Preventing the Expropriation of CompositeQuasi-Rents in Partnerships:
An Economic Rationale for Expulsions, Blackballs, Buy-Outs, and, Sometimes, No Contract.
byR. Scott Harris, Associate Professor of Economics, Montana State University Billings *
[email protected] A. Kastelic, Senior Undergraduate Student, Montana State University Billings *
* The authors wish to acknowledge a debt of gratitude they owe to the late Professor Armen Alchian who both oversaw the doctoral thesis from which this paper is derived, and who spent many hours on the original version of this paper editing and making insightful suggestions. His contributions were more than sufficient to warrant inclusion as a coauthor and we expect this would have been published much sooner if he had accepted that role. The authors have included and acceded to his suggestions, including the addition of the last section of this paper. Nonetheless, we bear the responsibility for errors and mistakes, but humbly dedicate any contribution this paper makes to the memory of Professor Alchian.
Abstract:
This paper examines the value generating rationale for clubs and partnerships and the roles of expulsions, blackballs (membership screening rights), and buy-out provisions in inhibiting actions by some members to expropriate the composite quasi-rents enjoyed by the other members. We find that in some instances, where the partnership exhibits “unique” characteristics, any written contact designed to inhibit opportunism within the partnership will create perverse shirking incentives that could destroy the quasi-rents they were meant to protect. Finally, we compare the use of expulsions, blackballs, and buy-outs to other established opportunism-inhibiting mechanisms such as brand-name capital, long-term contracts, common ownership , and rights of first refusal.
Preventing the Expropriation of CompositeQuasi-Rents in Partnerships:
An Economic Rationale for Expulsions, Blackballs, Buy-Outs, and, Sometimes, No Contract.
“Composite quasi-rents,” a term coined by Alfred Marshall1, arise when the magnitude of
the quasi-rents depends on the jointly-productive contributions of assets not commonly owned.
Both the initial assignment of rights to anticipated composite quasi-rents and, once realized,
protection against their expropriation is central to many explanations offered for the structure of
both inter- and intra-firm contracts. Anticipated composite quasi-rents commonly arise when
there are investments whose return depends on the subsequent specific performance of others'
assets. Such an investment is “jointly specific” with, or reliant on, the “supportive” assets of
others. While the overall realized investment return usually differs from that which was
anticipated due to events that were unforeseen at the time of the investment (resulting in profits
or losses), the return to the investor additionally depends on the investor's ability to limit
“expropriative” behavior by the supportive asset owners. Specifically, if no earlier restraint is
imposed, the supportive resource owners predictably will hold the investor's return hostage by
behavior designed to diminish the total return on investment unless they are paid a larger-than-
originally-negotiated share of the return. Therefore, prior to making such an investment, prudent
1 Marshall wrote: “Quasi-rent of a business...is an income determined for the time by the state of the market for its ware, with but little reference to the cost of preparing for their work the various things and persons engaged in it. In other words it is a composite quasi-rent divisible among the different persons in the business by bargaining, supplemented by custom and by notions of fairness. ...Thus the head clerk in a business has an acquaintance with men and things, the use of which he could in some cases sell at a high price to rival firms. But in other cases it is of a kind to be of no value save to the business in which he already is; and then his departure would perhaps injure it by several times the value of his salary, while probably he could not get half that salary elsewhere.” (Alfred Marshall, 1948, p. 626. Emphasis added)
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investors will insist on contracts or arrangements that contain investor-invocable mechanisms
that discourage such hostage taking. Otherwise, the investment— and, therefore, a potentially
profitable joint venture—will not be undertaken.
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An illustrative example is seen with an entrepreneur who leases a building and
establishes a business whose continued degree of success depends upon both that entrepreneur
and continuance at that location, regardless of choice of initial site. The lease terms initially
offered by the building owner must be competitive with those offered to the entrepreneur by
other building owners or the building will not be leased. But subsequent to signing the lease and
establishing the business, part of the value of the venture may depend on continuing business at
the same location. If that is the case, when the initial lease expires, an unrestrained building
owner would be expected to commit to lease to someone else (even at less-than-competitive
rates) unless the entrepreneur agrees to surrender at least some of the expected future location-
specific earnings to the building owner through higher lease payments.
