IN OUR OPINION, PERSPECTIVE #56 — APRIL 16, 2018
(A Continuing Series for Leading CPA Firms)
THE ART OF THE DEAL – AN M&A TRANSACTION
“Mastering the art of deal making is what transforms an
everyday company into a leading business empire.”
—Warren Buffet
While merger mania between CPA firms has been occurring for the last several years, let’s be clear – for every transaction that is consummated, our personal experience tells us that there are at least two that die at the altar. Further, there is at least one in ten chances (if not slightly more) that every consummated transaction winds up in a divorce within a short period of time.
In Our Opinion, an M&A transaction is not for every CPA firm. That’s why we say that an M & A transaction is an acquired taste. It truly is an art to negotiate a deal to the mutual satisfaction of both firms. It takes time to master the juggling and negotiating skills, patience and leadership necessary to successfully navigate through the obstacles (sand traps and pitfalls). And while there many obstacles to navigate, we have found that culture and valuation are the two that most often thwart potential transactions. This is why culture compatibility and a good understanding of valuation expectations are so important. Without them, deals fall short of expectations or never see the light of day.
The purpose of this Perspective is to share some thoughts on how to artfully deal with culture and valuation, and help improve outcomes and therefore the probability that a M&A transaction will be a win-win. Definitions are presented below:
Culture: A firm’s culture is the accumulation of shared values, beliefs and behaviors that determine how partners and staff carry out day-to-day tasks such as managing and governing the practice, serving clients, and attracting and retaining talent. It has three key prongs:
- The behaviors of the CEO, senior management and staff.
- The capabilities and decisions about where and how to compete.
- A firm’s operating and governance models that are core to how it functions on a day-to-day basis.
Valuation: Valuation is often referred to as the practice payment. It is what the larger firm believes the merged-in firm is worth in the market place. It also has three prongs:
- Price
- Payout terms
- Financing.
Culture:
The art of negotiating culture lies in understanding where the clashes or differences exist. Clashes usually take considerable time before they bubble up to the top of the “we have an issue” heap. We have observed that when it comes to determining culture compatibilities, many firms talk about a few cultural similarities as proof of compatibility, but cheap culture talk often fails to help firms navigate through the difficult task of dealing with potential culture clashes.
To successfully deal with culture, we believe that an assessment of culture compatibilities should be an area of concentration (not a gloss over or an afterthought). This assessment is usually addressed in the due diligence process. Our advice is to:
- Give mutual culture due diligence the same type of timely priority as financial, operational and legal due diligence.
- Have the CEO and other senior management (at both firms) drive culture due diligence and subsequent integration. It’s that important! Don’t delegate this important task to the Human Resources Department or, worse yet, have it outsourced to an outside consulting firm.
- Use some simple tools to diagnose the potential problem including:
- Observing different ways of working particularly when it comes to Quality Control.
- Holding key interviews and small group dinners to determine how the other firm interacts among themselves and if you would be proud to hold out the other partners at the other firm as your very own. This is commonly referred to as the “beer” or “cigar” test.
- Determine the culture you want to see. The larger firm usually has two choices here. It can assimilate the merged-in firm into its culture or it can create a blend of the cultures at the two firms. Depending on the facts and circumstances, either approach is viable.
- Develop a culture change plan.
- Sustain and measure progress.
- Be astute in developing transaction communications relating to cultural matters. Both the substance and timing of messages are very important. Senior management at both firms need to be tuned into managing expectations and anxieties while shaping workforce behavior in the desired cultural direction.
Valuation:
Many CPA firm partners believe that deals fall apart because of economics but we have found that, while economics are clearly important, this conclusion is a myth as financial considerations are usually flushed out quickly. If there isn’t a meeting of the minds, deal discussions shut down. Little ventured; little gained. Further, we have found that valuation can be successfully negotiated if two firms believe that 1+1=3 and that they can have greater success in the marketplace if they are together rather than apart. “Expectation gaps” in valuation, on the other hand, are often times why deals never get traction. This is why it is so important to understand, as you go into a negotiation, what the marketplace says a firm is worth. If you are misinformed about valuation, you may be passing on an opportunity that you should not be passing on.
Today, while some say it is a seller’s market because so many of the larger firms are hungry for growth that isn’t coming organically, we have found that not to be the case. Many CPA firms are looking to sell (either because of an ageing partner group and a lack of confidence in the next generation) and, as a result, it is a buyer’s market. Obviously, when you have a buyer’s market, valuations usually soften.
Our advice is that you should expect that your firm will be valued between 80% to 100% of net revenues unless you are a fixer-upper (in which case you probably be offered less) or if you are an extremely profitable firm (in which case you probably will be offered more). Some of the larger firms won’t pay more than what they provide for fully vested equity partners (which is usually two to three times average compensation over the three highest years). So, for example, if the larger firm’s retirement plan calls for three times compensation and the merged-in firm is doing $10 million in net revenues and $3 million net earnings to equity partners, the larger firm will not offer more than there $9 million in valuation (three times $3 million).
Whatever the valuation, most larger firms will want to make the practice payment over ten years and use the merged-in firm’s net current assets as the financing vehicle for the transaction.
It is our view that this is what the merged-in firm should expect as they enter into a negotiation. If this is acceptable, we believe the other potential challenges can be successfully dealt with.
IN CONCLUSION
There are many other reasons transactions don’t get consummated or break-up shortly after consummation. These include:
- Egos of senior partners.
- Different views on governance, autonomy and accountability.
- Concern about it “may not work” so why take a risk.
- Larger firm decides that the pain to integrate is greater than the gain to be realized. Not willing to invest the time and effort to see if 1+1=3.
- Lack of effective leadership taking partners through the decision tree from initial transaction identification to transaction consummation.
- Too many partners are willing to torpedo the transaction.
- Disagreement among the merged-in partners on how to cut-up the practice payment.
- Amount of retirement obligations at both the larger firm and the merged-in firm or at either firm.
- Dissimilar retirement and compensation plans.
We believe that these issues can be successfully dealt with if you successfully deal with culture and you know what to expect as to valuation. If you can’t artfully address the two “biggies”, better to call off the marriage than divorcing or worst yet, living together in disillusionment and frustration.
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Dom Esposito, CPA, is the CEO of ESPOSITO CEO2CEO, LLC — a boutique advisory firm consulting to leading CPA and other professional services firms on strategy, succession planning and mergers, acquisitions and integration. Dom, voted as one of the most influential people in the profession for two consecutive years by Accounting Today, authored a book, published by www.CPATrendlines.com., entitled “8 Steps to Great” which is a primer for CEOs, managing partners and other senior partners. In Our Opinion, is a continuing series of perspectives for leading CPA firms where Dom and his colleagues share insights, experiences and wisdom with firm leaders who want to “run with the big dogs” and develop their firms into sustainable brands. Dom welcomes questions and can be contacted at either desposito@espositoceo2ceo.com or 203.292.3277.
