Bottom-line Analysis Why Buy/Sell Agreements Are Critical To Your Practice (Part 1 of 3)
The single most important legal document in any group practice may well be its buy/sell agreement among its existing doctor owners. If this agreement is nonexistent, verbal, outdated, or ambiguous, your group practice may be sitting on a ticking time bomb.
At some time, every group practice is going to face the death, retirement, disability, divorce, or other form of voluntary or involuntary separation of a member. If you do not have a formal arrangement already in place that addresses the financial terms and conditions of these eventualities, your practice may be entangled in costly and seemingly endless litigation.
This is the first of three articles on buy/sell agreements. This first article will focus on the strategic and structural aspects of these arrangements. The second article will illustrate an actual arrangement and focus on the financial aspects. The third article will address special situations that may require creative solutions and modifications to existing buy/sell arrangements.
Buy/sell arrangements within the context of these articles refer to those arrangements between members within a group practice (and new doctor owners), as opposed to the sale of an entire practice to an outside party.
A well-written buy/sell agreement is very important to group practices for several reasons. First, it is a significant element of the recruiting process. It spells out the financial, logistical, and timing aspects of future ownership in the group practice. This is very important for attracting new doctors, most of whom look for the prospects of ownership. Second, it provides senior doctors with a measurable expectation of some monetary return upon retirement, death, or disability. Third, it provides for an affordable succession plan that enhances retention, stability, and future growth of the practice.
Keeping Up with the Times
Historically, group practices engaged in expensive buy-in and buy-out arrangements for their doctors. These arrangements often served the group’s original doctors well, but left newer doctors with little equity in the practice when the older doctors retired. These arrangements were justified on the basis of the following premises:
• Starting salaries offered by group practices were increasing annually, enabling young doctors to pay off education loans and fund a buy-in;
• The only alternative to group practice for most doctors was to start their own practice, and establishing a new medical practice would cost at least $150,000 in capital, with all its related risks; and
• Many new doctors fresh out of residency were always available to fill vacating positions.
| Exhibit 1: New Doctor Compensation and Buy-in Structure
A doctor is recruited out of residency by a surgical practice. The average compensation of a senior doctor is $200,000. The net asset value of the surgical practice, excluding patient receivables, is $25,000. The doctor is hired on a one-year probationary basis and then offered a five-year buy-in arrangement. Assuming the newly recruited doctor attains full productivity by the end of the third year, he or she will generate $134,000, which can be reallocated proportionately to the senior doctors in years 3 through 6 to compensate them for start-up costs and development. The new doctor, in turn, will receive additional compensation from doctors who subsequently join the practice and will therefore receive the $134,000 back.
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Today, starting salaries have leveled off or decreased. Doctors are coming out of residency with education loans that dwarf some home mortgages. Young doctors are entering institutional and HMO staff model practices with attractive starting compensation packages and no up-front investment. Some geographic areas and specialties are experiencing a shortage of candidates. Finally, and most obviously, new technology and procedures unfamiliar to senior doctors are rapidly changing patient care and related reimbursement.
As a result, these once feasible buy-in/buy-out arrangements have evolved into what some critics view as Ponzi schemes. The first doctors entering a practice leave with all the money, and the newest doctors are left holding the bag. This industry-wide problem is particularly troublesome for specialty practices whose expenses have outpaced their revenues.
Simply stated, young doctors cannot afford expensive buy-ins, and medical practices cannot afford the costly buy-outs. Unless changed, these arrangements will fuel discord within a medical practices and impede recruitment. Eventually, such arrangements can sink a practice.
The following example shows how these arrangements can deplete a medical practice of capital:
Dr. A and Dr. B funded a medical practice by contributing $50,000 each. Dr. C buys into the practice by paying Dr. A and Dr. B $25,000 each for one-third of their stock. This money does not go into the practice, but rather into Dr. A’s and Dr. B’s personal funds. When Dr. A retires, however, the practice’s buy-out agreement stipulates that it will pay Dr. A back his original capital contribution. In buying out Dr. A, the practice’s equity is reduced by half; in fact, the practice probably has to take out a loan to pay Dr. A because its original capital was used to purchase medical equipment, office equipment, and furniture.
When Dr. B retires and receives his $50,000 buy-out amount, all of the practice’s equity is depleted. Dr. C is left with a practice in debt, perhaps with Dr. C as co-signer to the loan, and without equity. And Dr. C is out $50,000 in after-tax dollars.
Many medical practices have recognized this problem and are restructuring their buy-in and buy-out arrangements. Because it is very difficult to tell a doctor one year away from retirement that he or she will not receive a $200,000 buy-out as planned, this restructuring often involves a gradual phase-in period. Similarly, new doctor owners should be relieved of undue financial burdens when buying into a practice or buying out a retiring partner.
Guidelines for Better Arrangements
When structuring or restructuring buy/sell arrangements, group practices should minimize new doctors’ after-tax outlay, purchase and redeem interests through the medical practice, fund future receivables through a compensation formula, minimize unfunded buy-outs, and minimize risks with insurance.