Some of the ways to discourage such expropriative behavior are use of (a) brand-name
capital, e.g. the building owner's reputation for expropriating quasi-rents makes it difficult and
more costly to attract first-time tenants with a competitive initial lease arrangement (see
Benjamin Klein, 1980; Roy W. Kenny and Klein, 1983), (b) long-term contracts, e.g., the initial
lease is as long-lived as the anticipated location-specific stream of entrepreneurial quasi-rents
(see Oliver E. Williamson, 1979; Masanori Hashimoto and Ben T. Yu, 1980), and (c) common
ownership of all investment-affecting assets, e.g., the entrepreneur buys the building and site (see
Williamson, 1971, 1973; Klein, Robert G. Crawford, and Armen A. Alchian, 1978). Finally, (d)
the preemptive rights of first-refusal also can be used to deal with this difficulty. With them, the
investor has the right to preempt control of the supportive resources (e.g. the future lease of the
building) at acceptable terms offered and accepted by another—terms which are market
competitive rather than quasi-rent expropriative (see Richard Scott Harris, 1985A, 1985B).
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Setting aside the circumstances under which one of these mechanisms would be preferred
over another (e.g., if the future viability of an entrepreneurial undertaking is highly uncertain, the
investor will avoid the long-term leases option), the major purpose of this paper is to suggest that
another class of preemptive rights—blackballs, and sell-out and/or buy-out provisions—are
useful in preventing expropriation of investment-reliant quasi-rents.
The Structure of Buy-Out Agreements
Broadly defined, buy-out agreements stipulate how departing coalitional asset2 owners
may (or, in many cases, must) sell their shares in a continuing concern. Though seen elsewhere,
they are very common in partnership agreements. A typical buy-out and sell-out agreement is:
If any partner leaves the partnership, for whatever reason, whether he or she quits,
withdraws, is expelled, retires, or dies, he or she [or heirs in the event of death] shall be
obligated to sell his or her interest in the partnership, and the remaining partners
obligated to buy that interest, under the terms and conditions set forth below (Denis
Clifford and Ralph Warner, 1980, bracketed phrase added).3
The additional terms specify how the buy-out price will be determined. Since a buyout
clause establishes the buyer, using a third-party generated market price to determine the buy-out
price is not feasible since no third-party would bear assessment and bidding costs knowing that
someone else is the designated buyer. Therefore, alternative methods are usually used to set the
price: appraisals, “fair market” valuations, “book value,” etc. Anticipated costs of using any of 2 We use the term “coalitional assets” in the manner established by Armen Alchian, 1984. 3 Though “partnerships” are specific legal entities, we use the term in a looser context that may include Limited Liability Companies, clubs, and other business and social coalitions where coalitional quasi-rents depend on individual behavior, decorum, etc.
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these value-setting methods vary as do the expectations that they will determine buy-out prices
closely approximating the “true" value of the shares. Though it will generally underestimate
“true” (but undeterminable) market value, reliance on “book value” is commonly used because it
is cheap to estimate. Also notice that in this particular example, the buy-out is permitted only by
remaining partners. As we shall see, while not all buy-outs include the specific mandatory
purchase provision, they always allow remaining partners to designate a successor because, in
any event, the remaining partners can resell the departed partner's shares to a buyer of their
choice.
Ownership Specification and Participation
Buy-outs are used where the nominal coalitional assets are separately owned and where
the value of the coalition depends on specification of asset owners. In the case of many
partnerships and clubs, the coalitional assets are the members themselves (who are, of course,
separately owned) though the nominal asset is the specific coalitional “membership.” As in the
example cited earlier, often the prospect of expropriative behavior arises because investment-
reliant assets can be separated from the coalition. It was the physical asset that was important;
specification of the owner did not matter. Now it is the specification—and, in some cases, the
continued participation—of owners in the coalition that is crucial.
To understand this, consider two examples: (1) a mutually owned country club wherein
members own equity shares in the club, and (2) a medical group-practice partnership. In both of
these examples specification of who owns shares is crucial in determining the value of the
enterprise—a value which is shared between all owners.
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The value of membership in a country club rests in part on the type of people the other
owners are.4 But, if any one member leaves or reduces participation in the coalition, that in and
of itself will not greatly affect the value of belonging to the club by the remaining members.
There will be other members whose general personality, status, and demeanor will maintain the
coalitional value for active remaining members. However, it is important that coalitional
members can expel an existing member who "turns sour" or habitually ignores the club rules5,
and that the existing members have the right to screen potential new members.
The concerns of members of a medical group-practice partnership (or other professional
partnership) will differ slightly, but importantly, from those in a country club. They, too, will
want to be able to expel coalitional members who perform badly and to screen new members.
But additionally, they are concerned that each continues to be an active participant in the
coalition. For example, doctors often establish group practices with others whose expertise is
specifically complementary to their own. If one of those doctors withdraws or reduces their
participation, the remaining partners will be worse off unless the departed doctor's specific
complementary skills and expertise are replaced. The remaining coalitional members will want
to have an automatic way to transfer the ownership shares of an inactive member to a new active
member.
