How can professional practices mitigate the risk of legal disputes?

Legal disputes can create significant disruption for professional practices, impacting shareholder relationships and day-to-day operations. Disagreements can occur for many reasons — and are often more challenging to navigate without clear documentation around valuation, decision-making, and exit strategies. While a shareholders’ agreement provides a framework to navigate these challenges, many practices have agreements in place that do not mitigate these risks effectively.

Let’s discuss the most common causes of legal disputes for professional practices and explore how planning ahead can proactively mitigate these risks.

What are the common causes of legal disputes?

Unforeseen personal events often cause disagreements that can escalate to litigation if your practice has an absent, unclear, or outdated shareholders’ agreement. A shareholders’ agreement is one of the most important documents in your practice and provides a legally binding framework to help navigate decision-making, dispute resolution, valuation, exit strategies, and more.

The most common causes of legal disputes in professional practices include:

Personal events

Unexpected personal events are often the catalyst for litigation. Divorce, debt, bankruptcy, illness, or alleged fraud involving one shareholder can impact the interests of the other shareholders in your practice and lead to a legal dispute. A comprehensive shareholders’ agreement can help mitigate the impact and prevent litigation when these personal events occur. However, a personal event typically triggers the litigation process if your practice has an ineffective shareholders’ agreement in place.

Absent shareholders’ agreements  

Many professional practices do not have a shareholders’ agreement in place. This means there is no defining document to refer to when a dispute occurs and therefore no framework to navigate ownership, valuation, or exit issues.

Unclear shareholders’ agreements  

Some professional practices have established a shareholders’ agreement with unclear terms. Flexible formulas can lead to different interpretations of the value owed during events such as a shareholder buyout. For example, the formula may state that a multiple is applied to a normalized earnings before interest, taxes, depreciation, and amortization (EBITDA). However, parties may interpret normalization if it is not defined in the agreement and the calculation is not explained in the schedule, which can create significant valuation differences.

Buyer-seller disputes

Buyer-seller disputes may arise several months after the transaction closed if the buyer feels that the transaction did not deliver what was promised. This includes the transfer of goodwill, patient volume, working capital, and other factors.

Shareholder buyout

A shareholder buyout may occur when there is disagreement around the future direction of the practice — including its growth strategy, allocation of effort, or potential expansion. These types of disagreements can lead to different perceptions of contribution, compensation, and the value each shareholder should receive if it is not clearly defined in the shareholders’ agreement.

How planning ahead can help reduce risks

A proactive approach can help your practice reduce the risk of costly legal disputes. These four practical steps can help you get started:

Develop a shareholders’ agreement

If your practice does not have a shareholders’ agreement in place, the first step is to draft this document. This involves holding a shareholders’ meeting to ensure that everyone is included in the process and agrees to the terms. It is best to develop a shareholders’ agreement early, when business is going well, and shareholders are on good terms. This makes it easier to address difficult ownership and valuation questions and achieve shareholder alignment.

The shareholders’ agreement can include jointly retaining a Chartered Business Valuator (CBV) to determine the fair market value of the practice and define the valuation process in clear terms that leave no room for different interpretations. Additionally, an advisor can help you develop an agreement that provides a framework to help navigate exits and disputes.

Define formulas and terms

Review your shareholders’ agreement to ensure that it includes clear definitions, examples, and explanations of terms to prevent different interpretations. Go through your shareholders’ agreement line by line to identify any terms with ambiguity. This might include defining the value of each shareholders’ interest or clarifying specific terminology such as a reduction reflecting a non-controlling ownership interest.

Additionally, it is important to address life insurance considerations, such as determining whether the life insurance policy or its value is included in the valuation or considered upon the death or exit of a shareholder. Ensure that shareholders agree in advance whether there is significant goodwill in the practice and whether that goodwill is transferable to avoid buyer-seller disputes.

Perform periodic reviews

Periodic valuation reviews can help establish a mutually understood value of your practice with your shareholders. A five-year review cycle is often useful for larger professional groups with significant shareholder turnover. However, smaller practices may conduct periodic reviews less frequently to avoid high costs.

A periodic valuation review helps you understand if the actions you have taken have increased the value of your practice. It also helps you identify any formulas or terms that have become outdated and update these terms. These reviews also help keep shareholders on board and ensure they understand how the valuation process works and the current practice value. If a dispute occurs, the most recent review can provide a framework that can be used as a basis for determining value.

Contingency planning

Contingency planning can help you identify situations where the personal circumstances of one shareholder could negatively impact the other shareholders of your practice. Consider what could go wrong in the life of each shareholder — including situations such as divorce, bankruptcy, fraud, incapacity, and death.

This will help you begin a scenario mapping process where you define each situation and document how you want your practice to react. For example, you can address buyout rights, transfer restrictions, valuation methods, and what happens if a spouse makes a claim against shares in the agreement to mitigate the risks associated with a matrimonial dispute.