Any time there is more than one owner in a veterinary practice, an operating agreement should be in place. An operating agreement spells out the conditions of co-ownership so that all parties can fully understand the expectations of future transactions and behavior.
The intention of the document is to preserve the continuity of the practice through the smooth transfer of ownership and assure fairness in the process. It is similar to a prenuptial agreement, as well as resembling a will in some respects. The recent AAEP AVMA Equine Economic Impact Survey revealed that few practices have an operating agreement, although as the size of a practice increased, the more likely it was that an agreement was in place.
An operating agreement can be titled differently, depending upon the type of business entity under which the practice operates. Partnerships and limited liability partnerships (LLP) often title the document as a Partners’ Agreement, while corporations have a Shareholders’ Agreement and limited liability companies (LLC) typically have a Members’ Agreement. Sometimes a practice simply has a Buy-Sell Agreement with a very narrow scope.
An operating agreement is a binding contract among the parties who sign it. A contract is defined as a written or spoken agreement that is intended to be enforceable by law. Without a well-written operating agreement, each transition of ownership becomes a different negotiation, with results that cannot necessarily be foreseen. Good operating agreements spell out expectations for the transfer of shares under a number of conditions.
Why Have an Operating Agreement?
In order to create an operating agreement, partners must agree on how different scenarios will play out. The objective of the agreement is to determine:
- Who can/will buy a departing owner’s interest in the practice?
- What are the triggering events for an owner’s interest buyout?
- What price will be paid for an owner’s interest, and how will that price be determined?
When an owner departs, the purchase of his or her equity can be a cross purchase, where the departing partner’s shares are bought and sold between individual owners/prospective owners, or redemption, where the interest is purchased by the practice. This concept is also known as an “outside” or “inside” purchase.
Cross purchase or redemption is important to consider because there can be a significant impact on the tax basis of the stock owned by the shareholders of a C Corporation. A stock redemption by a C Corporation will not increase the basis of the stock held by the remaining owners. By contrast, stock acquired in a cross-purchase transaction will result in a basis equal to the purchase price. This will result in a higher basis in the stock owned by the purchasing shareholders, allowing them to realize a lower capital gain on any subsequent sale of the stock. This basis issue usually is not a factor for S Corporations, partnerships or limited liability companies. In these types of pass-through entities, the owners will receive a basis step-up whether a redemption or a cross-purchase strategy is used.
What Triggers the Exit of a Partner?
There are a number of events that could trigger a partner’s departure. Sometimes the agreement for purchase of the shares of the outgoing owner will differ based on what event is causing the exit.
Triggering events might include:
- departure (before buy-in is completed)
- departure (early retirement)
- departure (retirement)
- departure (aged out)
Death of a partner is one of the most important reasons to have an operating agreement in place. If you were to die unexpectedly, what would happen to your equity in your practice? Would your family or heirs receive a fair price or be paid at all for your investment in the practice? How would the practice value be determined? Would your family receive that value as a lump sum, or over time with a promissory note? If paid overtime, would the note be secured? What would happen if the practice subsequently failed to produce sufficient profit to pay the note?
If your state allows non-veterinary ownership of a practice, would your heirs be locked into practice ownership forever? If they were unable to negotiate a fair sale of your shares, would they be able to collect profits from the practice? Or could the other partner, who might have voting control, decide not to distribute profits?
These same questions could apply for the loss of one of your partners. Could you and your practice afford to pay the value of his/her shares to his/her surviving family members? How quickly could you do this? Many practices choose to carry a life insurance policy on each partner payable to the practice in order to meet these obligations.
Another common reason for the withdrawal of a partner is disability. It is important that an operating agreement define disability and the conditions for determining whether it is present, including a procedure for disagreements about its presence or absence. Typically practices utilize a third opinion if disability is in question.
It is very important to consider unpleasant realities and how you might react to them. If you developed macular degeneration and were becoming blind and it was difficult for you to read radiographs and drive safely, under what circumstances would it be fair for your practice interest to be purchased? What if your partner developed signs of Alzheimer’s or dementia in his 50s, but refused to leave practice? Imagine that one of your partners was diagnosed with an aggressive debilitating cancer—what kind of fairness would you want your document to contain?
Remember that an operating agreement can be modified in writing with the agreement of all of the shareholders (or whatever proportion of shareholders you have memorialized in the document). However, it is important to consider multiple scenarios while constructing your agreement.
Aspects to consider with regard to disability include:
- For what length of time will salary and share-of-profits payments continue during disability, and what amount will be paid?
- How will you resolve disagreements about the degree and presence of disability?
- What length of time must a shareholder be disabled before triggering a buyout of equity?
- If a disabled partner returns to work, how long must he or she work before a new period of disability can be declared?
