Just as homeowners have felt the impact of factors such as fluctuating interest rates when hanging up a "For Sale" sign, CPA firms in a selling mode have seen a series of seismic shifts alter the buyer-seller market within the accounting profession.
Gone are the days when the global firms and consolidator roll-ups went on major buying sprees, cherry-picking stronger regional players and pasting them into their respective portfolios.
Now, the quinella of sweeping legislation such as Sarbanes-Oxley and a not-so-subtle drop in firm valuations have whetted the acquisition appetites of larger regional and even local CPA shops as they look to expand both their geographical and their client presence.
Allan Koltin, CPA, president and chief executive of Chicago-based consultancy PDI Global Inc., said that what happened over the past five years is quantum change on several fronts.
"The first has to do with who's doing the acquiring," said Koltin. "Previously, most of the acquiring was being done by middle-market national firms or public company consolidators. It seems, for the time being - although there are exceptions - that the acquirers have shifted primarily to the large, regional and local firms throughout the country. In today's post-Andersen/Enron/Sarbanes-Oxley world, one of the things we are truly finding is that 'bigger is better.' This applies not only to going after larger clients, but also going after top talent."
Koltin said that as the Big Four have essentially migrated to the Fortune 1000 companies, all other firms in the country have moved up one level on the food chain.
"Middle-market national firms are now much more focused on small and midsized public companies, large regional firms are going after large private and smaller public companies, and large local firms have migrated to very large private companies and have also become an outsource option for various Sarbanes-Oxley-type projects," he said. "Lastly, smaller local firms are now finding that they, too, can stretch beyond companies that were traditionally in the sales range of $1 million to $10 million, and now are focused more on companies in the $10 million to $100 million sales range. Never before in my career have I seen the kind of boom that is going on in terms of business within the accounting profession."
Mark Tibergien, CPA and principal at Moss Adams LLP in Seattle, noted that smaller practitioners in particular are not doing enough good planning for succession. Therefore, although he feels that it's still the best option to develop initiatives internally, they often turn to larger firms for help.
In addition, he said that the selling price of firms has dropped dramatically. "Not too long ago you could figure on two-and-a-half times annual fees. Today, that has dropped below one times annual fees. Also, buyers now want capacity, not clients. There is an oversupply of clients, but not of personnel to handle them."
Robert Gallagher, CPA and head of R.J. Gallagher & Associates, a Pittsburgh-based management, marketing and educational consulting firm, said that if you look at the top 100 firms in 2004, it seems that almost one-third grew less than 4 percent. "If you eliminate the growth in their net hourly rate, charge hours have been relatively flat for many firms. Thus, the need for them to grow is critical, and their expansion strategy includes identifying candidates to come on board via merger within a three-year time frame."
The starting blocks
Marc Rosenberg, CPA and president of The Rosenberg Associates, based in Wilmette, Ill., said that there are usually two kinds of sales: outright sales, where the seller walks away after a short transition period, and where 99 percent of outright sales involve firms of under $1 million; and a smaller firm merging into a much larger firm, where the owner continues working for the firm for a number of years.
"It's really a two-part transaction," Rosenberg said. "First, it's a merger, though it is crystal clear to both parties that the larger firm is the survivor and that the larger firm will manage all aspects of the combined company. Second, it's a sale, except that instead of selling the firm outright, the smaller firm owner participates in the larger firm's buy-out plan. The shorter the number of years that the owner of the smaller firm works at the larger firm, the more likely that the smaller firm owner may be able to negotiate a higher buy-out than the larger firm's customary plan."
However, he emphasized that the sellers must define where they stand in the process, which comes down to three areas:
* You definitely want to sell and you want to begin in earnest.
* You know you should and you know you need to sell, but you are scared. You're paralyzed. It's a big decision and you are afraid that the merger will not work. You think you know yourself and you think you're a control freak. You're afraid of going into an environment where you will lose control.
* You say that you want to sell but you'll never do it. Deep down inside, you feel that milking your firm for as long as you can and then dying in your chair isn't such a bad strategy.
"The seller should put together a generic profile of the practice information, without names," said Joel Sinkin, president of New York-based J. Sinkin Consulting and a partner in Blacklake Transition Solutions. "This should include the number of business clients, and services rendered to them, broken down by the percentage of service areas such as audit, compilation, review and tax, [as well as] staffing information, billing rates, annual gross volume, volume of any large clients, niches, industries the clients are in."
Sinkin advocated deciding on the parameters a successor should have. "These may include niches, licenses, excess capacity, size, location, culture, fee structure and the like." Moreover, he believes that the seller must also determine the time frame that it sees for partners reducing their commitment to the firm, and the roles that it sees for the retiring partners both before and after they reduce their time.