4 In describing one elite country club, author John Sabino summarized the coalitional value of the San Francisco Golf Club: “Belonging to one of these clubs is the ultimate safeguard. You can't rely on your neighborhood any more as anyone can buy a home next to you. The first class cabin on a plane is no longer exclusive with the frequent business travelers taking over. But, to be the Chairman of the admissions committee at an old line club such as San Francisco or Merion or The Country Club and you are a real member of the ruling elite. In Great Britain, it is easier to tell someone's class by their education, title and accent. Not so in the U.S. With the equal opportunity movement, a Harvard or Yale pedigree is no longer a shorthand way to see if someone is like you. To find the true landed gentry in this country, check the membership lists at the most elite of clubs in Boston, San Francisco or Philadelphia… Membership in an elite course such as these still represents something that money can't buy. Any fool could leverage himself to the hilt with a big mortgage, lease a BMW and give the appearance of having arrived. Only the truly elite could get into a club like San Francisco. You have to be nominated by seven members of the establishment. And they will not let in anyone without the proper pedigree. And for good reason. Their traditions are time honored and are to be respected. Why let in some technology genius who would ruin the decorum in the locker room by checking his hand-held email device every 3 minutes.” (John Sabino, 2006) 5 Club rules typically specify a dress code as well as where and when electronic devices can be used, smoking, etc.
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Expulsions and Blackballs as Inhibitors of Expropriative Behavior
We have listed two concerns that potential members will want to resolve before they join
any coalition where specification of owners is important. Those concerns are to have rights to
expel existing members who perform inadequately and the right to blackball (screen) new
members. We now examine how contracts that address these concerns must be structured to
avoid incentives for quasi-rent expropriative behavior. The right of expulsion might seem to be a
precautionary provision that is available to coalitional members in the rare event that they
seriously overestimate an applicant's qualities. But, the provision also constrains deliberate
“hold-ups” by any existing members who possess the ability to destroy coalitional value. If a
member who planned on eventually leaving the club wished to extract quasi-rents from other
members, they could commit to act obnoxiously unless the others bought them off.6 Such
opportunistic members could effectively capture the collective loss in value their ongoing
objectionable behavior would impose on the others. Since others originally purchased
memberships with an expectation of a certain value that depends on other members' actions (e.g.,
decorum, etiquette, and gentility, or continued specific coalitional contributions), the ability of
individuals to affect that value allows them to extract the quasi-rents from that value. Therefore,
the right of expulsion not only allows for past mistakes to be rectified, it also discourages “hold-
ups.”
A similar explanation is offered concerning the right of existing members to determine
membership acceptability of applicants (i.e., to screen applicants). If there is a limited number of
memberships where new members can gain admittance only by purchasing a departing member's
6 A plausible scenario for this would be where a dispute erupts between members and an element of revenge comes into play.
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share, one would normally think that the admission approval would be pro forma. After all, why
would a member who is departing on good terms not live by the golden rule and assist in
maintaining the value of the coalition for soon-to-be former colleagues? The reason is that there
are definite incentives for departing members to hold up these colleagues by committing to sell
their membership to someone known to be most repugnant to those who will remain in the
coalition. The danger of this occurrence is obviously higher if the departure is not amicable. To
see how this would come about, consider the following examples.7
Suppose among the buyers who are acceptable to remaining coalitional members the
most anyone is willing to pay for the departing member's share is $15. Instead of selling to one
of them, the departing member can seek another buyer who is most repugnant to the remaining
members. If such a person would impose a collective loss in coalitional value of $4 on the
remaining members, even though that person may not be willing to pay $15 for the membership,
it will pay the departing member to commit to sell to that person unless the remaining members
buy the seller off for $18.99 (= $15 + $4 less one cent). Those remaining members would buy
the membership at $18.99 and take a loss of $3.99 (after reselling to an acceptable applicant at
$15) which is one cent less the $4.00 they would lose if they didn’t pay off the seller and have a
repugnant colleague forced amongst them.
Calculating the “hold-up” price is even more complicated if current members anticipate
that some acceptable applicants would add to their collective coalitional value if admitted.
Suppose that among the acceptable applicants there is one who would add $3 to the collective
value of the coalition, but who is only willing to pay $14 for the membership. Though other
acceptable applicants (but who will not augment coalitional value) may be willing to pay $15,
the departing member could now hold up the remaining partners for $20.99 (= $14 + $3 + $4 less
7 The numbers are chosen for these and following examples are for ease of exposition only.
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a penny). Again, remaining partners will pay the hold-up price, and resell the membership for
$14 to the applicant whose membership adds the $3 to their coalitional value. They will pay
$20.99 and recoup $17 ($14 in the resale plus $3 in added coalitional value). The loss of $3.99 is,
as before, better than the $4 they would lose if they were to have an obnoxious associate thrust
upon them.
