Small practices (generally under $1 million in annual fees) are commonly sold to external buyers for over one times fees, often as much as 125 percent of fees. Yet, when partners retire from a multi-partner firm and are paid retirement benefits, the valuation average across the country has been steadily sinking over the years and is now well below 100 percent.
In fact, the 2004 Rosenberg MAP Survey reported average retirement benefits of roughly 80 percent of fees. How can the retiring partner justify getting only 80 percent from her partners, when other small firms are routinely being sold for as much as 125 percent of fees?
In the last five years, if I've been asked this question once, I've been asked it 100 times. The issue is getting hotter and hotter, because the CPA profession continues to struggle with succession planning issues and the aging of partners - over 50 percent of CPA firm partners are over 50 years of age. Partners, with an eye toward retirement, are obviously looking to maximize their big pay day (retirement benefits) to cap off their illustrious careers.
To answer this dilemma, we surveyed 80 managing partners from substantial mid-sized CPA firms across the country and national CPA firm consultants, receiving 37 responses.
The real cost of a small firm
The price that small practices are being sold for is an elusive statistic to measure. The CPA profession measures quite a few statistics, but has produced few definitive surveys of CPA firm sales prices. One exception was the 2005 Rosenberg MAP Survey, the results of which can be seen in the accompanying table (see box, this page).
Corroborating those data are conversations that I have had with CPA firms throughout the country and with leading national CPA firm consultants who are quarterbacking dozens of deals every year.
There are two reasons why firms might be willing to pay a premium - say 125 percent - for a small practice:
1. Except for a few minor blips, the last 10 years have been good growth years for CPA firms. But some firms, and quite a number of sole practitioners, are significantly challenged in their efforts to develop business internally. Buying a practice is seen by many as an efficient and relatively safe way to jumpstart a practice.
Chris Frederiksen, a CPA firm consultant in Mill Valley, Calif., and the U.K., said, "Firms see this as a way to boost fees with almost no additional overhead. For people setting up a practice of their own, the hardest task is achieving 'critical mass,' and such individuals are looking for a small block of fees to get them going."
2. The return on investment of purchasing a reasonably profitable firm at 125 percent of fees is an attractive 30 percent after five years. This only applies to the ideal situation, in which the seller retires after a short transition period, thereby turning over her earnings to the buyer. The return on investment for purchasing a firm where the seller stays on as an owner or an employee would be considerably less.
So, why the gap between external sales and internal retirement benefits?
The three most convincing explanations are:
1. With a small practice, there is a large pool of willing external buyers, but with an internal retirement, the universe is limited to one "buyer" - your own firm. Whenever one has the luxury of having many buyers, the price will always be higher.
2. "80 percent could be more than 125 percent," said Jim Howard, managing partner of Atlanta-based Smith and Howard. Most deals are based on collected fees, but retirement benefits usually are not reduced if clients leave. Since there is a much better chance that clients will be retained if younger partners take them over, the 80 percent (in the case of a retirement) will almost always be applied against a higher fee number than the 125 percent (in the case of a sale).
3. In an internal retirement, the remaining partners feel that they have helped to build the practice and, per Bill Young, managing partner of Richmond, Va.-based Mitchell Wiggins & Co., "The firm has spent untold dollars in acquiring and maintaining the clients." Hence, the remaining partners have earned some "sweat equity," thus driving down the price.
Mike Perlman, managing partner of Skokie, Ill.-based Silver Lerner Schwartz & Fertel, said, "I would argue that the remaining partners should not have to pay for goodwill they helped create. At our firm, partners with large client responsibilities couldn't have grown their practice without the help of others."
Other reasons for the gap:
* "The burden of paying over one times fees, over and over again, to retiring partners would be a disincentive to younger partners coming up," said Ed Amorosso, managing partner of Norfolk, Va.-based McPhillips, Roberts & Deans. In most cases, the younger partners enable the older partners to earn what they do while they are still practicing.
* There is some question of who the clients belong to anyway - the firm or the individual partner.
* Don Taylor, managing partner of Syracuse, N.Y.-based Fagliarone CPA Group, said, "Many times, a partner has done little over the years to introduce clients to others in the firm, and then wants to walk away with a premium for doing so. In the meantime, the clients disappear."
* In an internal retirement, the remaining firm partners may be busy with their own clients, and are unsure of their ability to take on additional clients. Too much burden may be placed on the remaining partners. This pushes down the value of the clients.
* Ira Rubenstein, managing partner of Manhattan-based ERE, stated, "I think it is more difficult for a retiring partner to carve out his/her practice and sell it to an outsider."
* "Since there are no consultants' fees in an internal retirement, the 'price' paid to a retiring partner is less than for an external sale," according to Gerry Herter, managing partner of Tustin, Calif.-based HMWC.
A test question
We asked survey participants: If a partner in a three-partner firm wanted to retire, and the firm's partner agreement had no provision for buying out a partner, how much should the two remaining partners pay to the retiring partner - 125 percent of his client base, based on external firm sales prices, or 80 percent of fees, based on what firms are paying to retiring partners?
Participants clearly lean towards a price somewhere between 80 percent and 125 percent. Quite a few pointed out that the failure to address the buyout in the partnership agreement was a huge mistake. Because of this, the ultimate price will be subject to both the negotiating ability of the parties involved and the market rate for selling firms.
* Seven responses said 125 percent of fees, based on collections, but only if a buyer can be found at 125 percent; otherwise, the price should be lower.
* 12 people said 100 percent of fees, based on collections, with a five-year-to-10-year payout period.
* Eight people said 70 percent to 100 percent of fees, based on collections, with varying terms and conditions.
* Ten people didn't give an opinion or didn't really answer the question.
Marc Rosenberg, CPA, is a management consultant to CPA firms nationwide who works with firms in partner compensation, retirement and succession planning, mergers, facilitating retreats, strategic planning and practice management reviews. His firm, The Rosenberg Associates, is based in Wilmette, Ill. Reach him at (847) 251-7100 or marc@rosenbergassoc.com.
