Fair compensation is the foundation of a good partnership, but it's not an easy thing to arrive at. Some practice owners decide on a salary arbitrarily, while others do what I call "bottom feeding"—cutting themselves a check for whatever is left over at the end of the month. Neither approach is fiscally responsible, even for a sole proprietor. Applying these methods to a partnership just compounds the confusion. If you're an owner, how do you know if you're getting paid fairly?
One compensation formula I've written about in the past is ProSal. With this approach, doctors are paid based on a percentage of their production but receive a guaranteed base salary. ProSal works well for associate doctors, but it doesn't provide for a return on investment or division of net profit for partners. In addition, ProSal may not adequately account for disparities in time, ownership, and management responsibilities.
Fortunately, there's a compensation method that allows for these differences within partnerships. It's called the Four Tier formula, and it's designed to provide fair compensation to owners on the basis of their individual production, stock ownership (and therefore return on investment), net profit, and management time. Let's look at each of these tiers on the following pages.
Tier 1: Production
For the first tier of the Four Tier formula, the practice pays each owner a percentage of his or her production. This percentage normally ranges from 18 percent to 25 percent, depending on what benefits the owner receives. Like associates, owners' total employment costs shouldn't exceed 25 percent of their individual production.
So, for example, you might receive 18 percent of your production if you have substantial benefits such as health and dental insurance, a CE allowance, and your dues and licensing fees paid for. Or you may receive 24 percent with minimal noncash benefits. This allotment can vary among partners, which is in itself a benefit.
Tier 2: Return on investment
As an owner, you're entitled to a return on your investment. Your investment is the stock you own in your veterinary practice. To determine the value of your investment, you'll need to have your practice appraised by a veterinary-exclusive CPA. Don't try to perform this task yourself, or even ballpark it using an outdated method. In my experience, the rules of thumb used by owners to determine the value of their own practices (for example, the "value equals one year's gross" myth) are often completely inaccurate.
Spend the money on a professional appraisal, then use that value to determine your return on investment income for the year. In subsequent years, you can calculate the change in value based on the percentage change in the gross revenue your practice achieves. Have a reappraisal performed every five years or so.
Let's say your practice's appraised value came in at $1 million. If you owned 50 percent of the stock, your stock value would be $500,000. In the Four Tier formula, owners normally earn a 9 percent to 12 percent return on investment. So if your return is set at 10 percent, you'd be paid $50,000 for the year ($500,000 x 0.10).
In an S corporation, this return is usually paid monthly as a shareholder distribution—in this case, $4,166.66 a month. Naturally, this number is adjusted on an annual basis. S corporations declare the practice's value at an annual stockholders' meeting. (Yes, you're supposed to do this.)
Tier 3: Division of net profit
The third tier of our formula divides the practice's net profit among owners. Net profit is any money left in the corporate account at the end of the year after all owners' compensation has been paid, all bills are paid to current, and money for future equipment purchases or capital investments has been subtracted. Your employment agreement should specify how net profit is determined and how it's divided.
One option is to divide net profit among practice owners based on their percentage of ownership. This method is pretty straightforward. If there are two partners and one owns 60 percent of the stock and the other owns 40 percent, net profit is divided 60-40. But what happens if the 60 percent owner is partially or completely retired? Is it fair for him to receive 60 percent of the net profit when he's producing little or no income in the practice?
This is where a second option comes into play—to divide net profit based on production. In our example, if the 60 percent owner only worked a day or two a week and was responsible for 30 percent of the owner-produced income, he would receive 30 percent of the net profit at the end of the year.
Some practices create a hybrid formula. So, during the first five years of an owner's retirement, he might receive net profit on the basis of ownership (a return for his blood, sweat, and tears over the years) and then, in the sixth and subsequent years, he would receive net profit based on production. There are many variations to this theme, but the bottom line is to find a formula that's fair to all partners.
The division of net profit is paid out at the end of the year, unless the practice decides to declare a dividend early in anticipation of a highly profitable year.
Tier 4: Management
The fourth tier in the Four Tier formula is optional, as it compensates for management. Between 3 percent and 4 percent of a practice's gross income (not individual production) should be allocated for management. If your practice employs a practice manager, this money may already be spent on that individual. However, if you're an owner who also manages the practice or works with the practice manager, you deserve to be compensated for that.
Let's say your practice grossed $2 million in a year. You should allocate $60,000 to $80,000 for management. If you pay a practice manager $60,000 a year, then you'd conceivably have $20,000 left to compensate owners for their time managing the practice. Remember the 3 percent to 4 percent of gross is for all management of the hospital. So if you employ a head receptionist, head technician, or office manager, the portion of their salaries spent on management must also be included in this percentage.
Four Tier works for healthy practices
So what happens if there's not enough income in the partnership to fund this formula? That means there's a problem in your practice that needs to be addressed. A healthy practice should be able to pay its owners a percentage of their production, a return on their investment, and a management fee while still turning a net profit at the end of the year.
There are many advantages to using the Four Tier compensation formula—as many practices have already discovered. For one thing, transitioning from ProSal to the Four Tier system feels natural for associates since they're already familiar with production-based compensation. In fact, the second tier of compensation can be used to fund a new partner's buy-in.
But even if you're never tried production-based compensation, your equine veterinary practice could benefit from this fresh look at how divvy up the earnings and keep you and any partners happy. And it could be a gateway to help that reticent associate see joint ownership for a time as a viable option.
This article originally appeared in another form in the June 2010 issue of Veterinary Economics.
Mark Opperman, CVPM, is the owner of VMC Inc., a veterinary consulting firm based in Evergreen, Colo.