Partner Shareholder Agreements Part 1 Of 3

Most of the time when we are called in to work with firms, it is to help them plan for or implement significant change. The dialogue may start out with a general firm retreat, or it might simply be a session devoted to solving a few specific problems. Visionary firms are always looking to make changes long before their operating environment forces them to, from enhancing their ability to compete, making changes to improve profitability, building infrastructure to support succession, upgrading their people development, modifying the compensation process, increasing revenues, and more. Consider the pre-scandal Tiger Woods performance for perspective. Here was Tiger at the turn of the Century, the number one golfer in the world, deciding to tear his swing apart and rebuild it. Why would anyone at that level have the courage to go back to the drawing board to make himself better when he is already the best in the world? Do you remember the slogan, “If it ain’t broke, don’t break it?”

Here is the problem with the “leave it alone if it ain’t broke” strategy. To constantly make yourself or your organization better, faster and stronger, you have to continually re-evaluate the foundation that supports your success. While you might be touted as one of the best of the best, that doesn’t mean you will remain in that position for long because you are operating in a dynamic competitive environment where your competition has their sights on surpassing you. At some position in everyone’s development process, you reach a point at which you have, as my partner might say, “milked that cow for all it can deliver.” At such a place, about the only way to take yourself to the next level is to rebuild the foundation upon which everything you are doing is resting. Picture a pyramid. It is wide at the bottom and narrow at the top. If you want the pyramid to be taller, you don’t just cut off the tip and continue building up. You need to start again from a wider foundation so that it can support your new soaring structure. So, visionary firms continually optimize on whatever foundation they have built until the moment that the foundation starts showing cracks. At such time, before that foundation fails, these firms, just like Tiger, know to start rebuilding (infrastructure, processes, governance, etc.) a more robust foundation that can withstand the load that continued future success will place on it.

So what does this have to do with partner / shareholder / member agreements (henceforth referred to simply as “partner agreements”)? A lot!! Why? Because many firms are built on partner agreements that have long outlived providing a reasonable foundation to support the firm’s current success level and size. Here’s an egregious example we have run across numerous times. Some firms have multiple versions of their partner agreement in place with no single version that has been executed by everyone in the owner group. This, while it may seem insignificant on a normal operating day, is a structural flaw looking for an incident. As soon as the firm encounters its first serious conflict within the owner group, the agreements will be called upon to resolve the issue. However, you can almost guarantee that any issue that has risen to this level of contentiousness will have been dealt with differently in the various versions of the agreement and since no single agreement is the undisputed authority, bad stuff happens. For instance, if this results in someone leaving the firm, based on our experience, the departing owner will cherry-pick the clauses he or she likes from each version of the agreement to create legal confusion, thereby allowing them to take greater advantage of the firm. In many cases, even when there is only one executed agreement, the same problem arises through a different structural defect in that the firm is currently operating differently than the agreement reflects. In this case, the firm ends up losing once again because its legal foundation (the partner agreement) is no longer aligned with the current operating foundation which results in disgruntled owners being able to take advantage of the firm.

Another example of a common problem we see is that the voting thresholds don’t support a reasonable governance structure. For example, consider a scenario when a firm has 2 partners. It is justifiable that unanimous consent is the right voting threshold for a few significant issues like adding a partner, terminating one, changing the retirement formula and other such major firm decisions. However, evolve this situation so that the firm has 3 partners or more. Unanimous consent now, in our opinion, is a bad voting practice. We use our rule of thumb, which is ... the highest vote required to approve major firm decisions should fall around the super-majority threshold of 66 and 2/3rds percent. But regardless of where you prefer your thresholds to be, we give you this strong phrase of warning because of the problems we have encountered within firms: The voting threshold should be positioned so that a “No” vote does become a show stopper when the vast majority are saying “Yes.” Consider this scenario of ownership:

In this case, we would suggest that the highest voting threshold for any decision be 66 and 2/3rds, or you could easily make an argument that 59% should be the highest threshold. Why? First and foremost, because when you have this many partners, you don’t want an operating environment where one person should ever be able to block a decision. And the reason for suggesting the lower threshold in this scenario would be to disallow any two partners from blocking a vote either. To our way of thinking, assuming the firm has long evolved away from being controlled by its founding owner, if five of seven owners want to do something, they should be able to move forward (if the firm is still controlled by one or two founding owners, you usually have a whole different series of issues that we are not attempting to bring to light in this column).

