Legal and Financial Issues Affect Ownership Transition
By: David S. Chartock
There are legal and financial issues that will affect the payout of a retiring partner or owner and "gut" choices that have to be made that will affect the perpetuity of a design firm transitioning its ownership.
Barry B. LePatner of Barry B. LePatner & Associates, a New York, N.Y.-based law firm, which has helped many design firms with transition plans, said, "Traditionally, design firms have not paid attention to the critical strategic reasons for the early adoption of an ownership transition plan because most firm leaders believe they will often be at their desks for their lifetimes and miss the opportunity to provide growth and leadership to the next generation at an earlier rather than a later stage in their careers."
"Too often," he observed, "talented individuals in these firms have been forced to leave and start their own firms because their seniors did not adopt an ownership transition program that allowed them to be part of the future leadership at an earlier stage of their careers. The ideal time to plan for the next generation of leaders is when the senior or founding principals are between 45 and 50 years old. The reason for this is that at this age they will have had a second tier of talent with 10 to 15 years of experience. Firm leaders should be able to identify those individuals who have leadership potential, the marketing savvy and judgment to be able to take over leadership of the firm."LePatner pointed out that one of the critical mistakes design firm leaders make is that they believe that by giving someone a title or making them a partner will put them on the right career track. Though well intentioned, sometimes this sends false signals from the principals to the next generation of leaders. These false signals include giving a title without a meaningful equity share in the firm; allowing the younger generation to now have a strong say in the management and policymaking of the firm; not creating a financial game plan that will ensure that (a) the senior or founding principals have a mechanism for getting their equity stake out of the firm upon retirement and (b) a fair, tax-oriented mechanism for junior principals to buy an equity share in the firm is in place that won't force them into poverty.
"It is critical for a firm that wishes to structure an intelligent ownership transition program to create a strategic business model that integrates a financial plan for distribution of profits and equity throughout the full business cycles of expansion and recession," LePatner pointed out, noting that in addition, a marketing plan is needed to ensure the design firm will have steady markets to work in during good and bad times.
LePatner also said a tailored program is needed for the distribution, over a 10 to 15 year period, of the stock belonging to senior principals.
Advanced Planning
"Transition requires a lot of advanced planning," noted C. Jaye Berger Esq. of the law office of C. Jaye Berger of New York, N.Y.
Most architects and engineers work beyond 65 years of age, therefore, she said, if they have it in mind to plan for transition, they should think about it in their early 60s.
"They should look for someone who is technically adept and has business sense. The lack of business sense is the weak link," Berger warned.
"Sometimes more than one person will be required. Legally," she continued, "the ultimate goal is a written agreement. If the design firm is a professional corporation it would be a shareholder agreement. If it is a limited liability partnership, it would be an operating agreement. Incorporated into either of these would be a defined role of each party and possibly how the transition will occur."
To illustrate her point, Berger said, "for example, let's say a junior person starts with "X" amount of percentage ownership. The agreement should stipulate how much more this person will own over what time period and what they will have to pay to get it. It is quite common when a design firm takes in new people for the older generation of management to provide the money or a means of earning the money to buy into the company. This might be in the form of an annual bonus or part of an overall compensation package. Sometimes the younger generation may be asked to pay some real cash."
Trust
"Trust is a big element in getting into this situation," Berger pointed out. "An ownership transition plan requires a leap of faith by all parties. Sometimes, things can go awry. It is usually the result of a breakdown in communications where one party may feel the other is not upholding their end of the agreement. Things can unravel quickly. Some current and future partners have done things that are rash, such as empty the company bank account or go off on their own and steal key clients. Often there is animosity and little money that is fought over. This might lead to all parties being in litigation. Therefore, I recommend an arbitration clause be included in all agreements."
Like the law office of C. Jaye Berger, the New York, N.Y., and Newark, N.J.-based law firm of Zetlin & De Chiara has also represented a number of design firms involved in ownership transition. Firm partner Michael Zetlin said design firm partners today are more conscious of transition plans and are embarking on ownership transition plans earlier than what had been historically the case.
"Often times in the past, it wasn't until partners reached their mid-60s that they contemplated transition. Today, owners contemplate it earlier -- in their mid-50s, because they want to make sure they receive the fair value for their interest in the firm and they now recognize they need a transition of ownership to the next generation to ensure continuity of the firm. By the time leadership is in its 50s, they should begin to sell-off their interests in the firm to the next generation of leadership and begin to empower the junior partners of the firm with greater responsibility."
Zetlin recommended that transition should be part of a partnership or shareholder agreement of the firm. "This is a negotiation," he explained, "and makes sure all aspects of a transition are well thought out, considered, debated and resolved."
Good Tax Advice
Furthermore, he said "good tax advice is necessary so there are no hidden tax consequences based on the value of the shares."
"If you are dealing basically with ownership interest in a firm that carries value in terms of liquidation or book value, the transfer of those shares to an employee is treated as compensation under the U.S. Tax Code to the extent the employee is receiving the shares at a bargain purchase price," said Ken Weissenberg, a partner at David Berdon & Co., a New York, N.Y.-based accounting firm.
For example, he noted, "if there is a firm with an asset value of $1 million and 10 percent of the firm is transferred without a sale to an employee, then management has given that employee $100,000 in value and it is then treated as wages. However, if an employee purchases the shares for $ 100,000 or comes up with a valuation on paper to make it less, the employee can basically buy the stock for a note for $50,000 and then, over the next 10 years or so, through bonuses, pay off the note. This way, the employee builds up equity in the firm."