These examples assumed that the objectionable applicants were willing to pay no more
than acceptable applicants for the departing member's share. But, if someone who is
objectionable is willing to pay more than what the seller could get by holding up the remaining
members, the shares will be sold to that person and the remaining members will lose coalitional
value. In the last example, this would occur if the repugnant applicant was willing to pay
anything more than $21.01 for the departing member's share. Since the most the departing
member can get by holding-up the remaining members is $20.99, the sale would be to the
repugnant applicant for $21.01.8
8 Though these examples cover the essence of the exposition, a formal proposition is as follows: Without screening or expulsion rights, the price departing members can receive depends on two factors: (a) the price each potential new owner is willing to pay, and (b) the losses (or gains) that any newcomer would impose on remaining coalitional members. If there are n different potential buyers, each willing to pay different prices, Pi (i = 1, 2,..., n), for the departing member's share, and each of whom would change the collective value of the coalition to the remaining owners by Vi, the price departing members would get for their share is
n n n(1) Max{[ Max(Pi + Vi) + Max(-Vj)], Max(Pk)}
i=1 j=1 k=1
where i, j, and k represent independent surveys of the n potential buyers. Note that the "i" survey will choose from among the applicants acceptable to the remaining partners while the 'j" and "k" surveys will choose from among those who are unacceptable.
This equation states that sellers will receive either the most they can get by holding up remaining coalitional colleagues or the maximum price a buyer is willing to pay, Pk. The maximum hold-up price is (a) the amount the remaining partners will receive if they buy the membership and resell to the buyer who brings them the greatest wealth gain, [Max (Pi + Vi)], plus (b) the loss, [Max (-Vj)], the seller could impose on them by committing to sell to the buyer who is most repugnant to the remaining owners.
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Even if coalitional members had only a right to expel without a right to control who was
admitted, a departing member could still hold them up by committing to sell to someone who is
not quite obnoxious enough to be expelled. If there are costs involved in expelling obnoxious
members, the maximum loss such a sale would impose on the remaining members is limited to
the expulsion cost. Nonetheless, there will be a predictable loss of coalitional value to remaining
members.
Screening Rights as Promoters of Quasi-Rent Expropriation: A Reason for
Buy-Outs
If the only concerns were the right to screen potential coalitional members and the right
to expel current members, writing the necessary contractual clauses seemingly would be
straightforward. The country club, for example, could have a committee of members whose job it
is to undertake such tasks. And, in fact, that is what occurs in many country clubs where
membership represents an ownership share that is not individually negotiable.
A problem is that this method of preventing one form of hold-up gives rise to another,
“reverse” hold-up potential. Any existing owners who depart will encounter higher costs of
selling their shares if the remaining owners take advantage of their right to refuse admission to
potential buyers. Since this outcome can be anticipated prior to joining, wise initiates will insist
that arrangements will be made for the sale of the departing partner's shares to the remaining
partners at the seller's (i.e., departing member’s) option. The method of determining the price for
the departing member's share likewise would have to be specified in advance since otherwise the
remaining partners could later set “too low” a price.
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A numerical example will illustrate: As in our earlier example, suppose that admissible
buyers are willing to pay $15 for a departing member's share. Furthermore, suppose that the costs
of selling by a departing owner are $1.50 leaving a net return of $13.50. As we shall see,
remaining owners can insure that they incur lower selling costs, e.g., $.75 per share. The initial
coalition will be more valuable if brokering shares is assigned to those remaining in the business.
While the remaining members could buy the departing member's shares at $14.25, spend $.75 to
resell them at $15 and break even, the remaining members could act opportunistically and gain
even more. Knowing (or suspecting) that the departing member must incur $1.50 to sell, the
remaining members could commit to decline to buy unless the departing owner agreed to
renegotiate the sale price downward to as low as $13.50, which is the net return the departing
owner would receive by selling the membership himself. If the remaining members commit not
to pay more than $13.51, the seller will agree. The remaining members will then resell for
$15.00, incur $.75 selling costs and collect $.74 of the departing member's “rent.”
A generalized statement of this possibility is that whenever the selling costs for departing
members exceed those of the remaining membership they will be subject to this type of hold-up
by the remaining members. And, since the remaining members have screening rights over any
potential member, they can arbitrarily increase the departing member's selling costs by
committing to veto any applicant to whom the departing owner might have sold, thereby insuring
that the departing member's selling costs exceed theirs.9
9 We are not asserting that all potential opportunistic acts will be undertaken; obviously there are other costs (if only to self-esteem) that can obviate such behavior. Nonetheless, the exposition demonstrates that expropriative opportunities exist and create perverse incentives on the margin. One certainly may view this in a more benign context where there is no arbitrary commitment to use the screening process to exact a departing member’s quasi-rents. However, the anticipated costs of selling one’s membership increase to the degree that there is uncertainty over the potential buyer’s acceptability to those entrusted with screening new members. The higher the probability that the chosen buyer will be blackballed, the greater will be the expected selling costs for the departing member.
