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Common Partnership Mistakes

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As a practice management consultant, I have been involved in many aspects of a partnership buy-in, starting them from scratch, modifying existing buy-ins/partnerships and representing those selling as well as those buying-in. My involvement in all of these phases of a partnership has led me to the conclusion that there are a few basic mistakes often made in the following areas:

  1. Valuing the practice
  2. Uniformity in a buy-in or buy-out
  3. Overhead sharing or profit sharing
  4. Unplanned buy-out
  5. Decision making

Valuing the Practice for Buy-In or Buy-Out
The first mistake commonly made by many during the buy-in process is hiring an appraiser such as myself to "value" the practice for the buy-in. While I enjoy appraisal assignments I do believe it is a mistake to go that route. The reason I state this is two-fold:

  1. A practice valuation is a snapshot in time, indicating the value of the practice at a particular moment, based on the information provided. So an appraisal is theoretically only good for that buy-in and cannot be used for future buy-in or buy-out processes. This leads me to my second point.
  2. Each appraiser approaches valuation assignments differently. Unless the same appraiser was used each and every time, inherent appraiser bias may skew a buy-in or buy-out towards either party. Furthermore, even if different appraisers apply the same methodologies, they may interpret data differently and assign variables differently, resulting in varying conclusions of value.

To combat this, my suggestion is to utilize agreed upon formulas for valuing tangible assets, accounts receivable, office and medical supplies and goodwill. These formulas are uniform (meaning they can be applied to a buy-in or buy-out) as well as "timeless" (meaning they can be used now or in the future).

While the formulas for valuing tangible assets, supplies and A/R may be easily agreed upon, establishing a formula or methodology for goodwill can be another matter. There are many ways to identify goodwill value. Some of the methods I have used are:

  1. Base the practice’s entire goodwill value on a percentage of gross collections.
  2. Set the goodwill paid to the doctor buying into the practice to equal the income they personally derive from the practice.
  3. Set goodwill at a nominal amount that is not dependent on practice productivity or an individual’s income.

Any of the above three methods is acceptable provided it has been discussed and agreed to by the partners, and assuming that the partners agree to use the same approach presently and in the future, for both a buy-in or a buy-out.

In most buy-in or buy-out agreements both parties are simply seeking to pay and receive a fair and reasonable price. Part of the perception of fairness is that one party is buying in under the same conditions as any other, and that the buy-in and buy-out are on equal terms.

I have been involved in situations where there are several partners in a practice and each one bought in under different terms and conditions. The differences in each buy-in were subtle. But the difference from the first to the last was fairly substantial when all the incremental changes were viewed in total. The issue was coming to a head when it was time for a buy-out and none could agree on how that should be accomplished.

A standardized or uniform buy-in process creates a level playing field for all the partners and lays the groundwork for a smooth transition on a buy-out.

Overhead Sharing or Profit Sharing
I am always amazed when I am presented with a partnership in which the doctors agree to share overhead or profits on no more than a handshake. Handshake agreements are great when times are good but formal documents should be created to identify the responsibilities and obligations of all parties. This will be crucial should the relationship ever sour.

One of the greatest advantages to sharing overhead is that it obligates each partner to a share of the practice’s expenses. A typical approach is to divide expenses into two pools and divide one pool by ownership share and the other by productivity. Each doctor then pays for their allocated share of the expenses out of their A/R and whatever is leftover is equal to their earnings for the year.

It is important to note that the overhead isn’t allocated entirely by productivity. I worked with a practice some years ago in which two doctors had been partners for 17 years and made an agreement to share overhead on a handshake. The overhead was allocated according to each doctors’ productivity, which worked fine for many years, as their productivity was fairly equal.

One doctor pulled his investments out of the stock market right before a substantial downturn while the other saw his investment of millions dwindle to a figure in the low hundred thousands. The doctor who pulled out of the stock market was flush with cash and dropped his work schedule down to one week a month while the other kept working full-time.

The result, according to their handshake formula, was that the full time doctor now represented almost 90 percent of the practice’s productivity (by default) and was now responsible for 90 percent of the overhead. He was now working just to keep the doors open and received no compensation for over six months (until the practice went bankrupt). This could have been avoided with a formal expense sharing arrangement that wasn’t based entirely on productivity.

Another approach is to pay for all of the practice’s expenses out of every partner’s A/R. However, expenses that are personal in nature (car, trips, etc.) should be removed before ascertaining profits. Once profits have been identified they are placed into two pools, one allocated according to ownership and the other by productivity to determine each partner’s share. Before a partner is paid their share, we would remove from that profit share each doctor’s personal expenses (as previously identified).

Unplanned Buy-Out
Too many practices do not have a mechanism for dealing with an unplanned buy-out. An unplanned buy-out can be necessary for several reasons: death, disability, loss of medical license, etc. In cases of death or disability, the repercussions of an unplanned buy-out can be somewhat mitigated by use of key man insurance for life or disability.

Absent of proper insurance coverage, an unplanned buy-out can have a two-fold effect: (1) the practice loses a productive partner and (2) the lost of productivity may put the practice in a cash crunch if a buy-out is also due.

A planned buy-out is addressed in most partnership/shareholder agreements. It should specify, just like a buy in, how the partnership share is to be valued and paid out. Typically, if a buy-in occurs over five years, a buy out should occur over five years too.

In an unplanned buy-out, or a buy out without notice, some precautions need to be taken. First and foremost, if there isn’t proper notice for the buy-out for any reason, some or all of the goodwill may be forfeited. Since the departing physician isn’t available to transfer the goodwill in a timely manner it simply follows that not all the goodwill will be paid out.

Decision Making
Many practices have an administrator who can make most, if not all, of the day-to-day decisions without having to consult the physician owners. However, for those practices where the doctor(s) acts as administrator, or for those where the partners want to be kept fully informed of all the administrator's actions, I suggest using an agreement that clearly defines decision-making authority, which I refer to as the Managing Partner Agreement.

Basically, the Managing Partner Agreement provides one of the partners with certain unilateral decision making abilities. For example, it may say the Managing Partner can make any decision unilaterally as long as it does not exceed a certain dollar amount (say, $5,000 or so) or doesn't exceed the term of their position (the Managing Partner title may rotate on an annual basis among the partners). For example, if the Managing Partner wants to sign a lease for a small piece of equipment, but it is a two-year lease, then that would extend beyond their term and they must first run it by the other shareholder partners. This works well if it proves difficult to get all the partners in the same room at the same time for decision-making. If the Managing Partner title is rotated among all the partners, one of the powers may be that the Managing Partner has tie-breaking authority in voting. Basically, any duty can be assigned to the Managing Partner, as long as it is agreed to by all. For acting as Managing Partner, a doctor may be paid a nominal salary above and beyond his or her profit sharing portion.

If the practice has an administrator, the same decision making parameters can be applied to their employment contract.

In conclusion, the areas outlined above are those in which a few basic mistakes are commonly made in partnership situations. It is my hope that this article has provided some illumination into those danger areas and helps you to evaluate whether or not these issues are adequately addressed in your own practice.

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About the author: Brad Ruden has more than 15 years of experience consulting in ophthalmology, sits on the editorial board of Ophthalmology Management, and has had articles published in EyeWorld, Administrative Eyecare, Ophthalmology Times, Ocular Surgery News, Ophthalmology Management, Optometric Management and Primary Care Optometry News. He is a member of the Academy’s Consultant’s Directory and holds a Masters of Business Administration from Arizona State University, as well as a bachelor’s degree in Business Administration from Southern Illinois University.