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Buy / Sell Agreements Vital to Partnerships

Consider: Drs. A and B have been practicing dentistry together for 15 years. Last year, each netted $255,537 out of the practice. Last week, Dr. A was killed in an auto accident. How much does Dr. B owe heirs of Dr. A's shares of the practice?

Unfortunately, like most business owners, Drs. A and B did not have a Buy/Sell Agreement. If they did, it would be very clear how much Dr. B owes the heirs of Dr. A. Buy/Sell Agreements clearly set forth the value of the practice and how much the surviving partner would pay to the heirs of the deceased partner.

In the absence of a Buy/Sell Agreement, Dr. B must pay the heirs of Dr. A the "value" of the practice. What is the "value" of the practice?

Practice value defined

According to a Certified Public Accountant, the book value of the practice is $80,920. That is based upon the depreciated value of the equipment and the accounts receivable. Since Drs. A and B were each 50 percent partners, Dr. A's half of the book value of the assets is $40,460. Is Dr. A's wife only entitled to one half of the book value?

Dr. A's wife contacted two of the leading dental brokerage firms in California, which both indicated that they could sell the entire practice for $600,000. Therefore, the market value of Dr. A's half of the practice is $300,000. But often times, people who want a listing on a business or property overstate the value of the asset. How much would a willing buyer really pay a willing seller, with neither party acting under any compulsion to buy or sell? Anyone who has tried to sell a practice knows that $600,000 sounds like an awful lot more than most people would pay for a dental practice today.

Mrs. A's CPA and Attorney told her the value of the practice should be determined by capitalizing the earnings. Taking the amount of money Dr. A earned out of the practice last year ($225,537) and capitalizing that by a factor of four (4) means that Dr. A's share of the practice is worth $902,148. But should we use a cap rate of four(4)? or three (3)? or five(5)?

Mrs. A hires an attorney and demands from Dr. B a check for $902,148 for Dr. A's share of the practice. Dr. B's attorney writes back and states that the book vale of Dr. A's half of the practice is $40,460, but for the purposes of resolving the matter, he is willing to pay $100,000.

The parties are unable to come to an agreement. Mrs. A files suit against Dr. B. Each side has to hire a CPA, an appraiser, expert witnesses and attorney. Litigation costs and attorneys fees to Dr. B exceed $ 80,000. Mrs. A's attorney took the case on contingency-one-third if the matter settles before trial, 40 percent if it goes to trial, plus costs.

Ultimately, the matter goes to trial two years after Dr. A's death, and the court awards $500,000 as the value of Dr. A's practice and orders Dr. B to pay immediately. Obviously, Dr. B doesn't have that much money in his checking account, or his investments, and is forced to borrow against his pension plan and house to pay the judgment. He is financially devastated for years to come.

Mrs. A believes that she didn't receive fair value for her share of the practice, especially after paying $45,000 in attorney's fees. Her net is $303,333.

Life insurance and buy/sell agreements

How could this scenario have been avoided? Had Drs. A and B sat down with their attorney and prepared a Buy/Sell Agreement, none of this would have happened. Drs. A and B. could have agreed on what would have been a fair value to pay each other's family in the event of death. To minimize the adverse impact on the surviving partner, each could have each purchased insurance on the other. The cost of insurance would have been extremely reasonable and affordable. Let us assume that they agreed on a value of $1 million. They could have contacted their insurance agent and obtained life insurance policies on each other. Dr. A owns the policy on Dr. B and Dr. B owns the policy on Dr. A. This is called cross-ownership agreement.

Then, when Dr. A died, Dr. B would have received $1 million from the insurance carrier. Pursuant to the written Buy/Sell Agreement (which had also been signed by each doctor's wife), Mrs. A would have accepted a check for $1 million as payment in full for any and all of her interest and the estate's interest in the practice, thereby eliminating the need to hire appraisers, CPAs, attorneys, and take over two years to litigate the matter.

Dr. B would not have incurred the litigation expenses and would not have to come up with $500,000 cash all at once. The life insurance company would have assumed the risk for Dr. B.

Disability Insurance and Buy / Sell Agreements

In addition, a Buy/Sell Agreement wherein properly written, would also address several other issues that can come up in a dental practice: disability, disagreement and divorce.

• Disability

  What if either dentist became disabled and was unable to continue to work? How long would he/she be entitled to continue to take his/her draw out of the business, without contributing to the profit and cash flow of the practice? A Buy/Sell Agreement would provide how long that a dentist would be entitled to take a draw, thereafter agreeing in advance to be bought at a predetermined price, payable over a period of years. Again, your insurance agent can assist you in securing disability insurance to cover the risk.

• Disagreement

  What if Drs. A and B are no longer compatible and no longer capable of working together? A Buy/Sell Agreement, when properly drafted, would address the procedures and protocols to follow in dissolving the practice in an orderly manner, as well as how to divide the charts and contact the patient in a businesslike and professional manner, and to decide who takes which equipment and who assumes which debts.

• Dissolution of Marriage

  If either Dr. A or B dissolves his marriage, a properly drafted Buy/Sell Agreement would ensure that their (soon-to-be) ex-spouse does not interfere in the operation of the practice. Drs. A and B would agree ( and their spouses would sign the agreement at the time of its execution) that even if Dr. A or Dr. B has to give their (soon-to-be) ex-spouse all of their interest in the house, the savings, the pension, or whatever, the ex-spouse would have no right to participate in the operation of the practice.

Review and Update Buy / Sell Agreements Annually

Very few business owners (and even fewer professionals) have prepared and executed a proper Buy/Sell Agreement. Of greater concern is the fact that of the few who have executed buy/sell agreements, even fewer keep the document current. Had Drs. A and B executed a Buy/Sell Agreement in the above example 15 years ago, what value do you think they would put on the practice? Significantly less than what it's worth now. Once a Buy/Sell Agreement has been executed, it needs to be reviewed annually and the values need to be updated. What might have been a fair value to the heirs of a deceased partner 20 years ago certainly wouldn't be fair today. If the document is not updated, Mrs. A would be barred from objecting to whatever value is set forth in the original document executed 15 years prior to Dr. A's death.

In addition, if you do not have a Buy/Sell Agreement, see your attorney and commit to having one done this year. If you already have a Buy/Sell Agreement, make sure it is current, up-to-date, and addresses not only buyouts upon death but upon disability, disagreements and divorce. If the agreement is not funded with insurance, contact your life insurance agent immediately. If it is funded with insurance, perhaps it is time to review your insurance as well. The insurance industry has changed considerably over the last few years, rates are more competitive than ever, new products are on the market that were not available even a few years ago, and you may be able to get more insurance for a lower price.

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