When voting thresholds are set too high, what we find is certain partners end up having the power to hold the rest hostage, either allowing them to get concessions or to freeze the firm right where it is so nothing significant will change. Either of these situations creates a bad business environment in which to try to run a firm. Rather than being in a position to create strategy and implement it, a culture is created around maintaining the status quo and making small incremental changes since everyone is armed to throw their personal anchor in the water at any time, thereby stopping your firm’s forward momentum.

Another foundational decision is to determine whether you want to vote an issue as if it is a board of director vote (one person-one vote) or by voting your ownership percentage. We are comfortable with operational policies and processes being decided by a one person – one vote structure. But we believe all substantive issues, which includes almost all major financial issues (retirement, compensation, termination, etc.) should be voted on by your shares or stock or ownership percentage. The problem is that most firms don’t have even have a documented process That They Follow identifying what issues call for which types of votes. To make matters worse, even when that voting configuration is clearly articulated, many firm don’t even call for a vote until it is clear an issue is going to receive unanimous consent. We tell our firms all of the time ... “Get used to voting every issue.” Follow Roberts Rules of Order, or some less formal variation of it, and allow people to make a motion, have it seconded, then call for discussion, then vote it either up or down and move forward. Don’t get carried away with enforcing Roberts Rules to the letter. Rather, do get carried away enforcing a voting process that makes sense for you. This way, voting becomes less personal and more collegial. Often the only time a vote is taken is when one owner wants to publicly shut another owner up. Your leadership group needs to be comfortable voting on everything, and once an initiative, strategy or action is passed, whether you agreed with it or not, it becomes your job to vehemently support it as if it was your idea in the first place.

Other issues that continually get in the way are the roles and responsibilities of key positions within the firm. For example, what powers and responsibilities does the Board have? How about the Executive Committee, if you have one? The same questions need to be addressed regarding the Managing Partner and line partners as well. While some agreements address a few of these issues, we have never seen it done comprehensively, and even those that have done a great job of it as a first pass rarely are kept in alignment with the way the firm progresses and actually operates over time.

In part two of this topic, we are going to list a number of policies that we typically cover with our firms as well as some common issues that are important. However, for now, we want to conclude this discussion with a very important suggestion. For a firm to be able to easily change with the times and reflect the evolving best practices of the profession, we believe that one of the key foundations of the firm -- the partner agreement --has to be equally nimble. Many firms operate differently than their partner agreement calls for and are only called to task on those differences when disputes occur. This is why we suggest that all partner agreements be rebuilt on what we call an SOP (standard operating process/procedure) foundation. This means that the minute the firm starts operating differently than the partner agreement outlines, those changes are reflected in the agreement immediately. And in many cases, we actually want to be able just as nimbly to change the partner agreement even before we change the way we will be operating. For example, let’s say a shareholder with a large block of stock is getting ready to retire and the reshuffling of that stock will give one or two people too much power based on current voting thresholds. In this case, before the stock changes hands, we need to update the partner agreement to reflect thresholds that make sense given the changes that are about to occur. This could come in the form of raising the voting thresholds if, for example, two out of seven partners gain too much control, or lowering the thresholds if two out of seven can block almost any vote.

We have adopted an approach, through the guidance of our attorneys, that allows all of the changeable issues covered by the partner agreement to be dealt with in separate policies. And then we have the partner or corporate agreement adopt all of those policies, future revisions of those policies and new polices created, as part of that partner agreement. The critical success factor of this approach is generating a framework whereby specific policies can be reviewed at any time, with proper notice, and instantly changed and incorporated back into the agreement when the proper voting thresholds are met. At the moment a vote is passed, the updated policy supersedes the existing one so that all of your policies stay current and there is only one version if your agreement.

For clarification, we are not attorneys and therefore we recommend that each firm work with their own attorneys to create the right legal documentation for their firm. So, while this dialogue is not meant to address the partner agreement from a legal perspective, we do cover it from a business issues perspective --which embraces best practices for firms when building a successful business foundation from which to operate. So, look for us next time when we review a common list of agreement policies and problems in our next column.