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If the initial coalitional contract is such that remaining members can extract the “rent”
from departing members, future wealth redistribution predictably will occur with remaining
members gaining at the expense of those who depart. If initial formative coalitional owners are
risk neutral, the initial value of the business will be unaffected by the possibility of such an
occurrence if nobody knows who will leave first. However, if members are risk averse, or if
some expect they will depart the coalition before others, the chance that an owner will get less
than anticipated upon departing lowers the value of initiating the business. A buy-out at the
seller's option with an appropriately predetermined method of setting the buy-out price can
remove this risk and thereby encourage formation of the interdependent partnership.
A buy-out by the remaining partners not only protects those who may depart, it also will
be desired by those who remain. For them, it is the other remaining members and the potential
new members (buyers) whose values and characteristics are interdependent; the departing
member is then of little or no consequence. The seller just wants out (or is being forced out).
Obtaining the rights to easily designate new members is important for those who remain since if
the departing member is the one who finds a new member, only enough costs will be incurred to
find a minimally acceptable applicant whereas if the continuing members search they will
usually find it worthwhile to search for better prospects. Furthermore, information flows about
the future of the coalition will be both more efficient and less subject to self-serving distortion by
a departing seller if the potential buyers and remaining partners deal with each other. Finally,
since potential buyers will be more prone to contact the coalition instead of a specific departing
or departed partner, search costs will be lower. If these factors are important or significant, the
remaining partners will want to bear the costs of arranging the sale of a departing partner's share
and the buy-out will be mandatory rather than at the seller's option.
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Since the remaining members possess screening rights and can use them to increase the
departing member's selling costs, there seems to be little difference between whether the buy-out
is at the seller's option or is mandatory. Even without the “mandatory” buy-out, we would still
expect virtually all shares to be sold through the remaining members. A survey of country clubs
in Orange County, California, a few years ago as well as current surveys in Montana and Arizona
lends credence to this assertion. All clubs where membership represents equity ownership
required that new members be screened by a committee of existing members. All clubs provided
for memberships to be repurchased by the club. Most buy-outs were at the discretion of the
departing member, though some had the stronger provision that required departing members to
resell their memberships to the club. Mandatory buy-outs were not always specified.
Mandatory Buy-Outs/Sell-Outs
The foregoing discussion demonstrates why remaining coalitional owners wish to screen
potential new members and why the contract allows departing owners to force those who remain
to buy their shares as a protection to a departing owner from expropriation by remaining
partners. The mandatory feature is not required to protect against this type of expropriation; it
merely allows the remaining partners to choose the selling costs. It is also important to note that
the buy-out provisions discussed to this point do not compel a timely sale; they only specify how
the sale will occur when the seller decides to sell.
A mandatory sell-out/buy-out does more. Recall that the foregoing discussion centered
around a coalition (such as occurs in country clubs) where the value to remaining owners did not
depend on the specific active participation of all owners. We shall now see how mandatory buy-
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outs serve to discourage expropriative behavior when specific participation of members is
necessary to maintain ongoing coalitional value.
It may be imperative that the remaining members choose to buy and resell a departing
member's share if a withdrawing partner knows that without a replacement, the coalitional value
for the remaining partners is diminished. Members could commit to “retire” and to delay or
refuse to sell their shares to the remaining members unless they were paid a price exceeding the
agreed-to buy-out price. For example, doctors could “retire” or otherwise leave (or even be
expelled from) a medical group and refuse to sell their shares unless paid an amount in excess of
the agreed-to buy-out price and equal to the present value of the lost income they can impose on
the remaining partners (because those who remain cannot cheaply replace the contributions
provided by formerly-active members as long as those inactive members are still officially part
of the coalition). To avoid that possibility, the remaining partners will want the right to choose to
“buy out” the departing (or departed) member, i.e., to be able to force the departing member to
sell to them. The mandatory sell-out/buy-out along with the right to expel a coalitional partner
will achieve the desired goal and protect all members.