"Client retention will be increased the longer you and your partners can participate in the transition of clients to the successor firm," he said. "This will increase the value of the practice. Plan ahead and start the process, if you can, before you are forced to by circumstances or desires."
Where the buyers are
Rosenberg said that finding buyers is the easy part.
"More than 90 percent of so-called bigger firms are looking to merge in smaller firms," he said. "The scale is all relative. The $1 million firm is looking to merge in a $200,000 practice, the $3 million firm is looking to merge in a $1 million firm, and the $7 million firm is looking to merge in a $2 million firm."
He pointed out that the odds are that if you picked up the telephone and called three firms, all three would be eager to talk to you. "They will probably be willing to drop what they are doing and meet with you as soon as you want."
According to Rosenberg, firms see merging in practices as an excellent way to boost their top line and make more money. "They see it as a way to avoid marketing, something most CPAs abhor - buy fee volume instead of generating it from scratch yourself. Today, many firms are looking at ways to bring in new talent, and merging in a smaller firm may be one way to do this."
In addition, he said that many sellers are reluctant to approach buyers directly, because they don't want it known in their marketplace that they are shopping their firm. "This is understandable, but one way around this is to hire an experienced consultant. They can make discreet phone calls to potential buyers, describe your firm without stating your name, and get some preliminary information from the buyers."
Many firms also advertise in newspapers and other publications that they are looking. Others send out letters to smaller firms to let them know that they are in a "merger mode" and to see if they can get firms to call them.
Pitfalls abound
Structuring the right terms, insuring that the seller is paid as agreed, transitioning the firm to the new owner, and structuring the guarantee are all potential problems that could impact a sale, said Bruce Clark, the founder and chief executive of New Clients Inc., a New Jersey-based concern that has successfully sold hundreds of practices nationwide.
Sinkin pointed to his own laundry list of pitfalls, which include ego, culture, choosing the wrong successor, creating terms that do not enable the deal to be successful, poor transition plans, and failure to recognize that everyone has to win, among others. "Also, the successor firm must make a profit to be motivated to close the deal, and the seller should be well paid for their years of sweat equity. And let's not forget that making clients and staff feel bought and sold, instead of receiving a value added from the newly combined successor firm, is a major danger."
Rosenberg called attention to specific hazards, which include:
* Failure to ask the right questions. "Mainly, this pertains to what life will be like working at the other firm."
* Failure to know the right questions.
* Assuming that the buyer's technical standards are acceptable. "Maybe the seller has known the buyer for many years and, therefore, assumes that the buyer's technical standards are acceptable. The seller feels that it would be an insult to ask to review workpapers and internal financial statements. Don't add your firm to the list of those who were unpleasantly surprised after the merger."
* Letting the buyer cherry-pick your clients. "This is the process whereby the larger firm really is buying the smaller firm for the 20 percent of his clients that make up 80 percent of the dollars, and really has no interest in the other clients. If this works out to your advantage because of rate increases and cross-selling opportunities, then this point is obviously a non-issue. But if you have a $300,000 practice and the buyer only wants to keep $150,000, then you have a problem."
Most experts in the field agree that trying to rush the transaction is a no-no. They maintain that the most important keys to the success of a merger are personality fit, personality fit and - yes - personality fit. And this takes time!
Valuing what you have
As far as valuing a practice, Clark noted that there are a few benchmarks to consider. "We find write-up and tax easier to sell and, therefore, generally command larger multiples of one to 1.5 times gross, with many falling in the 1.25 range. Strictly 1040 work will sell for one times gross, or less. Practices heavy in audit tend to be harder to sell because of the liability and the labor-intensive nature associated with performing these types of engagements."
Clark added that financing a sale has become a bit more difficult over the past two years: "There are a few sources that utilize the Small Business Administration 7A program, but if you have ever dealt with the SBA you know this can be as difficult as traveling the road leading from the Baghdad airport in Iraq. Most buyers go to their local bank for help in financing the sale or use a combination of bank financing, personal resources and seller financing."
Rosenberg said that at least once a year, he gets a call from a firm that wants him to perform a valuation of their firm. "I recently read an article in which a national broker of CPA firms advised sellers to get a formal valuation of their practice as a first step. This is all rubbish."
Rosenberg maintained that the value of a firm depends upon the following factors:
* Your negotiating ability;
* Your urgency in selling; and,
* What firms are selling for in your market. (Note that very few markets are different from any other market in the country.)
"If you decide you want 1.25 times fees for your practice, don't give in to the first firm that offers 1.1. Be patient," he advised. "Give yourself two to three years, if necessary, to go through the process until you find a buyer that really wants your practice."
