ADMITTING NEW PARTNERS

by Joel A. Rose

Admitting a new partner into the firm is a relatively straightforward process once the qualified candidate is found.  Generally, the applicant is known to the firm either through association for an extended period of time or, the candidate has experience acquired elsewhere and was employed as the result of this skill and professional background.  Once the firm decides that it has the right candidate, there are still some basics that have to be reviewed. Following is a brief overview of the various issues that must be dealt with in order to set the stage for admitting a new partner to the law firm. 

Voting for Admission

In order to admit a new member to the firm, most law firm partnership agreements require a vote of either the majority, 66-2/3 or 75 percent of the partners.  In the smaller firm a new partner must receive a unanimous vote. As the firm grows larger the chance for a unanimous vote all but disappears, and the odds of an applicant receiving a veto increase.  Some partnership agreements stipulate that the vote reflect individual partners rather than partnership interests, viewing the "one-partner, one-vote" as more democratic and avoiding placing weighted votes in the hands of more powerful or senior partners. 

Equity Interest

The next item that will probably be considered involves the new partner's share in the profits and losses of the firm.  There is no standard answer to this question.  Consideration will be based on many factors including, but not limited to, the applicant's salary history, contribution (measured generally by chargeable hours or clients brought to the firm), and the nature and quality of the work performed.  Even a brief list of the many possible factors involved in setting a new partner's income share reveals the subjective nature of this question and how it will vary from firm to firm.  In setting the income share of the new partner, the partners will become aware that the pie must now be cut in a different way, with more pieces and not necessarily more income to be divided.  In some firms either a committee or the senior partner sets the new partner's share of profits for the initial year (and sometimes for a few years thereafter).  The new partner is then deemed to have an ownership interest in the firm that is determined by the ratio of his/her distribution for the year to the firm's total profits.  It is recommended that the new partner be informed of his/her share of income and losses, and the method for determining the profit distribution.

Amount of Draw

In conjunction with setting the new partner's share of profits and losses, the partnership must also determine the partner's monthly or other periodic draw.  The amount of the draw will, like the share of the profits and losses, be based on several factors.  These include the salary of the attorney while an associate at the firm, the amounts drawn by the other partners, the cash flow position of the firm at various times during its fiscal year, the expected annual distribution of the partner, etc.  In some firms, in addition to the monthly or semi-monthly draws regular quarterly or other special draws are scheduled, usually in connection with required estimated tax payments. 

Capital Contribution

It is more than likely that the capital of the firm will change as the result of admission of the new partner.  Either at the time of election or at some point thereafter, the partners will be faced with the question of how much capital the new partner will be asked to contribute to the firm.  Here again, the answers vary widely, with no known formula fitting the requirements of all firms.  In some firms, a "free-ride" is given to the new partner for a specified period of time.  The supposition is that the applicant is not as capable of meeting a financial obligation at the time of admission as he/she will be later.  As a solution, this merely postpones the decision for a time and means that the remaining partners must carry the obligation in the interim.  In some cases, a token contribution is requested.   The amount required is usually based on the financial condition of the newly admitted partner.

Sooner or later, however, the capital contribution of the new partner will have to be resolved.  The partnership will have to determine whether the new partner will contribute to the firm some portion of the firm's capital account in existence at the time of admission, or whether the newcomer will be expected to contribute his/her share for all future capital requirements. Every firm will have to determine its own method for resolving this question. In general, the amount of capital contribution will be proportionate to the new partner's share of income and losses.

Dissemination of Firm

Financial Information Firms vary in their practice of how much and when to divulge financial information to the new partner.  From the point of "disclosure," it is generally believed that the better practice is to promptly provide the new partner with the firm's recent financial statements.  Most managing partners readily agree that no purpose is served by keeping relevant information from the new partner, and failure to disclose pertinent information may result in extreme discomfort for both parties, or indeed more serious difficulties for the firm.

