IN OUR OPINION, PERSPECTIVE #76 — FEBRUARY 4, 2019
(A Continuing Series for Leading CPA Firms)
THE ART OF THE DEAL
| “The worst thing you can possibly do in a deal is seem desperate to make it. That makes the other guy smell blood, and then you’re dead “. — Donald J. Trump |
The last several years have experienced a “merger frenzy” with small and mid-sized CPA firms (with annual revenues between $10M and $24M) getting acquired by larger CPA firms that have a strong brand and a track record of average to above average equity partner profitability. Further, while it cannot be characterized as a “merger frenzy”, there certainly is considerable “consolidation” among firms with annual revenues between $25M and $100+M.
In Our Opinion, the “merger frenzy” and “consolidation” have occurred and willcontinue (at least in the near future) because of some combination of the following challenges:
- Post the 2008 financial crisis, a decline in equity partner profitability because of slow organic growth.
- The inability to find experienced, professional talent.
- An ageing “baby boomer” population; senior partners (significant generators of new business) are retiring at a significant pace.
- The concern about significant technology and HR investments and their drain on profitability.
- The transformation (occurring as firms pursue higher margin lines of business) from the traditional CPA firm model to a professional services firm model that requires significant investment for talent and acquisitions.
- The need to shore up partner talent, credentials and the ability to compete for larger clients.
- Leadership succession issues.
As a result, there is a very good chance that your CPA firm, either as an acquirer or as an acquiree, will entertain a strategic transaction or “deal” in the near future. The purpose of this newsletter is to further a reader’s understanding of two important aspects when pursuing the “art of the deal”:
- The prices paid for accounting firms sold over the last two years with a particular focus on:
- Smaller firms with annual revenues below $25M.
- Firms with annual revenues between $25M and $100M.
- A synopsis of the terms and deal points for the above transactions.
The practice payment (i.e., the price paid) for CPA firms with annual revenues between $10M and $100+M is based on a multiple of annual revenues (usually ranging between 75% to 100% although there are exceptions both below and above this range). The multiple varies and depends on the bottom-line profitability percentage distributed to the equity partners. Presented below are typical illustrations:
- For smaller firms with annual revenues below $25M, experience has demonstrated that many of these firms face serious succession issues and usually require some upgrade in partner talent, audit/tax quality, size and profitability of clients, IT systems, marketing, etc. The expectation is that a firm’s bottom line profitability percentage (distributed to the equity partners) usually ranges between 37% to 50+% (although there are exceptions both below and above this range) as the partners, on average, have between 1,500 and 1,800 annual billable hours. Presented below is typically found in the marketplace:
- If a $20M firm with 40% equity partner profitability is acquired, the practice payment would be about $20M.
- If a $20M firm with 60% equity partner profitability is acquired, the practice payment would be about $24M.
- For firms with annual revenues up to $100M, experience has demonstrated that many of these firms want to be associated with a larger brand to shore up partner talent and client credentials and to enhance their ability to compete for larger clients. Succession issues are also a concern but usually to a lesser extent than what is
found with firms with annual revenues below $25M. The expectation is that a firm’s bottom line profitability percentage (distributed to the equity partners) usually ranges
between 32% to 37% (although there are exceptions both below and above this range) as the partners, on average, have between 1,200 and 1,500 annual billable hours. Presented below is typically found in the marketplace:
- If a $80M firm with 37% equity partner profitability is acquired, the practice payment would be about $80M.
- If a $80M firm with 60% equity partner profitability is acquired, the practice payment would be about $96M.
Synopsis of the Terms and Deal Points for the Above Transactions:
The CPA firm “merger frenzy” and “consolidation” have occurred and willcontinue (at least in the near future) also because acquirers, who usually have (or are) effectively addressing the challenges facing sellers, need talent and critical mass to fund investments and compete in the marketplace.
The above “deals” or transactions are usually structured as asset purchases. Presented below are the typical terms and significant deal points:
- Admission of Partners:
- Generally, acquired firm partners will join acquiring firm as either equity or non-equity partners with the rights and obligations set forth in the acquiring firm’s Partnership Agreement, except as expressly amended in their respective
Agreements in Supplement. The Partnership Agreement contains customary restrictive covenants as to clients and employees after a partner leaves the firm.
- Individuals admitted as equity partners will make varying amounts of capital contributions (risk capital) per the terms of the acquiring firm’s Partnership Agreement (usually about $100K upon admission and up to $350K over time with annual contributions after the initial $100K at six to ten percent of compensation, along with the right to prepay up to $350K at any time). The proceeds from the purchase of the acquired firm’s fixed assets (below) can be credited toward capital contributions. Interest is paid on capital contributions at about ten percent per annum.
- Aggregate compensation to acquired firm partners during the two years after closing (the “guarantee years”) will be guaranteed at not less than their aggregate compensation for the year prior to closing, provided overall acquired firm revenues and profit are maintained at the same level as for the year prior to closing. Compensation would be reduced pro rata in the event of a decrease in revenues and/or profitability. Acquired firm partners will be considered for
discretionary bonuses should revenues and/or profitability increase. Compensation would be allocated among the acquired firm partners in such
manner as acquired firm representatives determine, subject to the acquiring firm’s right of reasonable review.
- Compensation would be paid per the terms of the acquiring firm’s Partnership Agreement and the Compensation Plan, with the anticipation, however, that during the guarantee years, no newly admitted partner would receive after tax cash flow at any point during the year (assuming target revenues and profitability are met) less than after tax cash flow received during the year prior to closing
- Acquired firm partners will receive a practice payment that would be allocated among the acquired firm partners prior to closing in such manner as acquired firm representatives determine, subject to an acquiring firm’s right of reasonable review. Each acquired firm partner would be entitled to receive his/her benefit upon withdrawal from acquiring firm (provided the partner has remained with the firm a minimum of four years), paid over ten years from the date of withdrawal. acquired firm partners would be eligible for consideration for vesting into the acquiring firm retirement plan (in lieu to the practice payment provided for above) based upon future performance.
- Asset Purchase and Other Business Combination Issues:
- Acquiring firm will purchase the fixed assets of acquired firm required for the ongoing operation of its business at book value, payment to be made at closing.
- Acquired firm will transfer to acquiring firm its AR and WIP existing at time of closing. The amount of the AR and WIP collected by acquiring firm, less any acquired firm debt assumed by acquiring firm, will be added to the practice payment. AR and WIP collections will be credited to acquired firm partners for
purposes of determining compensation during the Guaranty Years (and whether revenue and/or profitability targets have been met).
- Acquired firm will assign, and acquiring firm will assume, the acquired firm office leases and operating agreements.
- Acquiring firm will offer employment to all acquired firm employees.
- Acquired firm will purchase tail insurance at the same level as insurance is currently maintained to cover against post-closing claims and acquired firm partners will indemnify acquiring firm against claims arising out of acquired firm pre-closing activity.
IN CONCLUSION
The “art of the deal” is a sensitive negotiation between buyers and sellers. The best “deals” are cut when there is both an educated consumer as a buyer and an educated
consumer as the seller and that there is an understanding that there has to be reasonable give and take. A deep understanding of the prices paid and the important terms and deal
points will create efficiencies in the transaction process which usually is filled with starts and stops and can take months before closure is attained.
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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 shares 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.