He specifically noted that, unless firms have some skeletons in the closet, (e.g., a big client that is leaving, a lawsuit that is pending, a problem partner, etc.), firms under $1 million are being sold for a minimum of one times fees, and many for 1.2 to 1.3 times fees. "You don't need a business valuation to tell you this."
Allan Boress, CPA, head of Florida-based Allan S. Boress & Associates, and a business development consultant to the profession, raised one aspect that deserves attention from potential sellers: "A firm that wants to sell must form a plan two to three years ahead. It's akin to selling a car. You clean it up first. You do the same with an accounting firm. You put everything in order. By doing so, you can raise the revenue value 25 percent by showing how much more valuable it is. We will, in the not-too-distant future, get to be a buyer's market, and the seller then has to look that much more attractive."
PDI's Koltin said that, in terms of firm valuations, "They still remain roughly one times gross fees, although I've seen valuations as low as 80 percent of gross fees and as high as 125 percent of gross fees. Clearly what is not going to happen in the foreseeable future will be a change in the pricing model of firms or the entrance of new consolidators/public companies into the marketplace. I will say that I am seeing (at least at the size firms I work with) virtually all mergers going on, and substantial cash payments at closing appear to be a thing of the past."
"In regard to determining value, most acquisitions with less than $1 million in revenue have a down payment," said Gallagher. "I generally try to include a 30 percent down payment with the remaining contingency payment based upon collections over a five-year period. There is a floor and ceiling on the amount of the contingency payment. Brokers like to obtain 50 percent to 60 percent down payment."
Get thee to a pro
Rosenberg advised that you should never try to sell without getting professional assistance.
"This is a huge transaction for you," he said. "It's likely that you've never bought or sold a practice before, so, clearly, don't try to do this on your own. You don't know what questions to ask, and you need someone to confer with during the process. Hire an experienced consultant to CPA firms, one who has lots of know-how in working with firms on mergers, to advise you every step of the way."
Clark agrees that accountants who are selling their practice should definitely use professional help. "I am sure you heard the old story that an attorney who represents himself has a fool for a client.
The same applies here. Using a professional broker places an important barrier between the seller and buyer and provides a vital source of information to both parties."
He said that one of the key concerns of the seller is confidentiality - "not having the fact their business is for sale leak out into the general business market where they are located. Having a broker representing you prevents this. We make sure that every buyer signs a confidentiality agreement, before any specific information is revealed to them. As a further precaution, once we receive the signed agreement we contact the seller first to tell them who is interested in talking to them. This allows the seller to remove any buyers whom they may not want to know their business is for sale."
The next important step, according to Clark, is to pre-qualify buyers financially. "There are many accountants who would love to buy a practice. There are just as many who do not possess the financial wherewithal to do so. We require financial statements, both business and personal, on the sale of any practice over $100,000 in annualized billing. This prevents the seller from wasting time with unqualified candidates."
He said that locating a buyer in most markets is not difficult, and there are usually at least 10 prospective buyers for each practice listed. "The challenge is to find the right buyer for this practice and their type clients."
Sinkin noted that it is very difficult to negotiate your own deal, plus you probably do not want the public, competitors and staff being aware of your plans prematurely. Also, he said that if there are 50 things one needs to know to make these deals successful, the smartest of us may only think of 35 of them. He advocates using a consultant with a lot of experience specific to accounting, one that has relationships with potential successor firms and can be a tour guide through the process.
"This consultant can share the practice profile you put together without revealing your identity, to make sure potential successor firms meet your requirements and have interest in what you have and what you want prior to giving your name out," Sinkin said. "In addition, they should be able to help you price your firm, prepare for due diligence, draft sample agreements, create transition strategies, and have input into assorted topics including, but not limited to, exposure concerns, handling of accounts receivable, compensation, and many other critical factors that contribute to making a deal work."
Gallagher said that the necessary due diligence, computation of value, executing a confidentiality agreement, and developing memorandums of understanding are sacred to the process, and that certainly consultants can assist this process very effectively. "Many firms that are interested in selling out or being acquired go through a broker who would like primarily 110 percent to 125 percent of billings for their client. I have reviewed several of these transactions and there is always a requirement for a significant upfront cash payment at closing. I realize that firms would like to gain more critical mass, knowledge and the like. However, I am still a proponent of a 10 percent down payment with cash collections over the next five years being part of the equation. The other important factor is the tax consequence for the seller, especially with the difference in capital gain rates and ordinary income rates."
