A Business Perspective on Practice Equity Offers
There has been a lot of chatter about this article (VIN: Practice equity offers to veterinarians on rise, raise questions). I wanted to provide a comment, hopefully onethat is balanced and reasoned, and looks at the matter from a business perspective. I’ve reviewedand negotiated the business and legal terms governing these equity structuresfor multiple different sellers in the course of my strategic financial advisorywork.
The article is blending a lot of different types of equity and circumstances in which it can be obtained. Below are the types of “equity” a DVM owner or DVM associate might be offered. Like any equity investment, all of these carry upside potential and risk. Like any other equity investment in a private Company all are illiquid.
1. Corporate equity – This is a grant of shares or units in the parent Company (typically an LLC). In effect, you become an investor alongside the private equity firm that owns the Company, and management. Your rights are defined in the corporate LLC operating agreement. Oftentimes there are multiple classes of ownership each conferring different rights. My partner wrote a little more on the topic here. And I did here. There are many acquirers that offer corporate equity. In some cases, owning this corporate equity has returned multiple times the value of the original grant. In other cases, the equity investment has lost value.
2. Joint Venture Equity - This is a grant of shares or units in the new entity formed to own the practice being sold. You become an investor alongside the Company, who in turn, is owned by the investor. Your rights are defined in the joint venture operating agreement. Typically, selling DVMs are the minority partner with rights, in theory, befitting the minority partner. I’ve written a little more on that topic here. There are some acquirers that offer this “true” join venture equity. These arrangements also can provide attractive returns. This kind of equity can be more liquid that corporate equity, in that it sometimes provides for a “Put” option wherein the minority partner can sell back his ownership after some period of time at a pre-defined valuation. Almost always, the best valuation available to the seller occurs when the Company is recapped, a new investor buys the original investors ownership in the Company.
3. Synthetic Join Venture Equity. This grants you economic rights in the new entity that look like the economic rights possessed by the minority partner in a joint venture. Your employment agreement and the asset purchase agreement govern your rights in this kind of agreement. Consolidators use this structure because they want to provide the economic incentives associated with a practice level ownership without providing actual ownership, which comes with more legal rights, and because structure is viewed favorably by the corporate’s bank lenders.
As a business seller, your objectives post sale and an independent analysis of the risk and potential rewards inherent in the security you are offered should inform what kind of equity you may be willing to take, and from who. Your knowledge of the buyer should impact your decision making, particularly when taking corporate equity. With corporate equity and JV equity alike, if you have an option to take cash, or equity the consideration can be framed as follows: Do I expect that this investment will generate greater returns than an investment in an S&P index fund? If so, is the additional risk I must take (including the fact that the investment is illiquid) justified by additional upside. The risk / return profile of corporate equity varies depending on the corporate. Equity in a large Company probably doesn’t have the same upside as equity in a start-up. Equity in a highly indebted concern, has substantially more risk than equity in a Company with less debt. All of these things matter, but the fundamental analysis is focused on determining whether the investment will return more per unit of risk than the alternatives you have.
All of these forms may be subject to a vesting or claw-back schedule whereby the equity becomes, in effect, active after a period of time, or after certain milestones are met. Vesting can carry some tax advantages for the equity holder. Vesting is far more common when the equity is “gifted”.
A DVM might be offered any of these types of equity in variety of circumstances:
1. DVM owner sells their practice to a Company. The DVM owner might receive equity as a form of consideration in such a deal. Here, it is less common to see equity that vests. In this circumstance, the key terms can generally be negotiated at the right time, which is not upon receiving a first draft of the operating agreement or corporate LLC agreement. Each buyer will have their own form documents that they use, and like to keep consistent. They are unlikely to alter these without a costly fight once a seller has accepted an LOI, though they may alter them to convince a seller to accept an LOI.
2. DVM partners with a Company to establish a new clinic. The DVM owner receives and equity stake, possibly one they need to “buy” into. Here, there may be a vesting schedule depending on whether the DVM brings cash equity to the table, or does not and borrows from the Company partner. These agreement can, and should, be negotiated thoroughly.
