Consider professional service buy-in for young professionals
By Beau Ruff
One of the big planning challenges for professional service organizations is attracting new talent — young doctors, lawyers, accountants and others — to ultimately take over the business or the practice, and facilitate the business succession strategy.
It is a financial challenge for the young professional recently out of school who is trying to simultaneously start a practice, buy a first home and get out from under his or her crushing school debt.
When presented with the option of a higher paying job (and no equity interest in the business) and a lower paying job (with the promise of an expensive buy-in down the road), young professionals seek the safety of the higher paying job.
This complicates the exit scenario for established equity owners looking for the succession and transition plan.
To entice the next generation of professional to the practice, consider the concept called a “tiered equity buy-in.” This strategy reduces the initial outlay of cash for the professional while compensating the existing equity owners more on the backend as the owner exits the business.
Often, a professional services business really has two businesses: the operating business and the real estate and building where the operating businesses operates.
Consider first the typical buy-in. The new professional loaded with debt must promise to pay a portion (or all) of a successful practice and a valuable building. The initial cash outlay can be monstrous for the young professional. Still, most professional service buy-ins are structured in this manner.
An alternative planning strategy is to have the buy-in be paid as the current equity owner exits rather than as the incoming professional enters.
An example helps to explain the details. Consider an operating business valued at $1 million and a building valued at $1 million. The practice has three current equity owners who also jointly own the building.
Consider that the plan is to bring in the new professional as an equal 25 percent owner. The young professional would have to buy in to both the practice and the building (with the hope of eventually taking over both) for about $500,000.
This column will largely focus on the building portion for simplicity’s sake, but the concept can be applied to both components.
So, the building buy-in component is $250,000. Let’s also assume that the next year, the eldest existing owner exits the practice and sells a quarter of his share to the other professionals. That existing owner received about $83,000 for the building buy-in from the new professional from a year ago and an additional $250,000 for his buy out at exit, assuming no growth, for a total of $333,000 for building.
Consider an alternate buy-in approach.
Instead of buying in to the existing equity and shelling out $250,000, the young professional is admitted to the building ownership but only participates in the equity gains from that moment on. The young professional pays zero upon admission but takes on a liability (the obligation to buy and the proportionate liability if the property goes down in value). The current equity is reserved to the current owner(s).
In this scenario, the young professional would become an owner of the building but have zero equity (all the $333,000 equity apiece would be reserved for the existing owners). Then, upon, the first existing owner’s departure, the three remaining professionals pay the exiting owner for his share of the building ($333,000 plus any appreciation in value of the building since the time of the young professional’s admission). The exiting owner is made whole but the equity ownership of the remaining owners is not equal. Instead, the two original owners would book equity at $333,000 plus $111,000 for $444,000. The newest professional would book his equity at $111,000 (equivalent to his buy-out responsibility for the exiting owner).
Effectively, this approach still makes the exiting owner whole while making the buy-in more palatable for the young professional and giving him or her time to establish the practice before requiring payments.
As to the operating business, a similar approach could be utilized. First, we’d value the business as of the date of hire. The equity could then would be broken into different parts (e.g. the accounts receivables and the regular assets).
The current accounts receivable, or AR, would be attributable to the existing owner. Any increase would be credited to the new owner. The corporation would agree that the AR is a form of deferred compensation owing to the individual professional, thus lowering the value of the business for the buy-in with after tax dollars but allows the new professional to use pre-tax dollars to buy-in to the AR. Here again, the key is to tier the equity in the business for a more gradual buy-in.
Of course there are other more traditional strategies like lowering the equity through refinance. But the tiered equity approach is worth considering. Although the numbers are substantially the same as a traditional buy-in, it feels like a better deal to the new professional that doesn’t have to come out of pocket as much early in his or her career.
[panel title=”About Beau Ruff:” style=”info”]
Attorney Beau Ruff works for Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick, where he focuses on assisting clients with comprehensive planning.