The Uniform Partnership Act was first drafted in 1914 by the Uniform Law Commission
and was adopted as statutory law in all states except for Louisiana. It was modernized and
rewritten in 1997 with the latest amendment in 2013. The latest version has been adopted in all
but 11 states with South Carolina moving toward adoption this year. Article 7 of the current
version addresses the issue at hand: “If a person is dissociated as a partner without the
dissociation resulting in a dissolution and winding up of the partnership business under Section
801, the partnership shall cause the person’s interest in the partnership to be purchased for a
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buyout price determined pursuant to subsection (b).” (National Conference of Commissioners on
Uniform State Laws, 2013)
Specific examples are cited in the following legal cases:
Hill Medical Corporation v. Russell R. Wycoff: “…According to the stock
redemption agreement, in the event of a "buyout event," which was defined to include the
end of Dr. Wycoff’s employment, he was required to sell his stock back to the
corporation and Hill Medical was required to repurchase the stock…” (103 Cal.Rptr.2d
779 (2001), 86 Cal.App.4th 895)
Wesley S. Blank v. Chelmsford OB/GYN, P.C.: “The parties also entered into a
stock purchase agreement which provided that, in certain circumstances, the corporation
would repurchase a shareholder's stock at the book value of each share, as determined by
the independent accountant of the corporation. According to this Agreement, the
obligation of the shareholder to sell and of the corporation to purchase the shares accrues
on certain circumstances, including ‘[u]pon the termination by the Shareholder or by the
Corporation of the employment of the Shareholder by the Corporation for any reason
whatsoever.’" (420 Mass. 404 (1985))
Coalitional Viability and the Specification of the Buy-Out Price
The Uniform Partnership Act specifies that the buy-out price shall be “…the amount that
would have been distributable to the person under Section 806(b) if, on the date of dissociation,
the assets of the partnership were sold and the partnership were wound up, with the sale price
equal to the greater of: (1) the liquidation value; or (2) the value based on a sale of the entire
business as a going concern without the person.” (National Conference of Commissioners on
Uniform State Laws, 2013, emphasis added)
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We conjecture that the foregoing statutory language has been carefully crafted. As stated
earlier, historically a common way to set the buy-out price was to use “book value” of the shares.
At least one potential pitfall is associated with this. When the coalitional venture is risky and
separately-owned portions of firm-specific capital comprise the bulk of the partnership's book
value, accounting practices may result in a book value that departs far from market value. This
can happen when in the face of an unexpected decline in coalitional market value, depreciation
schedules which are chosen according to generally-accepted accounting principles do not
account for the unexpected decrease in market value assessment of firm-specific capital. In this
event, book value may be overstated. (Though the opposite can also occur, we are interested in
this situation.)
If there is growing doubt about the future viability of the venture, it may be in the best
interest of an individual owner to “get out while the getting is good,” and force the remaining
owners to buy him out at an above-market price. If there is a sell-out provision where the share
price is tied to book value, there will be a race among owners to see who can bail out first with
the most pessimistic of them leading the way. Such a sell-out at an above-market price will
further reduce the value of the remaining coalition. A pyramiding effect would soon spell the
doom of such a business which otherwise might have been able to survive.
For example, suppose four owners have equal shares in a business with a total book value
of $20 but a market value of $16. The first to leave would expect to receive $5, the one-quarter
share of the book value. If the remaining members (as a business) are compelled to buy that
quarter share of the business for $5, they will purchase $4 worth of equity for $5. What remains
will be worth only $15 in real terms though the book value remains at $20. This process reduces
the real value of the business and, therefore, increases the probability of its failure. Indeed, rather
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than pay the departing owner according to the buy-out provision, the remaining owners may
liquidate the business in which case each owner (including the owner who was first attempting to
take advantage of the buy-out provision) will receive equal portions of the market salvage value.
To avoid this possibility, sometimes buy-outs were written where the future buy-out price
was to be determined by the lesser of some formula-derived value (e.g., book value) or an
appraised “fair market value.” Though obtaining such an appraisal may be costly, the mere
existence of such a provision would discourage a race to sell through forced buy-outs.
Note that the amended Uniform Partnership Act basically disqualifies “book value”
methods in favor of methods that use market value in the absence of the disassociating partner or
liquidation value. These appear to mitigate the issues associated with use of book value. In the
Hill Medical Corporation v. Russell R. Wycoff: case cite above, the buyout price was to be “price
measured by net book value, i.e., assets minus liabilities. Hill Medical did not carry goodwill as an
asset on its books.” (103 Cal.Rptr.2d 779 (2001), 86 Cal.App.4th 895) The absence of goodwill
both indicates the variability in how “book value” is determined and lessened the probability that
a pyramiding effect discussed in this section would occur.
Comparing Buy-Out Provisions with Other Expropriation Preventing Devices
We now compare the use of buy-outs with other devices to inhibit opportunism
mentioned in the beginning of this paper. We shall see that the other methods (i.e., first-refusal,
brand name, long-run contracts, common ownership) generally will not be useful when used
under the circumstances that call for buy-outs. Recall that blackballs (screening rights),
expulsion rights, and buy-outs at the seller's option are useful primarily where (1) coalitional
resources are separately owned, (2) the identity of the owners affects coalitional value, and (3)
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the continued active participation of any one owner is not crucial to the maintenance of overall
coalitional value. (In addition, if the remaining members find it in their interest to be brokers of
departing member's shares, they will use a mandatory buy-out.) If the third criterion differs so
that active participation of all owners is important in maintaining coalitional value, we anticipate
that the sell-out/buy-outs will be “mandatory.”
