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 *

sharris@msubillings.eduKari A. Kastelic, Senior Undergraduate Student, Montana State University Billings *

karikastelic1@gmail.com

* 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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Clifford, Denis and Warner, Ralph. The Partnership Book (California edition). Berkeley, CA:

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