This article first appeared on Forbes.
When drafting an equity agreement, partners need to be prepared for many different issues and eventualities. That’s why it is necessary to carefully consider the terms of the agreement, from the allocation of profits and losses to the systems in place when it comes to removing a partner.
We have helped set up several law firms, and these are the five key questions that we find partners should consider:
1. How will the profits and losses of the firm be allocated?
Many law firms equally split the profits and losses. An advantage to this approach is that the partners equally enjoy the ups and downs of the firm. For example, if the firm wins a big contingency case, all of the partners benefit.
Other firms use an “eat what you kill” system where each partner gets their net profits, but is also responsible for their losses. A pro to this approach is it may lead to less friction over time between the partners who want to work 70 hours a week and those who want to spend more time with their families, traveling or on the golf course. An eat-what-you-kill item might also create a framework that leads to less resentment if a partner decides to take off more time with a newborn child, to help a sick family member, or if they have expensive spending habits.
2. How will decisions be made?
Partners also need to decide what decisions will require a majority vote of the partners, a supermajority vote (anywhere from 67-90%) of the partners or the unanimous consent of the partners.
For example, if a majority of partners want to promote an associate attorney to be a new partner, is that sufficient?
It is important to be very clear which items require which voting threshold so there is no dispute over whether an item requires a supermajority or unanimous vote, as opposed to merely a majority vote.
3. How will equity be valued when a partner leaves?
Some law firms value a departing partner’s ownership using a formula in the partnership agreement, such as 1.0-1.5 times the prior year’s gross revenue. Other firms have a business appraiser value the ownership interest of a partner who leaves the firm.
It is important to not only plan for how the fair market value of the equity interest will be calculated, but also how the purchase price will be funded to make sure the payments do not overburden the remaining partners.
4. How can a partner be removed?
Some law firms require a majority vote of the remaining partners to remove a partner whereas other firms have a higher bar for removing a partner.
5. What powers will the managing partner have?
Some law firms like to set checks and balances on the powers of the managing partner. For example, any expenditure above $X requires the approval of a majority of the partners.
There is no one-size-fits-all answer to these questions. The key is partners having a clear equity agreement in place that provides a roadmap when these and other issues inevitably occur.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.