Author Topic: Preparing for Partnership Buy-in  (Read 11611 times)

AlwaysLearningToSave

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Preparing for Partnership Buy-in
« on: September 01, 2015, 01:39:57 PM »
I am a young attorney on the partnership track in a 20 - 25 attorney firm and a convert to mustachianism within the last year.  The firm is among the biggest for its market but is obviously a small firm in the grand scheme of things.  As I understand it, our firm structures the partnership buy-in to be about 50% of the partner's starting draw, and the draw is set so that a first year partner's take-home compensation is roughly similar to the attorney's take-home compensation prior to partnership.  There is potential for higher compensation based on production.  The goal, as it has been explained to me, is to have the partnership payment be large enough to ensure commitment to the partnership but not so large as to be overly burdensome.  An offer for partnership for me is still several years away, but the prospect of needing to come up with a partnership payment is definitely on the horizon and I'm not sure how to approach preparing for making the payment.  Of course there are lot of "ifs" between now and then, but if I want buying into the partnership to be a realistic option if/when I get there, I need to prepare for it now.

Since my wife and I are working to pay down student loan debt, there is a good chance we will not be able to accumulate enough cash to write a check for the whole payment and a portion of it will likely need to be financed.  I'm not yet at a 50% savings rate largely due to my daughter's unexpected healthcare needs, but we are hoping to make changes to get there.  If we get debt paid off and are able to hit 50% actual savings more than a year prior to partnership, there is a chance we could make the payment in cash. 

I'm intentionally not providing full case-study type information because at this point I am more interested in a philosophical approach the thought of buying into a partnership.  I don't particularly like the thought of paying a year's worth of mustachian savings just to keep earning income, but at the same time it could be the path to my highest earning potential as it is a strong, growing firm in a vibrant and growing market.  At this point, the prospect of opening a solo shop is terrifying and who knows what in-house or government opportunities might be available.  We like this community and I like my firm, so we are not really interested in uprooting.  If I save cash for a partnership payment, I am forgoing significant benefits from tax-advantaged accounts and I would likely not earn any significant return because I would want the money stashed in a readily accessible and low-risk account.  If I instead focus on investing in tax-advantaged retirement accounts and finance the payment, I'm incurring interest costs and increasing my monthly cost of living, albeit to buy into a potentially strong income stream.

Are there mustachian lawyers, CPAs, doctors, or other professionals out there who have wrestled with this dilemma?  Any helpful advice or words of wisdom on how to think about and prepare for the prospects of buying into a small professional partnership?

NOTE: Sometimes questions directed toward career prospects for attorneys elicit rants and warnings from jaded attorneys to run away.  I'm well aware of the potentially hard life of the private practitioner and the changing market for legal services.  I'd prefer not to hear such rants and warnings in response to this post, but welcome any thoughtful insights or critiques.
« Last Edit: September 01, 2015, 02:19:07 PM by AlwaysLearningToSave »

TN_Steve

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Re: Preparing for Partnership Buy-in
« Reply #1 on: September 01, 2015, 01:51:39 PM »
I am a young attorney on the partnership track in a 20 - 25 attorney firm ...

...

I don't particularly like the thought of paying a year's worth of mustachian savings just to keep earning income, but at the same time it could be the path to my highest earning potential as it is a strong, growing firm in a vibrant and growing market.  At this point, the prospect of opening a solo shop is terrifying and who knows what in-house or government opportunities might be available.  We like this community and I like my firm, so we are not really interested in uprooting.  If I save cash for a partnership payment, I am forgoing significant benefits from tax-advantaged accounts and I would likely not earn any significant return because I would want the money stashed in a readily accessible and low-risk account.  If I instead focus on investing in tax-advantaged retirement accounts and finance the payment, I'm incurring interest costs and increasing my monthly cost of living, albeit to buy into a potentially strong income stream.

...

My two cents:  Contributions to the tax-advantaged accounts are a valuable, wasting opportunity, particularly if you have a dual income couple with high marginal rates.  Fill those up before you lose the year's window for contributions.  The finance charges will pale in comparison--and since you'll likely have other debts paid off by then, it won't take you too long to pay off the partnership financing (while still funding the tax-advantaged accounts)

P.S.--we haven't faced the question, because, many years ago, I declined a BigLaw partnership for other reasons, and DW's med groups have had relatively easy buy-ins.  I did run numbers though, and I would have financed if I went that route.
« Last Edit: September 01, 2015, 01:54:34 PM by TN_Steve »

totoro

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Re: Preparing for Partnership Buy-in
« Reply #2 on: September 01, 2015, 04:16:55 PM »
"As I understand it, our firm structures the partnership buy-in to be about 50% of the partner's starting draw, and the draw is set so that a first year partner's take-home compensation is roughly similar to the attorney's take-home compensation prior to partnership."

So, if I understand this the buy-in is $50,000 for a partnership interest that results in a first-year partnership draw of $100,000 and this is the same amount you would be making working as an associate?

What is the incentive to become a partner - job security?  Usually it entitles you to profit-sharing on the firm's earnings does it not - otherwise why do it?

