Avoiding Pitfalls When Dissolving Your Design Firm

by Barry B. LePatner and Ronald Feingold

This article appeared in the May 2003 issue of the Prinicpal's Report, the monthly update for engineering, architectural, planning, consulting, and design firm owners.

Our law firm frequently addresses the critical issue of the rights and obligations of individual members of an architectural or engineering partnership or professional corporation when the firm faces withdrawal of a principal or a complete dissolution. Specifically, we are asked to comment upon the parties' rights with respect to an individual partner's share of firm's assets. All too often even if a partnership agreement or (if a professional corporation) a shareholders agreement exists, we are unable to refer to provisions which provide a precise mechanism for the distribution of the firm's assets upon a principal's departure or termination of the firm. A well-drafted agreement intelligibly governs the rights and obligations of the members upon the break up or a dissolution of the firm. This article will discuss three key subject areas that should be included in the agreement.

First, it is imperative that the agreement include a provision whereby a member can terminate his or her relationship with the firm by a prior written notice of such withdrawal or retirement. The agreement should also provide for payment of the member's ownership interest in the firm (discussed further below) upon such voluntary withdrawal or retirement. Payment of the member's interest in the event of his or her death or permanent disability should be included as well. To help pay for the buy out of a deceased member's interest, it is prudent for the firm to maintain policies of life insurance for each member, whose proceeds upon death can be used to fund the buy out of the deceased member. The firm buys life insurance on the individual. Since the firm owns the insurance, it can borrow the cash value, if necessary. The firm keeps the insurance in force until the individual's death, at which time the proceeds come to the firm tax-free.

Second, it is essential that the agreement define each member's ownership interest or equity investment in the firm by allocating a specific share of ownership in the firm for each member. So, for example, the agreement would allocate a specific amount of stock ownership in the corporation or designate a percentage of ownership interest in the Partnership. By doing so, there will in turn be a mechanism in place for the (i) distribution of the firm's assets to the individual members upon a dissolution or (ii) buy out of the withdrawing member upon his or her withdrawal, retirement or death.

A member's ownership interest or equity investment in the firm should be linked to and correspond with his or her capital contributions, i.e., the larger the capital contribution, the higher the ownership interest. Where a principal contributes no capital, he or she generally has no equity interest or investment in the firm's assets and receives no distribution upon the dissolution. (See discussion below).

The firm members should include a mechanism for the generation and accumulation of both working capital and long term capital. Working capital consists of the monies needed to operate the firm's daily business. Long-term capital is the money needed to purchase capital assets, e.g., furniture, computer equipment and the like. When two architects start a practice, one bringing over desks worth $1,000 and the other puts $1,000 in the firm's bank account, they have each contributed $1,000 of capital and their capital accounts will be reflected as such. Each member over time may be required to contribute capital to the firm. Funds realized from new principal buy-ins provide yet another source of fresh capital infusion. Capital contributions to fund long-term capital needs of the firm are usually paid by these cash infusions. Of course, profits left in the firm without being distributed to principals also will increase firm capital.

Third, it is vital for the agreement to provide for a mechanism for the distribution of the firm's assets upon dissolution. By stipulating the process for the dispersal of firm assets, unnecessary legal proceedings can be avoided. Generally, the firms' creditors are the first to be paid. Second, the members are repaid loans they may have made to the firm. Third, the capital assets are distributed to the members based upon their individual capital contributions. Finally, the firm's remaining assets, for example furniture, equipment, accounts receivables, cash and profits are distributed to the members based on the members' ownership interests in the firm. So, by allocating percentages of ownership or equity investment among the members, the firm has the basis upon which it can readily distribute the firm's assets.

Fourth, it is judicious to formulate a dispute resolution procedure in the agreement that will govern the resolution of disputes that may arise between the members during the dissolution proceedings. It should call for the selection of a mediator or arbitrator selected by the parties. If they cannot agree on the appointment of an arbiter, then they should agree to utilize the American Arbitration Association ("AAA") rules for the administrative appointment of an arbiter. The AAA would then make such appointment. The party bringing the claim will set forth the details of his or her claim and the desire to resolve the dispute. The arbiter will hold a hearing or hearings, limited to no more than one (1) day per party. The arbiter will render his/her decision within forty-eight hours after the close of the hearings. The decision rendered by the arbiter will be final and binding upon all parties and judgment may thereafter be entered upon it in the appropriate Court.

These are the just a few of the fundamental and crucial provisions that should be included in the design firm's agreement in order to avoid unnecessary difficulties on a dissolution. By taking the extra step in formulating the agreement, the principals will go a long way in evading needless obstacles and what could turn into a quagmire.