14 Key Provisions In Partnership Agreements
March 25, 2020
When drafting or revising a partnership agreement, there are several key provisions that serve as the foundation for your accounting firm’s growth and protection of its interests.
Below is an overview that will guide you through the 14 most common elements found within these agreements.
- Restrictive Covenants
- Arbitration vs Court
- Transitioning Between Retirement Systems
- Classes of Partners
- Retirement Payment Protections
- Fiduciary Fees
Accounting Firm Governance
All partnership agreements account for some form of governance. The basic premise is that absent an agreement to the contrary, the partners have all of the authority to act on behalf of the partnership. However, in most agreements, partners elect to cede certain powers to an executive committee and/or a managing partner. Even then, the partners usually retain certain prerogatives and rights.
Those rights generally include election of the managing partner and the executive committee and approval rights over major transactions and expenditures. Major transactions may include merging with a smaller firm, new partner admissions, partner expulsions and significant financial matters, like borrowings in excess of a certain amount and/or capital expenditures over a certain amount.
Executive Committee Rights
In most firms, the executive committee is the governing body with the authority to make or delegate all decisions, except the partner reserved decisions mentioned above. The managing partner is responsible for day-to-day management. However, for firms that have a strong managing partner, as is often the case for founding partners, the partnership agreement will set forth certain things that the managing partner has the authority to do in his/her own right beyond day-to-day business decisions. For example, this type of partnership agreement may provide that the managing partner has authority to bring in lateral partners or consummate small mergers.
As firms grow, governance tends to become more centralized, meaning there is less authority for the partners and more authority given to the executive committee. This is a more efficient way to manage, but its outcome means partners lose autonomy. Also, as the firm grows, the election process itself becomes more complex. There may be a nominating committee for the managing partner role and executive committee positions, a run-off election process, or requirements for department and diversity representation on the executive committee. In addition, more complex agreements will address terms, term limits, and staggered terms.
Voting in Elections
How partners vote must also be addressed. The most common approach is voting by percentage ownership. Other voting mechanisms include per capita voting (one vote per partner), voting by capital account balances and voting by last year’s compensation amounts. Firms decide which approach is right for them and in some cases, different voting methods are used depending on the decision. For example, some decisions, like the approval of a major expenditure, are made by majority, while others, like the removal of a partner, are made by a supermajority of 75 percent.
All firms need capital for both working capital purposes as well as investments. Typically, a firm admitting a new partner will require a capital contribution from that partner. That capital contribution may be a fixed amount or a percentage of compensation. Some firms have an equity model where a partnership interest is acquired at the firm’s valuation, either from the firm itself or from other partners.
Upon the admission of a new partner, the contribution of capital can made over a period of time so as not to reduce the new partner’s take home pay when he or she first becomes a partner. However, firms can require an upfront payment and may have an arrangement with a bank for partners to get capital loans.
Capital During a Merger
In a merger, the merging-in partners will generally be required to put in capital that is available from their existing firm and to fund any deficiencies in a relatively short period of time. The partnership agreement should provide for a mechanism to call capital or retain capital in proportion to either partner compensation or percentage interest in the firm. Firms with consulting or other practices can raise outside capital for those businesses, but this is rarely done in practice. There is typically interest paid on capital at the prime rate plus a percentage that can be adjusted by the executive committee.
Capital Considerations for Departing Partners
Once a partner leaves, that partner’s capital is returned. It is usually returned in a one- to three-year payout period. Capital is subject to set-off for any amount that the partner owes to the firm.
Additionally, when drafting or updating a partnership agreement, partners should consider whether the agreement should have a provision saying a retired partner’s capital account will be charged for its proportionate share of any contingent claims.
When Partners Retire
The vast majority of agreements provide for mandatory retirement. The larger the firm, generally the younger the age. The retirement age is generally somewhere from 62 to 70 years old. 65 is still very common.
Most partnership agreements will allow for early retirement starting at age 55 to 60, provided that the partner has a specified number of years of service as a partner. The notice period for early retirement should be long, probably two years, in order to allow for the proper transition of clients.
It’s not uncommon that early retirement is often discussed but rarely used. Most partners are generally not able to retire at 55 or 60, or don’t want to retire as they find this to be the time in life where they are most effective.
