When the time comes to promote a key employee to a business partner or equity holder, many business owners are often left wondering one simple question: how?
Although, from an organizational standpoint, a promotion may sound simple, from a legal standpoint, the transition from an employee to a partner in a professional practice, whether in law, accounting, medicine, dentistry, engineering, or otherwise, is often more complicated. In any event, ensuring that the transition is handled correctly is critical to ensuring organizational harmony between the new owner or partner and the existing owners or partners, while failing to properly paper such a transaction can doom the new partnership before it even begins.
Although the documentation needed to legally effect such a transition depends on the specific circumstances of each individual situation, a fairly common arrangement includes a new member buying into an existing practice through the use of a Stock Purchase Agreement or Membership Interest Purchase Agreement (for purposes of this article, all such agreements will be referred to as a "Stock Purchase Agreement.") Upon becoming a partner or equity holder in the business, the new member also agrees to, or joins, the practice’s Shareholder Agreement and/or Bylaws or Operating Agreement, while simultaneously providing services to the business under an Employment Agreement. Accordingly, this article will discuss three legal documents that are often essential to an employee-to-partner transition: (1) the Employment Agreement, (2) the Shareholder Agreement, and (3) the Stock Purchase Agreement. For purposes of this article, the terms "partner," "member," "owner," and "equity holder" will be used interchangeably.
Most people are generally familiar with an Employment Agreement. As its name suggests, an Employment Agreement governs the employee-employer relationship between a company and an individual. For parties contemplating an employee-to-partner transition, the employment agreement serves as the foundation for the new relationship between the firm and the individual who is being promoted. Although the individual may have been an employee of the firm previously, the transition to partnership is more often than not accompanied by a change in the nature of the newly promoted partner’s role as an employee, and such individual's Employment Agreement should reflect any such changes. Accordingly, a new Employment Agreement may need to be drawn up, or an existing Employment Agreement may need to be amended. In any event, the employment agreement should cover, among other things:
- The employee’s Updated Role and Responsibilities, which may include things like management, strategic decision making, growth, or financial oversight responsibilities.
- Expectations of Performance for the employee, including, for example, expectations in terms of client acquisition, revenue generation, leadership within the firm, or contributions to the practice’s reputation.
- Compensation Structure, which may include some combination of salary, profit share, bonuses, and incentives.
- Benefits, such as health insurance, retirement plans, and other fringe benefits, including with regards to vacation, sick leave, and time off policies, especially if the newly-promoted partner is expected to have greater flexibility.
- Non-Compete and Non-Solicitation Clauses, which are often subject to both federal and state-specific laws.
- Termination and Dispute Resolution Mechanisms, including buy-out provisions and valuation equations.
- Confidentiality and Intellectual Property Ownership, especially if the newly-promoted partner will have increased access to confidential or proprietary information.
While an Employment Agreement governs the rights and obligations of the new partner as an employee, a separate legal document (or documents) is usually used to define the new partner’s rights and obligations as a partner of the practice. Such document often takes the form of a Shareholder Agreement (or Member Agreement), which is an agreement that is applicable to all shareholders, partners, or owners of the entity, whether past, present, or future. Although a Shareholder Agreement may be a stand-alone agreement, in some circumstances the Shareholder Agreement may be contained within the practice’s other governing documents, which may take the form of Bylaws for a corporation, or an Operating Agreement for a LLC, LP, or other similar entity. Regardless of whether the Shareholder Agreement is presented as a stand-alone agreement or as part of the practice's Bylaws or Operating Agreement, the Shareholder Agreement should address, among other things:
- Voting Rights and Decision-Making among the practice's partners, which may also include multiple classes of partners, which different rights and responsibilities attached to each class.
- Restrictions on Transfers, which often provides existing partners with a right-of-first-refusal, or other buyout rights, such as tag-along or drag-along rights, in the event another partner wants to exit the company by selling or otherwise transferring their ownership interest (note: such restrictions may also be set out in a separate “Buy-Sell Agreement”).
- Retirement, Divorce, and Death Provisions, which address how ownership interests may be assigned or transferred upon the happening of certain involuntary events, and may be included with the restrictions on transfers discussed above.
- Valuation Mechanisms, for determining the value of a partner’s ownership interest in the event a transfer needs to be completed.
- Dispute Resolution and Deadlock provisions, which can provide mechanisms for resolving disputes on major decisions such as dissolving the company, contemplating a merger or acquisition, or admitting new members.
As noted above, if the Shareholder Agreement is not part of the practices Bylaws or Operating Agreement, such other governing documents should also be reviewed or drafted in order to help ensure there are clear provisions governing items such as allocation of profits and losses, distribution rights, indemnification rights, and management provisions.
An ownership interest in an entity such as a LLC or a Corporation is a property interest and, as such, must be property documented and executed in order to legally transfer ownership to a new party. Although some entities issue physical shares or unit certificates to represent an owner’s interest, most transfers nowadays are accomplished through the use of written agreements, and through documenting an ownership award or transfer on the books and records of the company. In some situations, this may only require amending a practice’s Operating Agreement or Bylaws to add a new name to the practice’s list of owners. However, in many situations, existing owners will sell a portion of their ownership to the newly-promoted member. In such situations, a Stock Purchase Agreement (or similarly-named document) will be used to document and effect the exchange of property (the ownership interest) from the existing owner(s) to the new owner(s). Among other things, the Stock Purchase Agreement should address:
- The Purchase Price and Payment Terms for the interest being purchased, which may include details regarding how the ownership stake is valued, whether the purchase price is payable in one installment or multiple, and whether any earnouts or contingent payments apply.
- The Number Of Shares Or Units Representing, Or The Percentage Interest Of, The Ownership Interest being purchased by the new partner, including details on whether the new owner will receive the entire interest outright, or if the interest will be granted in increments, or pursuant to options.
- Representations and Warranties, of both the buyer and the seller.
- Closing Conditions, which may include things like regulatory approvals, completion of due diligence, or financing approvals.
- Indemnification and Dispute Resolution provisions.
The Stock Purchase Agreement should also contain or state if any additional documents, such as a Bill of Sale or Joinder Agreement, will be required as part of the transaction.
