Courtroom Drama: Departing Partner Sues Firm Over His Buyout – Part 1 of 2

In this two-part series, Darth, a 42-year-old partner sues his former firm, Force CPAs, for a larger buyout payment. The courtroom dialogue will share with you the facts, evidence, and arguments from each side as we explore industry trends related to payments for withdrawing partners.  Note: The legal issues in this case vary by state law.  Be sure to check applicable state laws to apply the principles addressed in this case.

Facts:

• The firm is “Force CPAs.”
• Five partners.
• Annual revenue: $6M
• Three of the original partners retired in the past seven years and received buyouts.
• No written partner agreement.

Age, origination (Finding), client base managed (Minding) and compensation:

Ownership percentages: Equal ownership – 20% each.

Darth’s lawsuit against Force CPAs

Darth has been at odds with the firm for several years. After repeated warnings about his performance issues, Darth decided to leave the firm and accept a CFO position with a non-client, leaving his clients with the firm. In the absence of a written partnership agreement, Darth feels that the firm is required to purchase his interest and that the buyout amount should be 20% of the value of the firm. He alleges that the value is one times revenue plus accrual basis capital. This translates to $7.2M ($6M of goodwill, plus $1.2M of capital). As a 20% owner, the buyout comes to $1.44M. The firm has offered him $415,000, which Darth finds unacceptable and insulting. The court hearing, which was delayed due to a Covid-caused backlog in the court system, takes place 18 months after Darth left the firm.

The Plaintiff Starts the Case

Plaintiff calls the first witness, Darth.

DARTH’S ATTORNEY: Please describe for the court your professional experience.

DARTH: I spent eight years as a staff person with Powerhouse Regional CPA firm, rising to senior manager. The longer I worked there, the more I felt that a smaller firm would suit me better. Force CPAs recruited and hired me. I worked as a manager for seven years before my promotion to equity partner, the position I held for eight years.

DARTH’S ATTORNEY: How would you describe your time with Force?

DARTH: My years as a manager were great; they must have been because the firm promoted me to partner. I observed some practices that I thought needed to change, but I figured all CPA firms have problems, so I went along with the program. When I asked to sign a partner agreement, they told me there was none, but it was on their to-do list.

My first couple of years as a partner went well. Bringing in business has never been a strength of mine, but I persevered and managed to originate $300,000 by the time I left the firm. In my third year as a partner, things began to deteriorate. My compensation increases were always lower than those given to the other partners. I was being pressured to work more hours, which troubled me because my first priority was my family. The firm unfairly blamed me for some problems that were beyond my control. The last two years were horrible. The firm and I argued all the time. I dreaded coming to work. Finally, for my peace of mind, I decided to leave the firm. I was fortunate to get hired by Imperial Stormtrooper Corporation as their CFO.

DARTH’S ATTORNEY: So, you left Force and didn’t take clients?

DARTH: Correct. I was ready for a career change. My clients are valuable assets that Force retained after my withdrawal.

DARTH’S ATTORNEY: Why are you unhappy with Force’s offer of $415,000?

DARTH: The firm has no partner agreement. I kept bringing it up to the partners that we needed a proper, written agreement. They all agreed, but nothing ever happened. So, in the absence of a partner agreement, I feel the only fair and legal way to determine the value of my interest in the firm is to use ownership percentage. My ownership obligates the firm to pay me a buyout of $1.44M, which is 20% of the total value of $7.2M.

DARTH’S ATTORNEY: No more questions, Your Honor.

FORCE’S ATTORNEY: To your knowledge, have any partners retired from the firm and received buyouts?

DARTH: I am aware that three partners retired with buyouts.

FORCE’S ATTORNEY: Do you have any idea how their buyouts were determined?

DARTH: Not really. I never asked. It was before my time, and I had more important things to do.

FORCE’S ATTORNEY: Let’s examine some data. The following data is from Exhibit IV. You were a partner for eight years, originated $300,000 and managed a client base of $800,000. Luke, by comparison, co-founded Force, has been with the firm for 25 years, serves as the firm’s managing partner, originated $1.3M and manages a client base of $1.1M. Despite Luke’s performance data dwarfing yours, you feel that is fair for you to receive the same buyout as he did. Is this how you see it?

DARTH: Luke, as the firm’s MP and co-founding partner, had an obligation to his partners to create a partner agreement. Through his mismanagement, this responsibility was neglected. It’s unfair for his negligence to impact my buyout. Because there is no other way to compute my buyout, we must use ownership percentage. After all, ownership percentage must mean something. So, yes, I feel that a $1.44M buyout for me is eminently fair.

FORCE’S ATTORNEY: No more questions, Your Honor.

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The Defense

FORCE’S ATTORNEY: The defense calls Luke to the witness stand.

FORCE’S ATTORNEY: Luke, please tell the court what your role is at Force.

LUKE: I am the managing partner, and I co-founded the firm.

