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Issue #24 - 7.17.07
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A Fair Way to Buy Out Your Partner
In this final article of this three-part series about partnership issues, this topic has often caused the most consternation. Many senior partners are often times left with the unfinished business of being bought out. Whether it is due to high expectations for a final buy out value or a disinterested junior partner who does not want to incur additional financial obligations, this final piece of a transition plan can be a financial disaster. It is our recommendation that when partnerships are formed, there should be a mandatory buy out at retirement to avoid disagreements that can ruin friendships, cause legal battles and just end in bitterness.
In the event that the junior partner does not buy out the senior partner, a liquidated damages clause should be invoked and a financial penalty assessed to the junior partner to offset the financial hardship that a senior partner may endure if the junior partner does not buy out the retiring partner. Furthermore, if the senior partner is forced to enter the marketplace and recruit a third party to buy out his or her partnership interest, the value received may be substantially lower. Conversely, the junior partner may feel obliged to buy out the senior partner but at a greatly reduced value since no formula for a retiring partner was written in their shareholder or partnership agreement. In other instances, senior partners who have reduced their clinical hours as well as their clinical production unrealistically demand a full fair market value for their partnership interest. This, in our opinion, is also an unfair situation for the junior partner who, in the fact, may be supporting the majority of the practice’s overhead is unwilling to pay full market value.
To address these scenarios we have designed a partnership buy out formula that will provide a fair and equitable buy out strategy for a retiring partner.
Valuing the Practice
As discussed in prior articles, a dental practice’s value consists of two asset classes - Tangible Assets and Intangible Assets. Tangible Assets include equipment, dental supplies, leasehold improvements (sometimes), dental instruments and technology. Intangible Assets consist of goodwill, location, phone number, restrictive covenant, etc. From our experience, in valuing numerous dental practices, we have found that approximately 24% of a practice’s value consists of Tangible Assets and 76% is allocated to Intangible Assets. Therefore, in our buy out formulae, we manipulate the Intangible Asset Value to address issues that may lead to a discount of the practice’s buy out value.
If in fact the Senior Partner has not been contributing near the same level of clinical production when the partnership was formed some form of discount is appropriate. When it is time for the Senior Partner to retire, the practice is revalued. A new equipment appraisal is ordered in order to calculate the value of the Tangible Assets. The Senior Partner should receive his/her full share of the Tangible Assets at fair market value. Accounts Receivable is paid out to the retiring partner, usually over a 12 month period. Any cash in the partnership’s or corporate account should be split based on ownership interest. Finally, any liabilities are deducted from the practice’s value. Often times, the amount of the retiring partner’s accounts receivable is used as an offset against any outstanding liabilities.
Since Intangible Assets comprise the majority of a practice’s value, by adjusting this value you can achieve sizeable discounts if the retiring partner has not been substantially contributing to practice production. A description follows as well as an example illustrating how the process works.
Step One:
At the formation of the partnership, we calculate the relative proportion of personal clinical production between the partners. This number is then recorded for future application in the case of the retirement of a partner, as well as our formulas for applying discounts in the event of death and disability.
Step Two:
When the senior partner retires, we then recalculate the relative proportion of personal clinical production between both partners and if there is a difference, an adjustment is made in the following manner.
- Subtract the difference between the baseline production ratio and the current production ratio
- Take the difference between and divide that number by the original production ratio
- Take the percentage reduction and multiply be the Intangible Asset Value to calculate the discount to Intangible Asset Value.
For example, if the senior partner has been working less days and produces less, this discount can be as high as 25 to 35% of the Intangible Asset value. Conversely if a retiring partner wants close to receive full practice value then he/she is motivated to remain productive and not reduce their workload...
| Case Study – Partner Buyout | |||
| Future Buyout Using Discount | |||
| Case Study | |||
| Practice Value in 2007 | $796,200 | ||
| Intangible Asset Value (IAV) | $706,200 | ||
| Tangible Asset Value (TA) | $90,000 | ||
| Full 50% Practice Value equals | $398,100 | ||
| Step 1 | Establish Baseline for Clinical Production Ratios | ||
| 1999 | 2007 | ||
| Dr. Senior | 52% | 40% | |
| Dr. Junior | 48% | 60% | |
| Step 2 | Calculate % Reduction in Clinical Production Ratio | ||
| Dr. Senior (1999) | 54% | ||
| Dr. senior (2007) | - 40% | ||
| Difference | 12% | ||
| Step 3 | Calculate Discount Rate on Clinical Production Ratio | ||
| 12% (difference) / 54.7% (baseline) = 22% | |||
| Step 4 | Calculate Amount of Discount for Intangible Asset Value (IAV) | ||
| Full 50% Value | $398,100 | ||
| X .22 | |||
| Discounted IAV Value | $87,582 | ||
| Step 5 | Calculate Discounted Sale Price | ||
| IAV ($398,100 - $87,582) | $310,518 | ||
| 50% of 2007 Tangible Assets | + 45,000 | ||
| $355,518 | |||
| Step 6 | Summary Calculation of Valuation Discount | ||
| Full 50% Value | $398,100 | ||
| Adjusted 50% Value | - 351,537 | ||
| Discount Applied | $42,582 | ||
Summary:
Partnership relationships are all about fairness and throughout this three-part series, you have learned that there are varying ways that income can be split, profits shared, and buy outs preserved. Using this approach can mean that partners do not have to resort to legal means or the courts to resolve their differences.
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