What should written ownership agreements include?

This article by Stephen Knowles, a dental sector specialist solicitor for PFM Dental Legal Limited, was first posted on www.smile-onnews.com

If you own a share in a dental practice one of the management issues that is frequently overlooked or given insufficient consideration is a written agreement between the principals setting out how the practice is to be run, who owns what and what happens when certain key events affect one or more of the principals.

Running the practice

If there are more than two principals, the agreement needs to record how decisions are taken regarding the running of the practice. Is it majority rule on all decisions or should there be several key issues where unanimity is required? These key issues can include the hiring and firing of staff, incurring expenditure above a designated amount and, ultimately, a decision to sell. If there is an even number of principals should a managing principal have a second, casting vote or should there be another means of breaking a “deadlocked” vote?

Division of profits and losses

In dental practices, it is increasingly rare to see a “normal” partnership where profits and losses are shared equally amongst the principals. Where all principals work in the practice, the chances are the principals will work different hours and will contribute varying levels of fees to the practice “pot”. As such, most practices will seek to divide profits, to some extent at least, by reference to the differing levels of fee income contributed by each principal. An agreed formula for dividing up the practice expenses is then required. Examples include a simple equal division or a split related to the number of sessions each principal uses the premises.

Safeguarding the practice

Hopefully, the ownership agreement will gather dust on a shelf for many years to come but its value will become apparent should the following key events occur:
• Death of a principal
• Critical illness or lengthy illness of a principal
• Bankruptcy of a principal or loss or professional registration
• Dispute between the principals
• Principal wishing to retire
It hardly needs to be said that a sudden death or critical illness diagnosis can have a dramatic effect not only upon the deceased/ill principal and their family but also the running of the practice. The deceased/ill principal or his personal representatives will want to extract the principal’s ownership value in the practice to pass on to family members or provide much needed funds to assist the stricken principal. The remaining principals may not have the capital to pay in the timescale required. As such, the ownership agreement will usually include provisions requiring each principal to take out life cover to provide a readily available fund to pay the deceased’s estate the value of the deceased’s share in the practice.

Valuation provisions

Issues to discuss and resolve include whether the value of the deceased’s share is to be market value at the date of death; in which case valuation provisions will need to be agreed and included in the agreement. The principals will need to review regularly the level of cover to ensure it is sufficient and does not lag behind market value. Thought will also need to be given to determine what happens to any excess insurance proceeds if the insurance proceeds exceed market value. Alternatively, the value of the deceased’s share could be automatically set at the value of the insurance policy in place; in which case, there is a danger of the deceased’s estate receiving less than the true market value if the insurance cover is not regularly reviewed.

Critical illness cover

Critical illness insurance cover is not always included in an ownership agreement due to the cost of premiums. If not included, the principals will need to consider the time period given to the ill principal to (hopefully) recover or be obliged to sell their interest in the practice. Usually a right of first refusal is given to the other principals. It is vital that clear provisions as to the mechanism of reaching a value are included in the agreement. If agreement between the principals cannot be reached should there be just one independent valuation or should the departing and remaining principals each get a valuation with the average value taken? Alternatively, should there be a completely different mechanism?
Once a value has been reached another vital consideration is the time for payment particularly, if no insurance cover is available. How long will it take the remaining principals to raise the necessary capital?

Notice periods

Where the trigger event for departure is not so sudden (such as voluntary retirement or dispute between the principals) how long a notice period should be served by the departing principal? (It is rare to see less than six months and often more is considered necessary). Valuation provisions and time for payment will also be relevant. Once notice has been served, will the remaining principals be obliged to buy the departing principal’s share or not? If not, what happens if they decide not to purchase? Commonly, a sale of the whole practice is then triggered.
Once the above processes have been concluded the departing principal needs to be subject to a series of fair and enforceable binding out (non-compete) provisions given the goodwill that has been purchased by the remaining principals and the need to ensure their investment is not devalued by the departing principal competing against his former colleagues.

All in all, much to think about but the importance of having a written agreement in place as an insurance “safety net” cannot be over-stated. The time to put one in place is now and not when a dispute or illness is developing.

Martyn Bradshaw

Martyn Bradshaw is a Director of PFM Dental and heads up the Sales and Valuations department. Martyn has been undertaking valuations, sales of dental practice, practice finance and business advice to dentists since 2004 when he joined PFM Dental.