FORCE’S ATTORNEY: You heard Darth testify how unhappy he was that the firm failed to prepare a written partner agreement—that he repeatedly suggested this but nothing ever happened.

LUKE: Darth is justified in his feelings. I’m not proud of this. I can give reasons for this, but they may not be good excuses. We are a small firm, which keeps growing every year. Our partners work long hours to take care of our clients, bring in more business, manage the firm and, most importantly, train, mentor and develop our staff. The partners work very hard to make our firm a great place to work. We have struggled to address some administrative issues, one of which has been the preparation of a partner agreement.

FORCE’S ATTORNEY: How would you describe Darth’s performance?

LUKE: My partners were very disappointed with Darth’s deteriorating performance. We discussed these issues with Darth on many occasions, but nothing ever changed.

FORCE’S ATTORNEY: Can you give the court some specifics?

LUKE: I would be happy to. (1) Because his client base was so low, other partners delegated clients to Darth to get his managed billings close to $1M. Over time, Darth lost many of these clients due to his poor service; (2) his realization was 70%, well below the firm’s average of 85%; (3) the issue of most concern to the firm was his abusive treatment of our staff. A core value of our firm is that our staff are more important to us than our clients. Darth often gave staff large projects with tight deadlines at the last minute. He berated staff in front of other firm personnel. Upward evaluations of Darth by the staff were by far the lowest of any of the partners. Exit interviews with several staff cited Darth’s abusive personality as a reason for leaving.

FORCE’S ATTORNEY: Luke, did you talk to Darth about these performance problems?

LUKE: Repeatedly. His response was “I’ll change my ways,” or “The problems aren’t my fault,” and, in some instances, a denial that the problems even existed. This was very frustrating—so much so that we were on the verge of asking Darth to leave the firm. We were greatly relieved when he resigned.

FORCE’S ATTORNEY: Has your firm ever retired partners?

LUKE: Yes, we successfully retired three partners.

FORCE’S ATTORNEY: Did these partners receive buyouts?

LUKE: Yes. Long ago, we agreed that partner buyouts would be calculated by multiplying 2.5 times the retiree’s average compensation in the five years prior to retirement, times a 20-year vesting percentage, times a factor for client retention. The partners also received their ownership percentage times the capital of the firm. We used exactly the same approach to calculate the buyouts of each of our retired partners. It has long been my intent to amend our partner agreement to include this formula for partner buyout. But, as I said earlier, we were too busy to do this.

FORCE’S ATTORNEY: And the firm paid these buyouts, repeatedly, without a written partner agreement?

LUKE: That is correct.

FORCE’S ATTORNEY: Can you explain to the court how you arrived at your offer to Darth of $415,000?

LUKE: (Shows a poster to the judge) Very simple. We computed Darth’s buyout the exact same way we did with all past retirees, and it’s the way we will continue to do it. We started with Darth’s compensation of $250,000. Using a multiple of 2.5, the subtotal came to $625,000. We then applied a vesting percentage, which in Darth’s case was 40%—eight years as a partner out of 20. This reduced the subtotal to $250,000. We made a final reduction due to the substantial 30% client loss we have incurred since Darth left the firm. The result is $175,000. But that’s only the goodwill. We added in a factor for capital. Darth’s 20% share of the firm’s $1.2M of capital is $240,000. When we add the goodwill and the capital, the final total is $415,000. That’s what we have offered Darth.

FORCE’S ATTORNEY: Your witness, Darth’s Attorney.

DARTH’S ATTORNEY: Luke, you heard Darth testify earlier that he was unaware of any complaints about his performance. This is inconsistent with what you just told the court. Can you explain this?

LUKE: (shaking his head) Darth is obviously a troubled man. He is in denial of reality by propagating his “big lie.” We have a file documenting our discussions with Darth about his performance failures. Plus, we have written results of our upward partner evaluation survey and transcripts of exit interviews we did with staff.

DARTH’S ATTORNEY: I’d like to discuss your computation of what you offered Darth. You have no written partner agreement. Darth owns 20% of the firm. On what possible basis are you denying Darth his 20% share?

LUKE: A best practice in the CPA industry is to base retiring partners’ buyouts on what they contributed to building up the value of the firm, based on their year-by-year performance. Ownership percentage does not fairly or accurately represent the performance of partners relative to each other and has almost no correlation with what they did to build the value of the firm. We feel that a partner’s compensation relative to their other partners’ compensation is the fairest way to determine a buyout.

DARTH’S ATTORNEY: You expect this court to believe this far-fetched method of computing a partner’s buyout? On what basis do you make such an assertion?

LUKE: For many years, we have used one of the nation’s top CPA firm consultants. His name is Obi-Wan. I believe he is the next witness. Ask him your question.

Read Part 2 of 2 here where we hear more, as well as closing arguments from both sides and the judge’s ruling.