Kashmani

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Re: Preparing for Partnership Buy-in
« Reply #3 on: September 01, 2015, 04:47:12 PM »
Attorney and partner in a law firm here. Here are my two cents:

1) Don't assume that you need to come up with the cash. There are financial institutions that will provide you with a partnership loan, or you can mortgage your house or condo if you have one. I put a HELOC on my condo for the full amount of the partnership loan. The interest is fully tax-deductible, and I am paying it down over a number of years. Who in their right mind would finance a partnership buy-in purely from cash, or even 50% from cash?

2) With respect to whether you want to buy into the partnership, do your due diligence. Will you be earning more money than as an associate? What happens if you exceed production targets? How solvent is the partnership? For me, the ROI was more than worth it. If your total income will not change, or if the business income of the firm fluctuates too much year-over-year, remain on the employee track. As an associate you get paid first. As a partner you get paid last.

3) What happens if you leave the firm? Most firms, mine included, pay out the capital contribution over several years. Would this be a cash flow issue to you?

4) Can you handle the downside risk of having your capital at stake? If that thought causes you sleepless nights, don't become a business owner.

5) Depending on your jurisdiction, you may be able to form a professional corporation and have that corporation be a partner. This may create substantial tax savings, at least if you are earning enough to leave a decent chunk of money in the corporation each year. Here in Canada, a professional corporation also makes it possible to income-split by paying dividends to your spouse, which may be useful if your spouse earns substantially less or is at home with the kids.


AlwaysLearningToSave

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Re: Preparing for Partnership Buy-in
« Reply #4 on: September 01, 2015, 06:33:28 PM »
"As I understand it, our firm structures the partnership buy-in to be about 50% of the partner's starting draw, and the draw is set so that a first year partner's take-home compensation is roughly similar to the attorney's take-home compensation prior to partnership."

So, if I understand this the buy-in is $50,000 for a partnership interest that results in a first-year partnership draw of $100,000 and this is the same amount you would be making working as an associate?

What is the incentive to become a partner - job security?  Usually it entitles you to profit-sharing on the firm's earnings does it not - otherwise why do it?

Yes, there is a right to additional profit sharing available. Any additional money brought in over a basic production threshold is split 50/50 between the partnership and the partner, with bonuses paid from the firm as well. I didn't go into detail as I prefer to think primarily in terms of the draw because it is budgeted to be a relatively certain amount. I consider any additional profit sharing to be icing on the cake.

Edit to add: I have not actually inspected a full copy of the partnership agreement, but this is my understanding from conversations with younger partners. I'm sure it is more nuanced than I am portraying, but these are the broad strokes. Additionally, partner compensation is reviewed annually, so base draw increases significantly over time, assuming satisfactory production.
« Last Edit: September 01, 2015, 07:12:44 PM by AlwaysLearningToSave »

AlwaysLearningToSave

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Re: Preparing for Partnership Buy-in
« Reply #5 on: September 01, 2015, 07:36:46 PM »
Attorney and partner in a law firm here. Here are my two cents:

1) Don't assume that you need to come up with the cash. There are financial institutions that will provide you with a partnership loan, or you can mortgage your house or condo if you have one. I put a HELOC on my condo for the full amount of the partnership loan. The interest is fully tax-deductible, and I am paying it down over a number of years. Who in their right mind would finance a partnership buy-in purely from cash, or even 50% from cash?

Please elaborate. I understand that debt used to acquire an ownership interest in a business is fundamentally different than consumer debt but I'm still hesitant to use debt financing. The firm is a limited liability partnership, so if things go south I lose my capital contribution but otherwise walk away without personal liability unless I personally guaranteed a debt or I am liable for malpractice. If I cash financed the capital contribution, I'm out that amount of cash. If I debt financed, I lose the bank's money to the firm's creditors but I am personally liable for the full debt, plus interest and the bank can pursue any collateral I pledged. So the difference is simply the additional interest cost of debt financing versus the opportunity cost of having the cash tied up in partnership rather than other investments. Who knows what interest rates will be like at the time I buy in, but I'm assuming the debt interest rate would only be a bit lower than the average stock market return, so it is not a huge difference.

Are you just commenting on the need to diversify? I suppose if I debt finance, I can invest the cash I might otherwise have used to pay the capital contribution in a retirement account. Then then I am better diversified AND the investments are out of reach of creditors. Is this the point of your comment?
« Last Edit: September 02, 2015, 07:49:36 AM by AlwaysLearningToSave »

john c

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Re: Preparing for Partnership Buy-in
« Reply #6 on: September 02, 2015, 04:03:11 AM »
The issue is that you don't want to waste the opportunity now and each year to put your money in a tax-deferred account if you save to pay for the partnership.  This is a large amount of tax, if you are a high earner.

Also, what is the difference if you put $100k cash into the firm, and it collapses, or $100k in debt?  If cash, you lost your money.  If debt, you would have to pay the cash you otherwise saved, or default.

If you're buying a cash producing asset, like a rental property or partnership in a firm, debt is reasonable.  MMM's tirades on debt mostly refer to consumer/household debt.