Long- Term Contracts
Since it is the specific identity of owners that is important, long-term coalitional contracts
will not prevent a person who wishes to leave from forcing the issue by behaving in a manner
inimical to the desires of the other coalitional members. If the coalition has a way of expelling
disagreeable members, then all a member need do is get expelled to force an opportunistic buy-
out (since the expelled member could—as described earlier—commit to sell to a repugnant buyer
and thereby impose a loss on remaining owners). If there is no provision for expelling members,
a long-term contract only allows opportunistic members additional leeway to behave
obnoxiously for the entire duration of the contract. Then they can extract the present value of the
entire quasi-rent stream denied other partners through continued misbehavior.
Brand-Name Capital
The reliance on brand-name capital depends on repeat business being foreclosed if one
behaves opportunistically. Though there is the possibility that this factor has some inhibiting
effect, the cost of expropriation through this mechanism is less when there are relatively few
victims and when their version of what occurred can be disputed (one person's word against
another) if new potential partners even bother to check up on one's past behavior. Like quack
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patent medicine salesmen of western lore, the current value of misbehaving may be greater than
the expectational value of being caught and paying for that behavior in the future. Reliance on an
additional, surer deterrent to expropriative misbehavior usually will be necessary.
Common Ownership
Since it is the characteristics of the members that is important, it is impossible to
consolidate such coalitional assets through common ownership. One cannot own one's partner.
However, it is possible for one person to “own” a business and contract with others who might
otherwise have been one’s partners. An example is a country club or health club where
membership is a license to use the facilities, not an equity share. The owner would screen
potential members and expel those who misbehave in order to maintain the quality level of the
facility that maximizes the owner’s wealth.
However, problems arise if there are two assets specific to the coalition which will
generate quasi-rents: (1) the owner's assets, and (2) the composite attributes of the members. The
owner will attempt to expropriate the quasi-rents that accrue from the members' specific
composite attributes, while a close-knit membership would attempt to capture the quasi-rents
attributable to the owner's assets. For example, an owner could increase membership fees to
capture the members' quasi-rents. Such an owner would be limited by the collective cost to the
membership of establishing an alternative environment in which to maintain their specific value-
producing composite blend of membership. Alternatively, the membership—which would be a
close-knit, cohesive unit—could commit to leave the owner's facility unless membership fees
were reduced or other concessions granted. They will be limited only by the owner's cost of
replacing the membership. Joint ownership avoids these difficulties.
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Careful examination of those clubs and facilities that are not owned by members reveals
that the composite, joint attributes of the specific membership are not important to individual
members. Country clubs that emphasize the athletic aspect of membership are more likely fall
into this category whereas those that also emphasize the social aspects of membership (and
therefore depend on the specific composite attributes of the members to generate membership
value) will be jointly owned by the members. Owners of storefront legal clinics (like Jacoby &
Meyers) will hire their lawyers whereas a law firm engaged in cases that involve the joint efforts
of different legal specialists will be jointly owned as partnerships. In the former, specification of
the "blend" of specialized legal expertise and personalities is of no importance whereas in the
latter case it is critical. A similar argument can explain why the large accounting firms are
partnerships while the local bookkeeping or tax-preparing firm (such as H&R Block or Jackson
Hewitt) whose business is fairly standardized is structured as an enterprise that hires its CPAs or
tax preparers.
First-Refusal
Finally, we turn to first-refusal rights as an alternative to buy-outs. By their nature, first-
refusal rights would have to be assigned to the remaining coalitional partners whenever one
partner decided to leave. Recall that we have discussed two buy-out situations: that where the
buy-out is at the seller's option, and that where the sell-out/ buy-out is mandatory. First-refusal
rights do not conform to the requirements of the first case because they give the remaining
partners the option of buying the shares, an option they could decline and thereby engage in the
type of quasi-rent expropriation we have described. Even combining the right of expulsion with
first-refusal will not be satisfactory because the remaining members could expel a partner but not
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exercise their right of refusal while maintaining screening rights over applicants. On the other
hand, if there is a reason for specifying a mandatory sell-out/buy-out (i.e., remaining partners
wish to require a sell-out), the problem with first-refusal rights is that they can be exercised only
if the other “retiring” partner wishes to sell.