Another hidden financial consequence of ownership transitions, he explained, is how to build up the funds to pay off the older generation of partners.
"When the older generation is ready to retire, they need to be compensated by the firm for their interest in the firm. Generally," Weissenberg said, "design practices have significant difficulties when they fail to build up an adequate funding mechanism to pay for the retirement benefits for the retiring or founding partners. Depending on the individual firm, there are various things that can be done, such as building insurance with cash surrender values, building actual cash reserves and having loan facilities available for the firm to draw upon to payout the older partners. A last ditch alternative is selling the firm."
If the younger partners can't afford to buy out the older partners, he added, the alternatives are that the older partners don't get the money or they won't get as much as they would like.
"The only way to generate these funds is for the older partners to sell their practice to another practice with the available funds," Weissenberg said.
Weissenberg's colleague, Tony Cucci, is an audit partner with David Berdon & Co. He deals with the operational issues of a design firm's transition. "One of the things I see," he said, "is associates in design firms moved up through the ranks because they have technical expertise. Technical expertise does not necessarily make them good businessmen."
Cucci said he believed that a successful transition depends on the current leaders of a firm determining who will be the firm's future leaders.
This begins with finding and keeping good employees," he added. "Then, they need to be trained in areas other than the technical areas of the business, such as financing, marketing and administration. If this is not done, what happens when someone wants to retire is that there is no one to take over."
Cucci said the following are elements of a good transition plan:
• Find the right successor or successors. This can include internal development or external searches.
• Plan the financing for the shift in ownership. This shift should take place ideally over a 20-year period.
• The plan should incorporate short-term contingencies, such as the unfortunate demise of an owner or partner.
• Training is essential and should begin as soon as the older generation identifies potential successors to lead the firm. The potential successors need to be given training outside their area of professional expertise. This means training in administration, psychology, finance and marketing.
• A written plan is essential. It outlines specifics and contingencies. This plan should be communicated to key employees responsible for the plan's implementation.
• The financial implications of the plan need to be addressed as early as possible. If the retiring partner is to receive a specific amount upon retirement, it is best this amount is saved over a period of years so it does not impact on the current finances of the firm at the time the partner retires.
• The plan must be flexible and reviewed every few years to meet changing market and firm needs.
Jim Anchin, a co-managing partner with Anchin Block & Anchin, a New York, N.Y.-based accounting and consulting firm, said that above all else, the transaction must be understood. For example, if the firm is being sold to another firm, how the sale is structured, i.e. a sale of stock or assets, is critical to how tax liability will be impacted.
Bernie Rappaport, a tax partner with Anchin Block & Anchin, added that if the sale of the firm is internal, it is critical to determine: how the buyout is structured. For example, will it be a sale of stock or will it be a sale of stock coupled with a covenant not to compete and a deferred compensation payout. This impacts the tax liability of all parties to the transaction.
If there is a covenant not to compete or defer a compensation payout, the firm will receive a tax deduction for buying out the older partners. But, the older partners will then have ordinary income on the sale as opposed to capital gains. Since capital gains, Rappaport said, are taxed at a much lower rate, both parties have to crunch the numbers with their tax advisors to arrive at the correct allocation of the buyout.
An alternative to such a transaction is an Employee Stock Ownership Plan (ESOP). With an ESOP, the older partners sell their shares in a firm to the ESOP and the older partners may be able to defer the gain on the sale. "It is complicated tax-wise to do this and the right type of entity is needed," Anchin said.
For this scenario, Anchin suggested a C corporation. With an ESOP and a C corporation, he added, the younger partners get a share of the ownership of the firm without actually having to put up a lot of money. "It's sort of like stock options," he explained.
A firm with a lot of employees benefits from an ESOP, Usually, Anchin said, a bank will finance an ESOP.
The Z-3 Formula
Zweig White & Associates Inc. of Natick, Mass., specializes in management consulting and publishing for the architecture, engineering, planning and environmental industries. The firm, which was used by Thornton Tomasetti Engineers/The LZA Group of New York, NY, has what it calls a "Z-3 formula that bases a transition plan and transfer of ownership on internal sales of hundreds of architectural and engineering firms every year," according to company President Mark Zweig.
The Z-3 formula has five variables: revenue, backlog of work, number of employees, pre-tax and pre-bonus profits, and the book value of the firm. Zweig said the formula changes every year because it is based on actual transactions that occur in the industry.
Zweig, who is very blunt about ownership transition said: "I think most companies in our business have really screwed up ownership transition plans. The preferred method of ownership transition in our industry is internal. And, unfortunately, a lot of these plans were designed from an accounting and legal point of view with absolutely no consideration for the individual and organizational behavior issues that need to be addressed."
Making Sacrifices
Continuing, Zweig added that the result is design firms use book value as a valuation method for internal transition and the result is a firm in which owners have no incentive to make sacrifices to grow the firm.
"Instead owners are encouraged to optimize short-term profits and extract all the money from the company every year," he maintained.
"What design firms need is a valuation formula which, although discounted over an external sale, should parallel the real market value of the company. This is driven by revenues and profits and not the book value of the firm," Zweig explained.
Zweig said there must be a reason to make sacrifices to grow a company. "Owners can not extract the profits each year or let tax issues drive the whole transition program, or the firm will die."
To avert this scenario, Zweig said design firms "must invest in people, marketing, systems – all the things that hurt short-term profitability but can result in long-term revenue growth and profitability."
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