I’m a Partner – Get me Out of Here! (Exit Plans for Professionals)
21st May, 2012
Partnership is a good model for many businesses and no more so than for professional practices. Historically accountants, solicitors, surveyors, architects, doctors, dentists and consultants of all sorts have been in partnership. Many have now converted to Limited Liability Partnerships.
The question facing many partners as they get into their fifties and sixties is how they are going to get out.
Planning an exit is key in all businesses (and venture capitalists won’t go into a business without having first planned their exit) but is currently proving more difficult for partners.
In a limited company, the retiring shareholder needs to find someone to buy his or her shares. That can be more junior staff coming up through the business, their fellow owners or most likely a third party trade buyer. The price is negotiated and there are specialist valuers who can value a business. I’m not suggesting that the process is always straightforward or easy, but there is an accepted way of doing it.
Partnerships, especially professional partnerships are different. Ownership and management are intertwined, there are professional body requirements to consider, goodwill is often not valued and, most crucially, the market is changing.
In the past, partners would buy into a partnership. They would borrow money from a bank, pay it to the existing partners, or sometimes to an outgoing partner in repayment of his or her capital account, and then work in the business. Drawings would be drawn and their capital account would fluctuate and in good years increase and be left in the business to fund growth. When they hit retirement, a new younger partner would buy them out or the business would pay them out over time. As a variance on this, larger firms operate lock-steps, whereby capital is accumulated over time, paid for by reduced drawings. It can then be repaid over time.
So, what has changed?
The market has changed and a recession has arrived. These two potent facts come together to mean that a business may not be valued at what it was 5 years ago and so a retiring partner (or member of an LLP) has less goodwill and probably less capital to take out. Additionally a potential junior partner may not have the appetite or the ability to borrow money to buy into a practice. With fluctuating profits and more perceived risk, some key employees below partnership level may prefer to take a salary and not have the risk. They know that there is more upside in good years, but there is also downside in bad years and with mortgages to pay and families to support, they may not want to take the risk. Additionally, banks have been stung with some high profile partnership and LLP failures and so are more reluctant to lend.
There are specific issues affecting certain professions. Accountancy is still consolidating and using limited companies more. This creates less opportunity for potential partners, but a potential exit for retiring partners of smaller firms. Solicitors have Alternative Business Structures with their new models of legal ownership to worry about and GPs and dentists have the health service reforms to worry about. Surveyors and architects worry about the property market.
The key to a successful exit is planning. If you decide today that you want out at the end of the year, it’s not going to be easy. 5 years would be a good starting point if at all possible. You need to start by thinking about your business and you must look at it from an outsider’s viewpoint. What is it worth to someone other than you? It’s even more difficult if you’re in a partnership that will continue when you leave; you must ask who would want to buy into this partnership? Then it’s a case of not just looking at your business – your strategy, your assets, your liabilities, your financing, your staff and your clients; you must look at your partners. Who would want to be in partnership with them?
You need to structure the partnership and the succession to make it look a good investment to incoming partners or trade buyers. The sort of incoming partner you want to drive the business forward and deliver you your capital account over a period of years will ask the same questions as a trade buyer. Don’t be offended when they want to do due diligence; be pleased that they are business minded and diligent.
If you want new partners to buy out older partners you need to have career planning and succession in place. The young blood needs to see what their career progression is and to have stepping stones – associate, salaried partner or fixed share member – in place. You need to be aware of the age discrimination issues around compulsory retirement ages for partners, as still under consideration in the Seldon case, but it seems to suggest that succession planning is an allowable reason.
You must also be realistic as to what the business is worth if you do not have a lockstep mechanism in place. This is often a sticking point. I came across a small professional practice with 2 partners; one older and one younger. The business had little trade value. The older one wanted to retire and needed a certain amount of cash to pay off his borrowings. That was more than the younger one knew the older one’s share of the business was worth. The result was deadlock. The risk for such businesses is that the partners cannot afford to close them down if the professional indemnity insurance run-off is too expensive. Partners in such firms were not planning on bankruptcy as a means of retirement, but it may come to that.
However you sell a share of a business, it must be worth buying. You will need to tidy up the structure of the partnership. Often partners have, for legitimate reasons, kept assets such as property outside of the partnership. This may make sense, but you will need to be sure that the structure is transparent and prospective buyers do not suspect that the true value is being denied to them.
One further consideration for partnerships and LLPs is how transferable the business is. Is the business tied up in the individual partners? If they leave will the clients (or patients) stay with the practice? You need to ensure that clients, patients, or even (dare I say it) customers, perceive themselves as being served by the practice not the individual. This is a difficult line to draw.
For some practices, incorporation is a good way to realise goodwill. If all partners agree to this, a partnership can be incorporated and the goodwill paid over time by means of directors’ loans. This allows the partners to take out their goodwill at an effective tax rate of 10% if entrepreneurs’ relief can be obtained. There may be a big tax bill if the goodwill is considerable, so timing is crucial and there needs to be a prospect of good cash flow to repay the directors’ loans that will be created. Once the goodwill has been written down and the directors’ loans repaid, the business can be sold.
There is debate as to whether this goes against the ethos of partnership. The partners for the time being profit from the goodwill built up by former partners who have just taken out their capital accounts on retirement. Any partner retiring under the normal terms of a partnership or LLP agreement may want to consider a so called “anti-embarrassment” clause so they get some of the proceeds of the goodwill if the business is sold or incorporated within a period after they leave.
Is the partnership “just” a business which is designed to be grown and sold by the owners for more than they paid for it, or is it a collegiate practice where each generation works, earns a reasonable income, and then passes it on to the next generation?
There is no easy answer as to how the make a graceful exit with a reasonable sum for your hard work. The answer is planning. Make sure you know what model you operate and make sure you plan your exit in advance. You will need a good partnership or LLP agreement and good financial advice.
The Partnership Team at Aaron & Partners has experience of helping partnerships through this tricky process.
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