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Equitable Profit-Sharing

The Role of a Neutral Third-Party Valuation Expert as an Umpire in Partnership Deadlocks

Partnerships are common structures in professional service practices, offering opportunities for synergistic collaboration. However, conflicts can arise, especially in the absence of a well-contemplated equitable profit-sharing formula and a deadlock-breaking mechanism in the partnership contract. This article explores the fair resolution of partnership disputes arising from equitable profit-sharing in a 50/50 partnership with unequal workloads, and without a deadlock-breaking mechanism.

Equitable Profit-Sharing: The Role of a Neutral Third-Party Valuation Expert as an Umpire in Partnership Deadlocks

Introduction

Partnerships are common structures in professional service practices, offering opportunities for synergistic collaboration. However, conflicts can arise, especially in the absence of a well-contemplated equitable profit-sharing formula and a deadlock-breaking mechanism in the partnership contract.

This article explores the fair resolution of partnership disputes arising from equitable profit-sharing in a 50/50 partnership with unequal workloads, and without a deadlock-breaking mechanism. The article presents a case study of Dr. Ebb and Dr. Flow, who formed a partnership to provide dental services in Dallas, Texas. The partners were deadlocked over a profit-sharing disagreement, prompting my engagement as a neutral third-party expert by both parties’ attorneys to determine an objective criterion and a fair profit-sharing formula to resolve the impasse. The article provides my opinion and the reasoning behind it, highlighting the importance of objective criteria based on cost behavior for equitable profit distribution. This case study demonstrates the valuable role that a neutral third-party expert can play in resolving partnership disputes and promoting fairness in resolving the impasse of deadlocked partnerships.

All names have been redacted to protect the privacy of the parties.

Case Study: Summary of Facts

  1. Ebb and Dr. Flow met and developed a close relationship while attending the same dental residency program. After their training, they agreed to form a business partnership.
  2. Ebb and Dr. Flow formed Infinity Dental (a general partnership) to provide dental services to residents of Dallas.
  3. They both agreed to 50/50 ownership and control of the partnership. The partnership agreement had no deadlock-breaking mechanism.
  4. The partnership agreement stipulates that each partner will spend at least 15 business days each month working in the partnership.
  5. The partners agreed to the following profit-sharing formula:

20% of profits shared at a ratio of production

80% of profits shared equally

  1. In the first calendar year of the partnership, Dr. Flow worked for an average of 20 business days in a month, while Dr. Ebb worked for an average of 12 business says in a month.
  2. In its first calendar year, the partnership had a total production of $1,976,995 and a profit of $1,067,827. Dr. Flow produced $1,262,502, while Dr. Ebb produced $714,493.
  3. Per the profit-sharing formula stipulated in the partnership agreement, the profit was allocated thus:
  • 213,565 (20% of 1,067,827) was allocated at a ratio of 1,262,502:714,493
  • 854,262 (80% of 1,067,827) was allocated 50:50

Dr. Flow was allocated a total share of profit of $563,513, while Dr. Ebb was allocated a total share of profit of $504,314.

  1. Flow deemed the profit-sharing formula unfair and a deadlock ensued.
  2. To break the deadlock, the partners and their attorneys agreed to engage me as a neutral third-party expert to opine on the most suitable objective criterion for negotiating a fair profit-sharing formula consisting of the percentage of profit to be shared based upon the ratio of production and the percentage of profit to be shared equally.
  3. Pursuant to both parties’ agreement on my opinion of the most suitable objective criterion, I was subsequently engaged as a neutral to apply the objective criterion to provide an expert’s determination of the equitable profit-sharing formula, and to calculate the fair share of the profit accruing to each partner. Both parties agreed that my determination will be final and binding.

Equal (50/50) Business Partnerships

A business partnership is created with the intent and purpose of maximizing benefits accruing to each partner while minimizing the associated risk borne by each partner. The maximization of benefits is achieved through synergistic collaboration intended in the agreement between partners, while the minimization of risks is achieved through the spread of risk between partners.

A 50/50 partnership contract is a contract held between two equal business partners where both partners have equal ownership and control of the business. In a 50/50 partnership, each partner has an equal share of the profits or losses that the business generates, while also having an equal say in the operation and management of the business. A 50/50 partnership agreement also implies that both partners are expected to contribute equally to the success of the business.

However, a common issue with 50/50 partnership contracts is the lack of well-contemplated and defined mechanisms for the resolution of deadlocks.

Partnership Deadlocks

A partnership deadlock is a situation where two equal (50/50) business partners disagree on a major decision and cannot move forward until the decision is resolved.

An unresolved deadlock ultimately leads to the fatality of a business partnership. In the absence of a well-contemplated and defined mechanism to resolve a deadlock, if a dispute arises where both parties engage in positional bargaining and neither is willing to give, the only means of resolution is for a court to get involved and dissolve the partnership.

The most effective, equitable, and enduring way of resolving an equal (50/50) business partnership deadlock is by selecting a neutral third-party expert to apply an objective criterion to resolve the dispute by rendering a final and binding decision on both parties.