- If buyout ensues, will it follow the process outlined, as for a death?
Departures of partners can occur for a multitude of reasons. Because of the increased number of two-career couples in modern society, departures might follow a relocation of a spouse. In some cases, they could occur before a new shareholder’s buy-in is completed. That could cause hardship to an older ownership group, depending on the new blood to secure the practice as they execute their exit strategy. It is worth considering a penalty on buyouts that occur before a 10-year period or the completion of a buy-in. Some practices do not return any equity if the buy-in has not been completed. Others discount the value of the shares in this scenario.
As veterinarians reach mid-life, they might re-assess their dreams for their remaining years, they might have care responsibilities for ailing parents or spouses, or they might face their own serious health crises. It is not uncommon for people to develop new priorities as they age. Sometimes these lead to departure from a practice as an early retirement or career change. Other times a veterinarian is simply “done” with the stresses and demands of a career in equine veterinary medicine.
The agreement should have a stated amount of time for notice required before the departure of a partner—typically 6 to 12 months—in order for the practice to plan an orderly transition.
Retirement is an expected departure, although some veterinarians choose never to retire. Sometimes operating agreements specify an age where owners must sell their shares in order that younger veterinarians can take their places at the table. Some agreements require that owners produce a certain amount of revenue for the practice in order to remain as shareholders. Sometimes retiring partners continue on as associates for a few years.
Divorce can be an upheaval in a partnership in states where a non-veterinarian can own a practice. If the ex-spouse is awarded the equity in a practice, one can imagine the difficulties. Some operating agreements therefore have divorce as a condition triggering buyout.
If a shareholder is dismissed from the practice for cause—malpractice, sexual harassment, embezzlement, conduct unbecoming, addiction to drugs or alcohol, etc.—the operating agreement should specify whether a discount will be placed on the buy-out value. The same is true of disqualification to practice, such as that which follows the loss of a license to practice veterinary medicine.
Although it is not common, occasionally a departure occurs because of disaffection, which is when a person “quits in place.” That means he or she continues to draw salary and profits while failing to contribute to the practice in a meaningful way. An operating agreement can set standards for revenue production or “substantially equal time and effort” from partners to avoid this scenario.
In practices with two owners having equal (50%) equity, deadlock must be addressed. Occasionally partners have a dispute and simply cannot come to an agreement with which they both can live. The solution might be to have one partner buy out the other, and the agreement should cover the mechanics of this possibility. Or the partners could agree to accept the decision of a disinterested third party. This arbiter should generally be named in the agreement. When disagreements occur among shareholders in multiple-owner practices, operating agreement decisions on majority, super-majority or unanimous voting can be utilized to arrive at a solution.
Lastly, default on financial commitments (bankruptcy) by an owner might put the assets of the entire practice in jeopardy, so language that defines the buyout of such a partner should be memorialized in the agreement. A discounted value is sometimes specified in these cases.
Other Elements to Consider
A well-written operating agreement will include thoughts about the process of choosing new shareholders/partners, including whether the vote to admit a certain individual must be unanimous. It will often detail the owners’ rights to purchase additional shares to maintain or increase their percentage of ownership when shares become available. Details about dispute resolution, dissolution of company, mechanics for deadlock such as mediation or binding arbitration, as well as specifics of voting rights, voting and decision-making (majority, super-majority or unanimous) should be clearly stated in the agreement.
The document should include the mechanics for default in payment of buy-in or buy-out (grace period) under a promissory note. In addition, the expectation for inclusion or exclusion of insurance policy proceeds as a non-operating asset before valuation should be stated. This is important in the case of a death of a shareholder. If the proceeds of the life insurance policy held by the practice on the deceased member are considered practice assets at the time of the valuation, the value of the buyout will be higher.
In addition, the agreement should address the authority of a partner/shareholder to make unilateral buying decisions up to a particular dollar figure and the authority of a partner/shareholder to take on debt. It should include a non-compete clause and a non-solicitation clause for departing partners. When a separate real estate entity exists for a facility, the agreement might specify that a departing owner of the veterinary firm must sell his/her shares in the real estate company.
Because the operating agreement deals primarily with departures and sale of equity, it should include the method of valuation. If the asset method of valuation is chosen, the agreement should specify that “book value” of tangible assets will not be utilized in determining their fair market value. An approach for discounting aging accounts receivable should also be specified in this event.
Finally, the term, down payment, interest rate, whether fixed or adjustable, the form of note (interest only with balloon, equal payments of principle, amortized), the payment schedule (monthly/quarterly/annually), the priority/subordination to other practice debts, collateral/ security, prepayment, and default should all be clarified.
A well-written operating agreement allows for smooth ownership transitions. Don’t leave this to chance!