IN OUR OPINION, PERSPECTIVE #60 — June 11, 2018
(A Continuing Series for Leading CPA Firms)
PARTNER CAPITAL? BANK DEBT? BOTH?
WHAT TO DO, WHAT TO DO?
“Never take your eyes off the cash flow because
it is the life pressure of business.”
—Sir Richard Branson
As we work with small and mid-sized CPA firms, we are often asked about best practices when it comes to funding operations. Firms ask: “should we fund operations through partner capital, bank debt, or a combination of both?”
By way of background and in full disclosure, we have certain fundamental views (two to three times is presented below) that have a significant impact on the funding of a CPA firm. We believe that a firm should:
- Maintain its books and records on both an accrual basis (meaningful when matching gross production to costs of delivery) and on a cash basis (as the methodology for distributing partner compensation).
- Compensate all partners and file firm tax returns on a cash basis.
- Provide all equity partners, upon retirement, a deferred compensation/retirement benefit plan and the return of their cash capital contributions. You’ll note that we did not mention that upon retirement, firms should provide each equity partner their share of the firm’s accrual When added to the deferred compensation/retirement benefit plan, an additional distribution for a share of the firm’s accrual capital often cripples a firm. We understand that some firms provide partners both their share of the firm’s accrual capital and a deferred compensation/retirement benefit upon retirement but in our view that amount of payout is very generous and beyond that offered at many of the best firms in the U.S. Accordingly, we maintain that it is not either necessary or in the long term best interests of the firm to provide each equity partner their share of the firm’s accrual capital upon retirement on top of a deferred compensation/retirement benefit plan.
- Require that every equity partner make an initial investment in the firm (after all, they are partners and owners) and contribute cash capital or “risk capital” upon admission into the partnership. The amount varies depending on the firm’s size, complexity and operational needs. At smaller firms, initial cash capital for newly admitted partners usually hovers at about $25,000 while at the larger firms it can hover at about $100,000. If initial cash capital is a substantial amount, the firm usually provides new partners access to a banking relationship that will lend the partner money at the prevailing prime rate. In these cases, the firm usually acts as the bank guarantor of the individual partner loan.
Some firms only require an initial contribution of capital; others require that there be an annual holdback of cash compensation (usually 5% to 10% annually until a maximum amount is reached). It is not unusual to find senior partners at some mid-sized CPA firms with cash capital in excess of $300,000. As “risk capital” , interest on cash capital is usually paid annually to each partner at an attractive, predetermined rate that is favorable when compared to conservative investment returns (such as U.S. Treasury Bonds) that might otherwise be available.
With that background being said, here is our perspective on this important topic of funding operations. In Our Opinion, small and mid-sized CPA firms should fund operations through a combination of:
- Partner paid-in capital.
- Seasonal lines of credit to get them through operations during the busy or tax season as work-in- process and accounts receivable build-up. The line is usually cleaned-up annually.
- Long term borrowings for the purchase of fixed assets and leasehold improvements.
Regarding partner compensation, many small and mid-sized CPA firms use a three-pronged approach:
- Annual interest — on a partner’s total paid-in cash capital usually paid within 90 days following year-end.
- Monthly draws — for junior partners, monthly draws approximate 65% of a partner’s “targeted” compensation (while not guaranteed, target compensation for all partners usually approximates 75% to 80% of a firm’s budgeted profit or aggregate, anticipated compensation for all partners). For a senior partner, monthly draws approximate below 65% of a partner’s targeted compensation. For a junior partner, monthly draws approximate above 65% of a partner’s targeted compensation.
By the way, one of the traps that some small and mid-sized CPA firms fall into is paying monthly partner draws from a line of credit as opposed to from earnings. We have seen many firms lose some of their highest performong partners and get financially crippled when they play this “game” of paying monthly draws out of a bank line of credit (as opposed to ernings) and therefore we strongly advise against it. If a firm can’t pay monthly draws out of earnings, partners are either drawing at an unsustainable level or the partners aren’t billing and collecting on high margin work on a timely basis or perhaps both. Whatever the case, paying monthly draws from a bank line is usually a prescription for a disaster and we strongly advise against it.
- Discretionary profit allocations — generally used to reward exceptional partner performance for high performing partners and to reward one time, achievements stand-out performances that are special by their very nature. The firm distributes discretionary profit allocations, less monthly draws and any capital contribution holdback. As cash flow allows, a very large percentage of discretionary profit allocations is distributed shortly before April 15; the remaining percentage is distributed ratably on June 15, September 15 and the following January 15.
When it comes to deferred compensation/retirement benefit plans, most small and mid-sized CPA firms have arrangements that reflect the following thinking:
- Plans are not funded by current operations. Instead they are funded by future operations. This can be a dicey proposition for individual partners if a firm is not financially sound and properly governed.
- As a general guide, CPA firms are valued at one times annual revenues or three times total aggregate compensation paid to active partners. Equity partners are entitled to a return on their investment in the firm beyond the annual interest on their paid-in capital.
- An equity partners deferred compensation/ retirement benefit is usually two to three times his/her annual compensation (computed using the average of the three best years out of the last five years as an active partner).
- Deferred compensation/retirement benefit plan payouts to all retired partners are usually capped at a percentage of total earnings paid to all current partners as it is important for firms not to get too top heavy and burden future partners with an unfunded retirement obligation that can be crippling. This percentage generally ranges from 8% to 12% of total earnings paid to all current partners.
Successful small and mid-sized CPA firms are usually well run from a cashflow perspective if the factors mentioned above are adhered to. In today’s environment, firms can potentially run into financial difficulties when they aren’t growing at a 6% to 8% annual rate to cover the ever increasing costs of delivery not the least of which is the “bottomless pit” we refer to as information technology. Don’t fall victim to the “shoemaker’s shoes” syndrome. Let’s practice what we preach to our clients. Keep your eyes on the financial prize and fund your business with prudence.
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 firstname.lastname@example.org or 203.292.3277.