However, if you'd prefer to not have the debt, by all means, pay cash for it.

totoro

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Re: Preparing for Partnership Buy-in
« Reply #7 on: September 02, 2015, 08:13:13 AM »
The issue is that you don't want to waste the opportunity now and each year to put your money in a tax-deferred account if you save to pay for the partnership.  This is a large amount of tax, if you are a high earner.

Also, what is the difference if you put $100k cash into the firm, and it collapses, or $100k in debt?  If cash, you lost your money.  If debt, you would have to pay the cash you otherwise saved, or default.

If you're buying a cash producing asset, like a rental property or partnership in a firm, debt is reasonable.  MMM's tirades on debt mostly refer to consumer/household debt.

However, if you'd prefer to not have the debt, by all means, pay cash for it.

I agree. 

In addition, your firm may be willing to provide financing at a reasonable rate.  As a law firm owner I would as a share sale provides me with a capital gains exemption on the proceeds which is a large incentive for those in upper level tax brackets - although with so many partners it would be diluted fairly quickly and I'm not up on US tax issues but there are many here who are.  Bank financing would typically be available for this purchase as well, or a HELOC, which in Canada would work well as the interest is tax deductible.

You should make sure you understand the difference between good debt vs. bad debt and if you doubt that this would be good debt don't buy in.  You need to see the financials and it is too early to request them so I'd just sit tight and not worry about saving for partnership and instead deal with any debt and ability to reduce your current taxes through contributions to retirement vehicles.  You may wish to speak with an accountant as well.

Kashmani

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Re: Preparing for Partnership Buy-in
« Reply #8 on: September 02, 2015, 11:15:18 AM »
Attorney and partner in a law firm here. Here are my two cents:

1) Don't assume that you need to come up with the cash. There are financial institutions that will provide you with a partnership loan, or you can mortgage your house or condo if you have one. I put a HELOC on my condo for the full amount of the partnership loan. The interest is fully tax-deductible, and I am paying it down over a number of years. Who in their right mind would finance a partnership buy-in purely from cash, or even 50% from cash?

Please elaborate. I understand that debt used to acquire an ownership interest in a business is fundamentally different than consumer debt but I'm still hesitant to use debt financing. The firm is a limited liability partnership, so if things go south I lose my capital contribution but otherwise walk away without personal liability unless I personally guaranteed a debt or I am liable for malpractice. If I cash financed the capital contribution, I'm out that amount of cash. If I debt financed, I lose the bank's money to the firm's creditors but I am personally liable for the full debt, plus interest and the bank can pursue any collateral I pledged. So the difference is simply the additional interest cost of debt financing versus the opportunity cost of having the cash tied up in partnership rather than other investments. Who knows what interest rates will be like at the time I buy in, but I'm assuming the debt interest rate would only be a bit lower than the average stock market return, so it is not a huge difference.

Are you just commenting on the need to diversify? I suppose if I debt finance, I can invest the cash I might otherwise have used to pay the capital contribution in a retirement account. Then then I am better diversified AND the investments are out of reach of creditors. Is this the point of your comment?

A partnership buy-in is a capital investment that will yield a certain ROI. What type of ROI you will have to determine through your own due diligence. Interest on an investment loan is tax-deductible, at least here in Canada. The rules may be different than in the states.

Let's say your buy-in is $100,000, and you finance the entire amount through a secured loan. In my situation, the interest on that was approximately $3,500 per year. Since the principal of the loan is used to purchase a capital asset, your carrying cost is only the $3,500 per year. If that buys you an additional income stream of $50,000 per year, there is no significant downside to taking out a partnership loan. You could use a portion or all of the additional income to pay down the principal. When I bought in, I tried to pay down the loan by 1/4 every year.

Whether you finance from cash or through a loan will not change your liability, nor your net worth. If the firm goes belly-up,  you will be out $100,000 regardless of how you finance the buy-in. I looked at the downside risk of financing to be the risk that I would be stuck paying a $100,000 mortgage with a job somewhere else. I thought (and still think) that I could handle that without getting into dire financial straights. And the ROI was high enough to make the risk worthwhile.

I know that in the U.S. mortgage interest is deductible (it isn't here in Canada) so I would suggest that you take the tax consequences of your decision into account. Do the math on whether you are better off taking out $100,000 from your investments or leaving that amount in your investments and taking out a loan.

Your biggest consideration should not be how you buy in, but whether you should do so at all. By far your biggest risk will be the overhead attributable to you. This will be a constant in good years as well as bad years, with bad years posing the risk. If your firm has $100,000 of overhead per partner per year, you will have to bill (and collect!) at least $200,000 annually to make $100,000 in income. And I have seen some large firms where overhead is close to $500,000 per partner per year. I left that environment as an associate, and there is no way I would have taken on the risk of being a partner there.

And congratulations on finding the ways of Mustachianism early. Collectively, we are not known as a very frugal profession and it is good to see a canoe full of lawyers floating in this sea of engineers!

SubL stache

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Re: Preparing for Partnership Buy-in
« Reply #9 on: August 15, 2018, 06:32:06 PM »
Curious what came of this?  I am considering financing/saving cash for a buy in to my CPA firm in the next 2-3 years.