Alternate Status

Some firms are considering the use of "alternative" forms of membership instead of the more traditional form of partnership status.  The alternatives are being given various titles such as senior associate, junior partner or non-equity partner among others.  The practice is being used, quite extensively, by the larger firms.  The primary motivation for considering an alternative is monetary.  The reason is simple.  Chief among the changes brought about by the addition of a new partner is the resultant reduction in the distribution available to the other partners.  In today's marketplace, increasing financial pressures accompanied by a rise in operating expenses and stiffer competition, may give a firm little choice but to consider alternative forms of full membership.

  The critical variation in this kind of affiliation involves the applicant's limitation in terms of the net income (or loss) of the partnership. Consequently, for many purposes, this individual is a salaried employee although he/she may be able to vote or otherwise participate in the governance or operations of the firm.  Another way of limiting the candidate's participation is to restrict his/her vote to specific matters, or to deny the vote altogether.  In addition, attendance and/or participation in firm meetings may be permitted on a full or limited scale, as required.  Since the principal impetus for placing limits on partnership is financial, the use of this category will result in decreasing the right of specified individuals to share in the profits of the firm.

  Although consideration of the use of alternative forms of law firm partnership has increased substantially in the past several years, the firm should proceed with caution.  The consequences for both the firm and the individual should be fully considered.  From the firm's viewpoint, it will have to determine whether it will be required to insure that it is not presenting to the public as a partner an individual who, in fact, is not a partner but may be held to be one.  How should the firm characterize a partner who in one or more ways is less than a full partner when, for instance, preparing a list of partners and associates for submission to a directory such as Martindale-Hubbell, or new stationery?  In addition, the firm must consider the effect the "limited partnership" will have on the attorney in question.  A "half-way" partnership can present both psychological and financial barriers for the candidate who has spent perhaps years of service at the firm.  In today's highly mobile environment, the firm may well find that the candidate opts to reject the form of partnership being offered, and begins to search for an opportunity elsewhere.

Partner Departure

A departing partner, whether by death or otherwise, leaves a gap in the performance of administrative duties as well as in providing services to clients of the firm.  Assumption of partnership obligations and debts must be provided for, lest a creditor seeks to place the burden on one or several of the continuing partners rather than the partnership as a whole.  Although the partnership bears primary responsibility for the firm's obligations, a contract clause providing that the departing partner shall be indemnified from continuing or new obligations of the partnership should be included in the agreement.  The agreement should also provide that the departing partner remain liable for obligations incurred prior to the withdrawal.

  The agreement may also provide that the withdrawing partner must assume some part of the continuing obligations whether the firm continues or not.  The two most common continuing liabilities relating to a departing partner are the office lease and bank borrowing (usually for furniture and fixtures).  It is often desirable to deal with these directly in the lease or loan agreement.

Payout Provisions

Withdrawing partners are entitled to a return of their capital and to their proportionate share of partnership earnings.  Against this, however, there may be set-offs for debts of the withdrawing partner.  Further, the withdrawing partner may have committed acts that are in breach of the provisions of the agreement.  Consequently, a clause providing for payment of capital accounts should contain provisions to deal with such matters, including set-off of overdrawing and other financial obligations (including perhaps a litigation reserve).  In addition, the clause may contain language withholding payment in the event of a breach of the agreement by the withdrawing partner until the breach is satisfied.

  The immediate payment of capital and income accounts to withdrawing partners may, however, severely damage the continuing firm's financial condition. Consequently, the payout provisions should also provide for deferred payments with the right to further defer payment if the continuing firm's liquidity is severely affected by the payout.

Provisions regarding disposition of fees earned up to the time of departure, prospective fees on completion of matters in process, and disposition of matured interests of the departing partner in his or her contributed capital and retirement funds, should also be included.  The allocation of retainers for services performed over a period of time is often a point of contention. This may be avoided by providing that these are to be considered on a monthly basis.

Another important question to be addressed is whether the departing partner is entitled to an evaluation of the partnership assets and his continuing share of the profits or liabilities accrued up to the date of his departure. Absent a clause dealing with payouts, the withdrawing partner is entitled to an accounting.  We suggest that the firm avoid the possibility of being involved in proceedings requiring a formal accounting by including in the agreement a provision stipulating that the report of the firm's independent accountant shall be binding.