Minimize new doctors’ after-tax outlay. An increasingly common approach, especially with larger group practices, has new doctors make a contribution to capital tied to net asset value of the practice, excluding receivables. In this way, both buy-in and buy-out investments are minimized, and doctors keep all their receivables income. This approach has helped many practices attract top new doctors.
Purchase and redeem interests through the medical practice. Payment for an equity interest in the practice should go into the practice to fund working capital and the interests of retiring doctors. Other arrangements, such as buying stock directly from doctors and then having the medical practice fund the redemption, are self-serving and weaken the practice’s financial position.
Fund receivables through a compensation formula. At the point where the practice decides to offer the doctor an ownership interest (typically one to two years after initial employment), requiring a new doctor to pay for his or her share of the practice’s receivables in after-tax dollars, is unattractive and often prohibitive. An alternative is to use a step-formula approach to compensation, which funds a new doctor’s receivables in pre-tax dollars and is attractive to both the practice and the doctor.
Such an approach ties a new doctor’s compensation to a percentage of the average compensation of a senior doctor, gradually increasing the percentage over a specific period of time (i.e., 65{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}, 72{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}, 80{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}, 87{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}, and 94{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} over five years). Such an arrangement guarantees the new doctor an annual pay raise, helps fund the new doctor’s receivables until he or she attains full productivity, and compensates senior doctors for helping the new doctor establish relationships with both patients and the medical community. It also compensates senior doctors for revenue and patient ‘dilution’ often caused by trying to fill the new doctor’s schedule (see Exhibit 1).
Minimize unfunded buy-outs. A doctor’s retirement should not depend on the practice buy-out, and the practice should not have to fund it through a bank loan. Providing significant retirement income is the function of a qualified retirement plan, which every medical practice should have. Upon retirement, a doctor’s maximum buy-out should consist of a return of original capital contributed, or a pro-rata share of net asset value, and a deferred compensation arrangement based either on some factor or average compensation of a senior doctor or on the net realizable value of the doctor’s patient receivables (see Exhibit 2). Any amount above this should come from a funded plan.
Deferred compensation should be structured to require doctors to stay employed by the practice until normal retirement to get the maximum payout; however, exceptions should be made for death or disability.
Minimize risks with insurance. Small and medium-sized practices have fewer doctors to share the costs of an untimely death or disability buy-out. Some practices take out whole life insurance on shareholder doctors to fund an unanticipated death buy-out. Life insurance also helps cover the costs of replacing a key provider when the practice is the beneficiary. An added benefit is the cash value available to fund part of deferred compensation at retirement.
The costs of such a policy usually are 100{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} recoverable. Although premiums are not tax-deductible when paid, the proceeds on a death claim may be subject to a small alternative minimum tax. If a policy is redeemed for its cash surrender value, proceeds are tax-free to the extent of dividends paid.
When a practice makes deferred compensation payments to a retiring doctor or the doctor’s estate, the payments are fully tax-deductible. These plans can be structured with little or no tax costs to the medical practice.
Even more financially devastating than the premature death of a shareholder provider is an unanticipated disability of a shareholder provider. The costs of continuing to pay his or her salary add to the total financial burden of buying out the shareholder and finding a replacement.
Special insurance policies that are relatively inexpensive can cover disability costs. For a 40-year old doctor, a disability buy-out policy that pays $3,000 per month over 60 months ($180,000) can be purchased for an annual level premium of $141. These policies usually are written with a 12-month waiting period.
To maintain continuity, group practices need to establish a flexible system for transitioning ownership. As with compensation agreements, practice buy/sell arrangements should be reviewed periodically to ensure that they are affordable, fair, simple, and competitive.
James B. Calnan, CPA, is partner-in-charge of the Health Care Services Division of Meyers Brothers Kalicka, P.C. in Longmeadow; (413) 567-6101.
holder and finding a replacement.
Special insurance policies that are relatively inexpensive can cover disability costs. For a 40-year old doctor, a disability buy-out policy that pays $3,000 per month over 60 months ($180,000) can be purchased for an annual level premium of $141. These policies usually are written with a 12-month waiting period.
To maintain continuity, group practices need to establish a flexible system for transitioning ownership. As with compensation agreements, practice buy/sell arrangements should be reviewed periodically to ensure that they are affordable, fair, simple, and competitive.
James B. Calnan, CPA, is partner-in-charge of the Health Care Services Division of Meyers Brothers Kalicka, P.C. in Longmeadow; (413) 567-6101.
Exhibit 2: Retiring Doctor Deferred Compensation and Buy-out Structure
A retiring doctor originally contributed $25,000 for stock in the medical practice. At retirement, the net asset value of his or her interest in the medical practice is $105,000, including the doctor’s share of patient receivables, equaling $75,000. The doctor is paid out over 36 months as follows:
| Cash Redemption | Deferred Compensation | |
| Year 1 | $ 30,000 | $ 25,000 |
| Year 2 | $ 25,000 | |
| Year 3 | $ 25,000 | |
| $ 30,000 | $ 75,000 |
This arrangement provides a return of capital and some measure of equity growth. It also allows the practice to provide an affordable supplemental retirement benefit. It can be paid out of the medical practice’s current and future earnings without impairing capital or obtaining outside financing.
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