physician's buy-in; the shareholders' agreement (also called the buy-sell agreement); corporate bylaws; and various corporate resolutions that formally approve the transactions related to the new ownership arrangement.

The income division agreement will certainly be the focus of much attention by all of the partners. Make sure the income division clearly spells out the inner workings of the allocation of income and expenses within your practice.

The income division agreement should define the salary differential between the new partner and the existing partners during the "earn-in" period, and should identify whether any additional compensation will be paid to a managing physician or to the practice's founding or senior physicians.

If management compensation is to be paid to one or more physicians, make sure it is fair and reasonable. New and existing partners will likely chafe when one of the practice's physicians is paid a large sum for management duties, unless the managing partner can demonstrate the value of those management services. On the other hand, physicians who don't want to handle any management duties may agree to pay a little extra to those who will take on those responsibilities for them.

Write the agreement

Since ownership of an interest in a corporation is typically accomplished by acquiring stock, another important document in the buy-in process is the purchase-of-ownership agreement, sometimes called a stock-purchase agreement. This agreement will describe how the practice's stock is purchased and the payment terms. Sometimes, this document will contain the sellers' representations and warranties regarding the operation of the practice.

If the ownership interest is to be paid over time then it is common to ask the new partner to sign a promissory note in conjunction with the purchase-of-ownership interest agreement. Again, look to create fair and equitable contracts that include a reasonable interest rate. Try to avoid certain other terms commonly found in commercial transactions such as a confession of judgment --  a phrase that, if invoked, would authorize the shareholders to obtain a judgment against a partner who was late with a payment.

Your new partner's employment agreement should be consistent with the employment agreements of the other co-owners. It should describe such things as your new partner's increased time off from the practice, allowance for continuing medical education, or other perks of partnership. The agreement will likely contain a disability provision that may differ from the provisions in the new partner's original employment agreement because a disabled partner would represent a more substantial issue to the practice's future. Now is an opportune time to evaluate whether changes in types of practice insurance or amounts of coverage are warranted.

Describe the buy-out

Partners don't necessarily stay forever, so it is important that the employment agreement contain a provision regarding the physician's buy-out from the practice. As with the buy-in process, the value of accounts receivable and goodwill are separated from the hard asset value. The partner's value of accounts receivable and goodwill (if any) is usually paid to the departing physician as deferred compensation upon termination of employment.

Describe the repurchase of the partner's ownership interest in a separate agreement. Depending on your practice's corporate structure, this document is frequently called a shareholders' agreement or a buy-sell agreement. This agreement will discuss events that trigger the mandatory repurchase of ownership interest (for instance, termination of employment), and the calculation of the value-of-ownership interest. Remember, the valuation-of-ownership interest is limited to the hard asset value of the practice and should be consistent with the same formula used in the partner's original purchase.

If your new partner will own 50 percent of the practice with you, you may wish to include in the buy-in documentation process an agreement that describes certain protections for you and the other partners. These protections might include allowing you to retain the practice's name, office, phone numbers, medical records, and the like should the partner leave.

You might also consider adding to the buy-sell agreement an option that allows you to ask a new partner to leave if the relationship deteriorates to the extent that it is no longer realistic to continue working together.

An alternative is to review the voting requirements listed in your practice's bylaws or operating agreement. You may want to include a requirement that your approval or a majority of the partners' be obtained for certain fundamental issues such as the decision to sell or merge the practice, incur indebtedness or make large purchases, hire and fire physicians, and open or close a practice office. Some practices require approval by a super-majority --  two-thirds or three-fourths --  of partners for these critical decisions.

Your practice should have corporate resolutions that approve these transactions. If you are not yet in the habit of keeping up with corporate formalities, the admission of a new partner is an excellent opportunity to review your corporate minute book, approve any corporate transactions that have not been formally approved, and tie up any other loose ends.

While swimming in the sea of documents necessary to bring on a new partner, do not lose sight of the most important detail of all: your partnership relationship. The various partnership documents should reflect your understandings and should not be adversarial in nature. They should be fair to all shareholders.

Finally, you should review your various corporate agreements, particularly the income division agreement and the deferred compensation entitlement, on at least an annual basis to make sure that these documents still reflect the economic realities of your medical practice and medical practice valuation in general.

Joan M. Roediger, JD, LLM, is a partner with Obermayer Rebmann Maxwell & Hippel LLP of Philadelphia. As a member of the firm's health law department, her practice is focused on advising physician practices on legal and regulatory issues, including hiring new doctors, buy-in and buy-out arrangements, income division, practice sales, physician termination, fraud and abuse, compliance, HIPAA, and other issues. Ms. Roediger is a nationally recognized speaker on practice management-related issues. She can be reached at (215) 665-3216 or via e-mail at joan.roediger@obermayer.com or via editor@physicianspractice.com.

This article originally appeared in the July/August 2004 issue of Physicians Practice.