Retirement Transitions Plans
The partnership agreement should require all retirees to have a transition plan. The transition plan is critical in order to make sure that the firm retains the clients and other skills and abilities of the retiring partner. It is now quite common to have penalties for failure to give the requisite notice or failure to prepare and adhere to a transition plan. I like to give the executive committee latitude within a range to reduce retirement payments in the event of such a failure.
The transition plan itself is something that will be developed by the retiring partner in consultation with and ultimate approval of the managing partner or the managing partner’s designee. I have drafted partnership agreements allowing the executive committee to reduce a retiree partner’s payments by up to 50 percent for failure to give the requisite notice or failure to adhere to the transition plan.
Retirement benefits typically have a vesting period. It is not uncommon for the vesting to be over a 20 year period with some firms giving partial or full credit for years spent as an income partner. Merged-in partners will be given credit for the period of time they were a partner at their old firm. Death and disability usually should not accelerate vesting, although in some firms they do.
The retirement payment payout period is typically 10 years. Additionally, the total aggregate amount payable to retired partners each year is capped at some portion of the annual revenue or net income of the firm (for example, 4 percent if revenue). This is to ensure that the firm continues as a financially healthy organization while it is paying out the retired partners. Sometimes founding partners have better terms on their buy-outs. Retirement payouts typically do not accrue interest, although this is not universal.
Many firms obtain life insurance on their partners to fund some or all the buy-out payments. There is logic here in that upon death, there is less time to transition the business. Partners should discuss whether a partner has the right to take their insurance after retirement. Most firms do not allow for this.
Working After Retirement
Many partners will want to work after they “retire.” In essence, they give up their equity as a partner and become employees of the firm. For these situations, a year-to-year contract is best because it helps manage expectations. Typically, retired equity partners are paid on their personal productivity and for new clients.
When including provisions for working after retirement, there are also self-employment tax issues that need to be considered on the retirement payments if the firm also continues to compensate the partner for services rendered after retirement.
Restrictive Covenants in Partnership Agreements
Restrictive covenants, also called non-competes and non-solicits, create a significant part of an accounting firm’s goodwill. Restrictive covenants last anywhere from two to five years depending on the state. Some states will allow them to last for the duration of the buy-out period.
We usually counsel against pure non-compete agreements. They are hard to enforce as courts often view them as not being needed to protect the business interests of the firm. It is easier for a court to enforce something that the judge thinks is reasonable, and true non-competes are sometimes viewed as being unreasonable. There are exceptions to this.
In one case, we prepared a non-compete in a designated geographical area and for a certain industry for which the firm had developed proprietary tools and a large market share of clients in that industry.
Another technique is to provide that all future retirement payments are forfeited if the former partner solicits clients, even after the restriction period.
In addition to a restriction on client solicitation, I like to add a restriction on solicitation of referral sources. For many accountants, referral sources are as important as the clients themselves. This is particularly true in certain practice areas, like litigation support. Referral source non-solicits may be harder to enforce, but in most cases are worthwhile.
Liquidated Damages Provisions
Most firms have a liquidated damages provision for restrictive covenant breaches. In other words, the partnership agreement describes how damages will be determined if a partner leaves and takes clients or employees. This makes sense because in most cases if a client wants to follow a partner, the old firm will not retain that client anyway. Typically, we recommend liquidated damages in the range of 100-150 percent of the client’s billings over a period of time. If the percentage is much higher, the judge may disregard the provision.
Additionally, the partnership agreement should make the former partner responsible for the unpaid receivables of any client he or she takes. Similarly, with respect to poached employees, liquidated damages are usually in the range of 50-75 percent of annual compensation.
Amendments to Partnership Agreements
Amendments typically require a super majority vote of the partners, regardless of whether voting is per capita or based upon a percentage interest. Two-thirds seems to be the right percentage in most cases. Additionally, there may be restrictions on amendments to reduce retirement benefits for partners who are near the mandatory retirement age, unless a majority of those more senior partners agree to the reduction.
Choosing Arbitration vs. Court
We generally recommend disputes be settled in arbitration. By choosing arbitration over court, it keeps disputes out of the public domain. Large firms will sometimes have an internal body of neutral partners decide certain disputes, for example, how a retirement payment provision is interpreted, thereby bypassing arbitration and court entirely.
Typically, a partnership agreement will provide that a partner is liable to the firm for acts of gross negligence or willful misconduct to the extent the actions are not covered by insurance. In all other instances, the firm will indemnify a partner in connection with the partner’s work at the firm.