3. DVM Owner sells a practice and gifts equity consideration to key associates. Some buyers recommend, or require this as part of the sale. In this scenario, vesting is very common, because it encourages the associate to stay with the practice and because it is more efficient from a tax perspective to the recipient. In this scenario, the associate’s interests often run contrary to the seller’s interests.
4. Associate at a corporate owned practice is gifted equity. Vesting is generally the rule. These documents can be negotiated but the associate seldom has the leverage or significance to effect substantial, recipient friendly changes to the form documents. It is offered as a take it or leave it. Oftentimes the associate can take, or not take the agreement with the option to quit subject to a non-compete as their only negotiating leverage.
As someone who focuses on creating great partnerships through an ownership transition, there are many key business concepts that matter in all of these structures. Almost always, my client is the practice seller, yet in many deals both the seller and their associate DVMs receive, or have the option to receive, a grant of equity. Sometimes, in this scenario the objectives of my client, the seller, are different than the objectives of the associate, who is not my client. In every case, the buyer’s objectives tend to run contrary to the sellers and the outcome is a zero sum game i.e. buyer gets the additional upside or lower risk at the expense of the seller’s upside or higher risk. Now the buyers, when they encounter unsophisticated sellers represented by lawyers with no mind for business (a common occurrence), are able to transfer a lot of risk onto the equity recipient. From the buyer’s perspective, whether you can do this is a different question from whether you should. Oftentimes the buyers tilt towards “let’s take all the advantage we can” though this mindset seldom seeds a productive partnership which is the true goal in providing equity.
Some key business concepts in these structures:
1. How and when may the owner convert their equity to cash? Typically, there are many different ways this can happen and what we may allow for a selling client is different than what we may allow for an associate.
2. What happens if the holder of equity leaves the Company? For a seller who accepted equity as deal consideration, or as a condition to partner versus the associate who was given equity, the terms can be very different, though always impactful.
3. How will the equity be valued when it is able to be monetized? Not all exit scenarios are created equal. If a seller is given equity and subsequently fired for “Cause” (the definition of which can be negotiated) the valuation should be different than if the owner stays through a recapitalization. Likewise, if the owner fulfills her obligation but wants to leave before the Company is recapitalized, the valuation, justifiably, should be lower than if the owner waits through a recapitalization.
4. What rights does the equity holder have relative to other equity holders? In a true JV the minority holder will have some rights. We want fair rights befitting a minority partner. Oftentimes, synthetic equity arrangements have to be instilled with these rights. In the case of corporate equity, does the investor owner have materially different rights than the DVM seller shareholder? Oftentimes we see “roach motel” provisions were in the PE investor can exit the investment while requiring seller shareholders to stay in with a fresh non-competes. No bueno.
5. How does the equity “vest”, if applicable?
There is a lot to this, and everything frames the potential upside and the potential risk for the recipient of the equity. The negotiation and finalization of these terms also set the ground work for a good partnership. It is difficult to build a successful partnership that is one-sided in favor of one of the partners. It is a very uncommon DVM who is prepared to negotiate the business details with a corporate party.
Surely anyone will retain a lawyer to help understand the terms. The problem is that the buyers are sophisticated and know how to use all the negotiating leverage they have available to get their way in negotiation. Seller’s lawyers are also sophisticated, but they often don’t have any leverage to negotiate when representing sellers and associates. Also, they are not business people. What I mean by this is that they tend to focus on the risk, and downside not the potential upside that a good partnership can create.
In reading the article, I do see some bad behavior, but mostly I see bad deals that are seeded because the seller or associate could not negotiate from a point of leverage and focused more on protecting their downside rather than seeding a successful partnership. For instance, “Of particular concern, [ ] and [ ] both said they know of instances in which veterinarians have had their employment terminated just before their shares were due to vest. VIN News also is aware of an associate to whom this happened. The person was unable to speak about it because their contract included a strict nondisclosure agreement.” If your deal contains provisions that allow for this scenario, it is a bad one.
I don’t agree with the lawyer who says “take the cash bonus instead, because that's secure money.” I would say, instead “Equity can be a great way to build wealth for DVMs and set the seeds for productive partnerships. But, the deals must be structured thoughtfully and the risk return of the equity evaluated critically relative to other investment options.”