Unique Partnerships
Professor Alchian was known amongst his graduate students not only for his passion for
golf (hence his interest in country club organization and contracts), but also for frequently
positing what he called the “Laurel and Hardy” problem. He noted that the entertainment
partnership of Stan Laurel and Oliver Hardy10 had no formal partnership agreement and
wondered why that would be the case. He generalized that observation to claim that similar
partnerships would, likewise, not be bound by any formal written agreement, and that all intra-
partnership transactions would be more governed by unwritten understandings. Alchian knew
that both Laurel and Hardy had been well established in Hollywood before they teamed up but
neither of them ever enjoyed the degree of success that arose from their collaborative
partnership. As such, their partnership was unique in that neither Laurel nor Hardy could
produce the same value by teaming with someone else or going out on their own. If V(L) and
V(H) were the returns to Laurel and Hardy respectively outside of their specific partnership
while V[f(L, H)] was the return to their partnership, Alchian claimed that the quasi-rent
generated by the partnership was V[f(L, H)] – V(L) – V(H) and asked how their partnership was
formed to inhibit each of them from trying to expropriate a greater share of their jointly-earned
quasi-rents. Specifically, for example, why didn’t Laurel commit to disassociate from the
10 See http://www.laurel-and-hardy.com/ for context if you are unfamiliar with this Hollywood
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partnership unless Hardy agreed to divide the income so that Hardy received only a small
amount more than he would receive if he worked without Laurel?
The answer lies in the manner by which such an ultimatum would have to be delivered.
Hardy’s retained amount would have to be set, and Laurel would obtain the realized residual (or
vice versa). Either way, one of the partners would be guaranteed a future return for staying in
the partnership. Because that person could thereafter influence the coalitional partnership value
without bearing the consequences of his action (since his return was guaranteed), the goal sought
through such an ultimatum would be thwarted. The guaranteed return to one of the partners
would have to be based on the ex ante anticipated value of the partnership, but once the
guarantee was made, the recipient would bear zero cost of shirking in a manner that debased the
value of the ex post realized residual that such a contract would designate for the other. If Laurel
tried to capture the bulk of the quasi-rent by credibly committing to leave the partnership unless
Hardy agreed to settle for a guaranteed amount just a little more, ε, than V(H), then Hardy would
have no incentive to work to maintain the V[f(L, H)] that Laurel’s quasi-rent-including residual,
V[f(L, H)]-V(H)-ε, depended upon and Laurel’s realized return could easily fall below V(L) as a
consequence. Understanding that, Laurel would not make such a proposal. On the other hand, if
Laurel tried to structure the contract to guarantee him the bulk of the coalitional quasi-rents,
Hardy certainly would not agree to accept a residual that would likely fall below V(H) since
Laurel would bear no costs of shirking and thereby would have no incentive to maintain the
value of Hardy’s residual.
In a team that relies on the creative contributions of both members, it is virtually
impossible (i.e., very costly) to objectively specify and monitor any arrangement that prohibits
either member from shirking. Therefore, it is expected that partnerships that rely on unique
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creative synergy will resolve the division of the quasi-rents on a continuing ad hoc basis where
each partner receives a “fair” portion of the realized quasi-rents. Though shirking may still occur
since neither partner will bear the full costs of their individual shirking, nonetheless, each will
bear some costs. In keeping with the observations made by Klein, Crawford and Alchian (1978),
it is expected that monitoring of shirking (to the extent it can be done) will be primarily by the
partner who has the most to lose from any other member’s shirking,
The authors are aware, for example, that the doowop band Sha Na Na11 had no
coalitional or partnership contract that bound the individual members of the group. Indeed, an
entertainment law attorney-agent who represented the group suggested that the individual
members of that group were so eclectic that getting them to agree to any formalized contract
would have been impossible. That same lawyer-agent knew of no other bands, or entertainment
groups that have a formal written coalitional (or partnership or group) contract.12
11 Sha Na Na performed at the original Woodstock Festival and went on to host their own television show in the ‘70s. A few of the founding members still form the core of the group which still performs in their fifth decade. The group website is www.shanana.com 12 Personal interview with Harvey Harrison (1984).
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Conclusion
We have established that screening rights, expulsion rights, and buy-outs…and in certain
instances, no contractual agreement at all… are vehicles to inhibit opportunism where specifying
the qualities of share owners is important in determining the value of a coalition. We also have
demonstrated that making a sell-out/buy-out mandatory always allows the remaining owners to
choose to bear the selling costs of a departing partner's shares. Making that choice is especially
important if timely replacement of a coalitional owner affects overall coalitional value.
However, in coalitions that are uniquely defined by the singular personalities and talents of the
participants, any formal contract designed to inhibit opportunism will create adverse incentives
for shirking that predictable will destroy coalitional value. In those situations, we expect that
formal contracts will be eschewed and replaced by informal and ad hoc agreements.
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