Compensation is not something that we think should be addressed in a partnership agreement, however, in some firms it is indirectly addressed because compensation follows equity ownership. We believe that compensation should generally be tied to performance rather to percentage ownership.
All partnership agreements should have a dissolution section addressing what will happen if the firm dissolves. After dissolution, the firm may no longer have the right to enforce restrictive covenants because it no longer has a protectible interest in its business. Therefore, any partner may be able to take clients without payment, and there would be no way to fund retirement payments owed to previously retired partners or those nearing retirement at the time of dissolution. For this reason, it is important to require partners to pay for the clients that they take after the firm dissolves.
If the firm is sold or merged, rather than dissolved, the dissolution provision will often have to be overridden by agreement of the partners because the merger consideration will likely be distributed in a different fashion than is specified in the partnership agreement.
Transitioning Between Retirement Systems.
During the evolution of a firm, it may become appropriate to transition between retirement systems. A firm might begin life using a book of business approach, meaning the partnership will pay for a partner’s book of business when they retire. As the partnership matures, the firm might find a book of business approach results in partners behaving in a manner that may not be in the best interests of the firm, so the firm may move to a deferred compensation or equity-based model to pay partners on retirement. Similarly, a firm with an equity-based model may change to a deferred compensation model.
This type of change is often intended to prevent founding partners from getting too much on retirement based on their founding equity percentage. However, firms with an equity based model have ways to address this besides converting to a deferred compensation model. For example, they may require purchases and sales between partners in order to ameliorate the effects of historical disproportionate equity allocations.
When moving from one system to another, care needs to be taken to avoid disadvantaging those who grew up in the firm and are at or near retirement under the old system. We may use floor amounts for partners over a certain age. Another option is to maintain two separate systems and give the legacy partners the ability to choose the higher of the two systems.
Classes of Partners
Many firms have multiple classes of partners. Income partnership is the most common distinction from equity partnership. Income partners typically do not make a capital contribution and do not have voting rights. A minority of firms will pay some sort of deferred compensation to income partners when they retire.
A mandatory retirement age typically would not be appropriate for income partners. In all likelihood they will be considered employees under federal law, regardless of whether they get a K-1 or W-2, and as such are protected against age discrimination arising from a mandatory age requirement.
Contrast this system with a growing number of firms that are implementing two-tier equity partner structures. Firms often take the position that both tiers are owners and that mandatory retirement can apply to both. There is meaningful risk on this issue as the lower tier may not be viewed as owners in the eyes of the law. Suffice it to say that things like requirements to put capital at risk, sharing of profits and losses, and voting and control rights go into the analysis. The lower tier of equity partners will get some payment on retirement.
Restrictive covenants (like client non-solicits) are generally more enforceable and for longer periods on the sale of a partnership interest itself. Therefore, in some states, covenants for equity partners are analyzed under difference standards than for income partners. I typically recommend that income partners sign a separate agreement and not the partnership agreement. This leads to a cleaner delineation of the positions. One note of caution: be careful with introducing a second class of equity partners into an S-Corporation.
There has been somewhat of a comeback in retirement “claw-back” provisions. These essentially operate to reduce otherwise expected retirement payments if the retired partner’s book of business does not stay after the partner’s retirement. For example, you might see an approach where if the partner’s historical book falls by 20 percent or more in the 24-month period after retirement, then the retirement payments will be reduced on a pro-rata basis up to an aggregate of, for example, 15% of the retirement payments.
Several years ago, firms were moving away from claw-back, but now, at least anecdotally, I see firms using them again, at least in a limited manner. There is usually a buffer zone, and there is usually a maximum on the retirement benefit amount that could be clawed-back.
Retirement Payment Protections
Retirement payment protections are things you might see in firms that still have their founders. These protections may include personal guarantees of retirement payments by the remaining partners, the right to vote on certain matters (like a merger), and a security interest in the assets of the firm. You typically do not see these protections in more mature firms as they can hinder the ability of a firm to grow and combine with other firms.
Fiduciary fees can include executor fees, trustee fees, guardianship fees and director fees. The fees collected by a partner for those services should be paid to the partnership while the partner remains at the firm. For very large trusts, there could be exceptions. After retirement and while receiving retirement payments, it is common to split these fees in some fashion. Because the partner’s retirement payment generally relates to his or her historical compensation, it is appropriate for the retired partner to share these fees with the firm. A 50-50 split is not uncommon.