|Is Your Firm in Good Hands?
Best practice tips on succession planning.
June 18, 2009
Is your retirement payout secure? After you leave, will your equity interest and the firm be controlled by partners with the appropriate amount of business savvy, or will it default to technicians who — while being great experts in their field — are not good business people? In many firms, a big part of the succession management puzzle is all about who should actually own what shares of the firm's equity.
All Partners Are Not Created Equal
For many firms, the idea in the beginning is that "all the partners are the same, so their ownership should be the same." When the firm starts out with only a shingle, this is a very fair premise since there is firm is basically starting from scratch and because everyone is at risk in this new venture. So, for the sake of this discussion, let's start out with a two-partner firm and build from there, talking through the common issues that arise in the area of equity ownership.
The most common approach would be for the two partners to split the ownership 50-50. The reason why this often works so well is because the two people that join together often are brought together because of their complementary skills. For example one might be very technically competent and the other more marketing savvy. Together they make a great team — one, without the other, is less effective. These partners will often divide up the work. One might hate the administrative issues that constantly arise (typically, the one with the marketing savvy), while the other hates going out in the evenings to network and socialize, (usually the technical guru).
This equal ownership pattern is fairly common, even though, it is not really the best approach. With equal ownership, if both partners disagree, the firm is at a stalemate. The only governance that can really take place is maintaining the status quo. This stalemate happens frequently and it can cripple a firm. On the other hand, the common counter argument to my concern for a 50-50 split is simple: "If we both don't agree, then maybe we really shouldn't be doing it anyway." While this can be true, in reality, in a two-partner firm, one partner commonly defers to the other partner for decisions in their specialty area or their area of firm responsibilities. For example, if the issue in debate is really about the growth of the firm and attracting clients, then the technical partner will usually defer to the marketing partner. And the reverse normally is true if the issue is about compliance with a technical matter. However, in this arrangement, just as with marriages, this level of respect and trust can quickly deteriorate. For that reason, we suggest that one partner own 51 percent with the other owning 49 percent — allowing the firm to move forward even when there is a harsh disagreement.
The firm can easily mitigate the damage to the minority shareholder or partner by putting in standard operating procedures and processes that define how the minority shareholder can withdraw in a way that limits the damage to him/her, and on many issues, the firm can set a voting threshold above 51 percent so that it really does take both partners to agree. But for day-to-day operating decisions, you need to establish a voting process that allows the firm to continue despite strong disputes.
Three or More Is a Crowd
Assume that the two partners want to add a third partner. In this situation, it is common, if those two partners have had a good working relationship, and the third partner is added early in the growth stages of the firm, for the new partner to be granted one-third of the company. This is especially true if the new partner comes in with an existing book of business comparable to the other two partners' books. However, if the company is long past its initial growth stages and the partner being added has grown up working in the firm, the likelihood is that the newest partner will only receive or have access to a small portion of the equity — often somewhere between three percent and 20 percent, with the most common amounts falling in the lower end of this range.
On the face of this, there is nothing wrong with any of the splits describe above. The real question is always about future performance. And if the firm equity was split 50/50 before, the firm might actually be in a healthier position now with a third partner because there is at least a way to break a tie between the two founding partners.
However, having three partners is not 50 percent harder than having two partners, but rather, much more (two to three or more times) more difficult. Getting three people to think alike, have similar values, being comfortable operating in the same way, being willing to defer to each other's strengths, etc. is far more difficult to find with three partners than with two partners. So the question is: How do you hold the three partners accountable to each other? When there are only two partners and they both own about the same amount of the firm, if there is a major dispute, the answer is likely that they each will take their share of the marbles and go home. With three partners, this situation is far more complicated to deal with, regardless of the range of ownership that is allocated among them The reason this is so different is because the firm, rather than just split up into two separate businesses, will likely continue — but with one less partner. So now you have to have a process to formally deal with dismissing a partner, a process few people are willing to articulate on the front end when the prospect of the value of the new relationship is clouding all rational judgment.
The range of equity splits described above is not the problem; partner performance is the real issue. If the new partner performs on a par with the other two partners, getting a third of the company upon entry seems fair. But what happens when the new person joining significantly oversold what he or she was bringing to the table to get their one-third ownership? Or even more difficult, what happens when the new partner performs so well that it becomes clear that one of the founding partners is really not worth his or her pay?
I can cite examples of firms that currently have a similar situation with any number of partners, and either does not, will not or cannot, address this situation through compensation. And even if the firms can address the situation through compensation, it is just one issue. You can not overlook the constant damage that a firm experiences when a partner has voting privileges well beyond his or her contribution to the firm's success. For a firm to maneuver, change and thrive in a dynamic profession and economy, it has to be run by owners that are striving for success, not those hunkering down, locking the doors and trying to hold change at bay through denial of the current environment.
When you complicate the above scenario by adding a fourth, fifth, sixth, seventh and more partners, this issue of judging fair performance, fair ownership, fair voting rights, fair value upon retirement and fair compensation through the years become even more of an issue. Taking it a step further, when a senior owner retires and a large block of stock is to be transferred to the remaining owners, the odds of damage are even greater than those described above. Why? Because rarely will the founding fathers give up their ability to control the firm while they are still working, whether that is accomplished through the control of equity or through governance structures like executive committees. The founding fathers often are permanent members of the executive committee, which is chartered via partner agreement and the founding partners want it that way so they can continue to run the firm.
When that founding father finally leaves and his or her block of stock is redistributed to other owners, oftentimes, not only does that executive committee structure start to fail, but partners that have been marginal performers can end up inheriting or gaining disproportionate (disproportionate to what they bring to the table) access to voting rights that will forever change this firm's future viability and stability.
This can spell trouble with a capital "T" for the retiring senior owner or owners. Will your firms be in good hands when you leave?
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Dominic Cingoranelli, CPA, CMC, is executive vice-president — consulting services, at Succession Institute, LLC, a firm specializing in succession and practice management for CPA firms. He works with professionals who want to make their business better, faster and stronger. You can reach Cingoranelli at 512-338-1006 or visit www.successioninstitute.com.