September 16, 2019

IN OUR OPINION, PERSPECTIVE #92 — SEPTEMBER 16, 2019

(A Continuing Series for Leading CPA Firms)

PERSPECTIVE #92—IN OUR OPINION, SEPTEMBER 16, 2019

IS YOUR FIRM OVER PARTNERED? IT IS PROBABLY TIME FOR A GUT CHECK!

“An organization’s ability to learn, and translate

that learning into action rapidly, is the ultimate

competitive advantage”.          —Jack Welch

Today’s economy continues to face many challenges and mid-market companies, facing uncertainty, are not growing and investing in the future at an optimum pace. At the same time, technology changes continue to disrupt small and mid-sized CPA firms at a fast and furious pace. Mid-market clients continue to outsource non-core, but nevertheless, critical business processes in an attempt to improve EBITDA and working capital As a result, CPA firms are being challenged by rapidly changing their service line mix away from compliance and towards advisory services and very intense margin pressure on compliance services — with no reason to believe that the end is in sight. Further, there are too many competitors and a shortage of qualified talent. Wow! It certainly isn’t the good old days before the financial crisis (circa 2002 through 2006) when the Giant Four firms were the greatest referral sources for small and mid-sized firms and SOX created so much demand for services that pricing power was at an all-time high. Many firms were figuratively printing money and were afraid to answer the phone because they would have to turn away new business as production and utilization exceeded 100% of capacity.

On top of all this, as client needs shift, firms soon will be facing competition from disruptors such as Google and Microsoft as they buy market share by slicing and dicing real-time financial data that also deliver value add from immense databases that benchmark best practices in a quest for enhanced market valuations.

What are small and mid-sized CPA firms to do in this fluid environment?

IN OUR OPINION, an absolutely essential step requires firms to take a hard look at both their equity/nonequity partner mix and their equity partner count (what they are versus what they need to be). To that end, we would like to share some revenue and compensation financial targets that are commonly used by both the Giant Four and the Next Six. Now, we are not in any way suggesting that these are the targets small and mid-sized firms should adopt. Not at all. Instead, we believe that knowledge is power and that it’s beneficial for small and mid-sized CPA firms to have an insight into what’s going on at the larger firms so they can benchmark against them.

EQUITY/NONEQUITY PARTNER MIX:

Most firms today have a mix of equity partners (those who actually own, by investing their cash capital) and operate the firm with the expectation that their investment will have attractive returns by way of annual cash compensation, deferred compensation upon retirement and, if the firm is sold, possibly a kicker resulting from an attractive M&A transaction) and nonequity partners (those who are salaried with no capital at risk).

While the mix of equity to nonequity partners varies throughout the Top 100 firms, many of the firms strive for a 40/60 mix of equity to nonequity. We believe the trend toward fewer equity partners will be with us for the foreseeable future.

EQUITY PARTNER COUNT:

In determining the number of equity partners required to operate and grow the firm of the future, many of the larger firms have “stretch” revenue and compensation targets that are ratcheted up annually. While exceptions are out there, generally the larger a firm is, the greater the revenue per equity partner is. The same dynamic exists for equity partner compensation; the odds favor greater compensation at the larger firms . Arguably, the same dynamic exists for deferred compensation and valuations.

Presented below are the firm financial targets currently being used at any of the larger firms:

• Revenue per Equity Partner — $2,000,000
• Compensation per Equity Partner — $660,000

These targets are just that — targets — not bright lines. If they aren’t met, firms need to raise a red flag and evaluate what needs to be done to right their ship.

IF YOUR EQUITY/NONEQUITY PARTNER MIX IS NOT WHERE IT NEEDS TO BE, WHAT IS REQUIRED?

If financial targets aren’t being met, firms need to answer a key question when evaluating partner mix and count:

• Regarding nonequity partners, the key question is: “does the enterprise value of an existing or potential nonequity partner contribute towards perpetuating and growing the firm’s business, maintaining technical excellence and driving client and staff retention”. Beyond this threshold question, a nonequity partner/candidate needs to demonstrate a track record of performance in a number of practice areas, not the least of which is business development. The mandate, with the exception of those partners tasked with quality control, is that: (a) a nonequity partner has to annually originate a combination of new business and cross selling in the minimum amount of $150,000, and (b) a nonequity partner candidate needs to demonstrate a minimum amount of $300,000 in new business and cross selling over the three years preceding partner consideration. If these criteria aren’t met, an underperforming nonequity partner is coached with the understanding that, if improvements aren’t achieved, he/she will be counseled out of the firm. Same goes for nonequity partner candidates.
• Regarding equity partners, the key question is: ”does the enterprise value of an existing or potential equity partner significantly contribute towards perpetuating and growing the firm’s business, maintaining and enhancing technical excellence and driving client and staff retention and has this value been demonstrated by a track record of steady and increasingly improved performance”? The mandate, with the exception of those partners tasked with quality control, is that an equity partner or potential equity partner must demonstrate a track record of creating new business originations and by achieving actual results, net of losses, in the minimum amount of $250,000 each and every year. Further, there needs to be evidence that the partner is consistently cross-selling new products and services to existing clients. Again, if these criteria aren’t met, an underperforming partner is coached with the understanding that, if improvements aren’t achieved, he/she will be counseled out of the firm.

IN CONCLUSION

When small and mid-sized CPA firms consider the fluid environment and their future partner needs, we believe that many will find that there is a very strong possibility they have to downwardly adjust their equity/nonequity partner mix and perhaps their partner count. Realities are not easy to deal with but if your firm isn’t actively addressing this issue, we suggest that you are looking at the world through rose colored glasses. In addition to being over partnered, your firm probably is facing a number of several other undesirable outcomes including:

• “All stars” leaving the firm as they don’t see an opportunity to advance.
• Staff being stuck on repetitive, boring client assignments with little, if any, on- the- job training.
• Costly labor loads resulting in unacceptable margins.
• Partners doing compliance work, not consulting or advisory, and not developing new business.

All of these outcomes can be effectively dealt with if you do a partner gut check, understand your reality and your probable future, and deal with it with proper prudence. We know it’s tough out there, but things are not going to get better if we put our heads in the sand. We have a great profession built upon the cornerstones of trust and integrity. Let’s capitalize on the “market permission” we enjoy and the franchises we have developed. Let’s grow our firms in a way we can be proud of. Remember, hope is not a strategy. A strategy is a strategy.

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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.