Neutral Third-Party Expert

A neutral third-party expert (the neutral) is an independent financial expert with no ties to, or prejudices against, either party to the dispute. For the deadlock to be resolved effectively without the intervention of the courts, both partners must agree to be bound by the decision of the neutral. The neutral is bound by confidentiality agreements, which guarantees the privacy of the parties and promotes a safe environment for the resolution of disputes.

Objective Criteria

“If trying to settle differences of interests on the basis of will has such high costs, the solution is to negotiate on some basis independent of the will of either side—that is, on the basis of objective criteria.

At a minimum, objective criteria need to be independent of each side’s will. Ideally, to assure a wise agreement, objective criteria should be not only independent of will but also both legitimate and practical.

Objective criteria should apply, at least in theory, to both sides. You can thus use the test of reciprocal application to tell you whether a proposed criterion is fair and independent of either party’s will.” (Roger Fisher, William Ury, and Bruce Patton, 1991)

My Expert Opinion on Objective Criteria

In my opinion, the partnership’s cost behavior is the most suitable objective criterion to determine the fairest profit-sharing formula.

Based upon fundamental accounting principles and consideration of fairness, this equitable objective criterion also correlates to each partner’s contribution to the overall equity and value of the partnership. The reasoning behind the opinion emphasizes the matching concept, which requires expenses of an organization should be matched in the same accounting period with the revenue earned by incurring such expenses. Consequently, the profit earned by a business concern in each period must reflect the expenses incurred to earn the profit.

Cost behavior is the relationship between the operating cost of a business and the changes in its business activity. Costs behave primarily in two ways in relation to changes in business activity:  variable or fixed.

Variable expenses, which change with production levels, serve as an objective criterion for sharing profits at a ratio of production. On the other hand, fixed expenses, which remain constant regardless of production levels, provide an objective criterion for sharing profits equally.

My Expert Determination of Equitable Profit-Sharing Formula

To arrive at the fair profit-sharing formula, I analyzed the partnership’s income statement to determine its cost behavior. Based on my analysis (below), I opined that a fair profit-sharing formula for Infinity Dental would involve:

60% of profits shared at a ratio of production (reflecting variable expenses)

40% of profits shared equally (reflecting fixed expenses)

Infinity Dental

Income Statement for the year ended 31st December, 2019

Cost Behavior Analysis

 

Variable Expense ($)

Fixed Expense ($)

Total ($)

Revenue

 

 

1,976,995

 

 

 

 

Expenses:

 

 

 

Salaries and Wages

289,486

96,500

385,986

Payroll Taxes

23,883

7,961

31,844

Repairs and Maintenance

3,084

 

3,084

Rent

 

83,660

83,660

Interest

 

41,780

41,780

Taxes and Licenses

 

10,644

10,644

Depreciation

 

46,653

46,653

Advertising

 

31,073

31,073

Bank Charges

8,446

 

8,446

Software and Subscriptions

 

4,445

4,445

Insurance

 

12,067

12,067

Janitorial

 

7,200

7,200

Lab Expense

69,987

 

69,987

Legal and Professional

 

6,980

 

Office Expense

 

6,443

6,443

Postage

7,365

 

7,365

Security

 

646

646

Professional Education

 

6,249

6,249

Materials and Supplies

118,713

 

118,713

Telephone

 

3,314

3,314

Uniform

 

631

631

Utilities

21,958

 

21,958

Total Expenses

542,922

366,246

909,168

 

60%

40%

 

Net Income

 

 

1,067,827

 

Notes to the cost behavior analysis:

Salaries and wages and associated payroll taxes of dental hygienists are classified as variable costs, while salaries and wages and associated payroll taxes of administrative staff are classified as fixed costs.

My Expert Determination of Profit Allocation

Based on the equitable profit-sharing formula, I calculated the fair share of the profit accruing to each partner thus:

  • 640,696 (60% of 1,067,827) was allocated at a ratio of 1,262,502:714,493
  • 427,131 (40% of 1,067,827) was allocated 50:50

Dr. Flow was allocated a total share of profit of $622,712 while Dr. Ebb was allocated a total share of profit of $445,115.

Conclusion

In business partnerships, fair resolution of disputes is essential for maintaining successful partnerships. The case study of Dr. Ebb and Dr. Flow’s partnership highlights the role of a neutral third-party expert in achieving equitable profit-sharing formulas. By considering objective criteria based on the partnership’s cost behavior, my opinion provides a fair solution. This article emphasizes the importance of incorporating deadlock-breaking mechanisms and seeking the expertise of a neutral third-party expert to ensure fairness in partnership agreements.


Gafar Shittu, MS, CPA, CVA, is the Principal Consultant at GS & Company, CPA, a Dallas-based forensic, valuation, and disputes consulting firm. He is also the founder of deadlockbreaker.com, an online dispute resolution firm specializing in the resolution of partnership disputes. He is focused on assisting attorneys, individuals, and businesses with complex financial matters and disputes, including: business valuation, lost profits damages calculation, business interruption, shareholder, partnership and matrimonial disputes, fraud investigation, neutral expert determination, and alternative dispute resolution. Clients have sought Mr. Shittu’s advice and services because of his unique professional experience and knowledge. He is also a credentialed mediator and arbitrator appointed by the States of Washington and Michigan.

Mr. Shittu can be contacted at (951) 870-0202 or by e-mail to gafar@gsandcompanycpa.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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