Koltin noted that, in terms of firms working with an outside consultant or M&A advisor, he strongly urges them to do so. "Most of the work I do involves facilitating strategy and vision plans for local accounting firms. Often times we will go through two simultaneous exercises, one of which is to create our five-year game plan and then ask the hard questions, such as, 'Can we actually achieve these goals?' and 'What type of resources, risk and capital will be necessary to make this happen?' At the same time, we will evaluate the average age of the partners and talk about Option B, which would be to merge into a larger firm and probe the various benefits and pitfalls that can happen in an upstream merger."
Moreover, he said that he has found it rare that two similar-sized firms can come together. "In instances where this type of deal has happened, I find that more times than not they end up merging a couple of years later into a larger firm. The reason for this is they spent too much time debating the 'we' and 'they' of firm cultures, policies and procedures, and never seem to be able to get to the formula of one plus one equaling three."
Mergers sizzle
Gallagher said that the merger activity is extremely hot, and will continue to be very active as firms try to achieve their growth and expansion strategy. "The second- and third-tier firms are continuing to build their niche expertise and acquire niche-oriented firms. When you consider that there are over 40,000 CPA firms that have less than five professionals, many of these firms will eventually sell out or merge with various firms. So there will be much activity in this market during the next several years. Firms will need to be proactive and identify potential candidates and start the courtship."
Koltin feels that probably the No. 1 reason why mergers and acquisitions will increase dramatically over the next couple of years has to do simply with what happened (or didn't happen) between 1990 and 2000. In 1990, 2 percent of college graduates got accounting degrees. By 2000, this had dropped to 1 percent; hence a 50 percent decline of talent coming into the profession.
"The impact of that will take place primarily between the years 2005 and 2020," he said. "Until then, there are approximately 47,000 CPA firms that currently belong to the American Institute of CPAs. I would not be surprised if that number dropped by 15 percent over the next five years, and we would be looking at roughly 40,000 firms within the profession. Simply stated, as partners continue to age, they have been challenged with creating the 'B team,' which essentially is the younger generation of partners who will not only carry the banner after the senior partners retire, but also fund and pay out their retirement dollars."
On the positive side, Koltin pointed out that the firms that he has worked with that have merged upstream have benefited greatly in terms of freeing themselves up from some of the headaches and issues that sometimes plague smaller partnerships. "They have also told me that going after larger clients and attracting and retaining better talent seems to be easier as you become part of a larger firm (probably as much a factor of greater resources, depth and investments in recruiting, retention and training). I will say that, in today's world, it is critical for firms to have a five-year plan and, once they develop the plan, to create a system of governance and compensation that essentially causes the plan not to be shelved, but rather causes it to be agenda item No. 1 at all partner and executive committee meetings. In the past, a lot of firms got away with developing a strategic plan and putting it on the bookcase. In today's world the competition is too severe and chaotic to be passive towards planning and implementing the future success of the firm."
According to Gallagher, the main reason that the merger activity will continue to stay very active is that partners have many more responsibilities today than they had 20 years ago, especially with marketing, technology, human resources and their niche expertise. "Many firms with less than $2 million in revenue need to invest in their infrastructure by adding functional positions. If a firm desires to grow, they will need to make such substantial investments. Most partners would prefer client service versus administration; thus, the desire to merge upstream or be acquired. The merging partners can fulfill their main desire to service their clients. Larger firms are very attractive because they have the infrastructure in place. With almost 40,000 firms with less than five professionals, there will be substantial activity in the merger arena."
Moreover, Gallagher feels that second- and third-tier firms will continue to acquire firms to gain more critical mass and market share. "If the Andersen event did not happen, KPMG would probably merge, which had been the history of previous members of the Big Eight, namely, when they fell behind in revenue, they merged. Now, a merger isn't even an option for one of the Big Four, and one thing is for sure, you don't see Big Four firms acquiring CPA firms. It will be interesting to watch KPMG's strategy over the next several years."
He added that, generally, in a merger with a larger firm, there is a corporate overhead allocation of 6 percent of revenue, so the acquired office must absorb this charge through some efficiencies and reduction in costs as a result of the merger.
Future feeding frenzy
For Deena Katz, CPA and president of Florida-based Evensky & Katz, the future is either merge/acquire or be acquired. "Why? Because compliance, mega-global competition, outsourcing and 'professional blur' will put huge pressure on smaller firms. Unless we are small boutique firms, with a very specialized narrow focus, we will need to be bigger to be profitable and meet the rolling competitive landscape."
"The biggest problem is trying to merge different business cultures," she said. "I think about 30 percent of merger/acquisitions fail because of culture disconnect. We need to plan for the event, make sure we have realistic expectations about our changing role, and be certain that when we do exit, we have clear plans for life after our company."
Rosenberg looks to a "feeding frenzy" during the next 10 years in terms of CPA firm sales and mergers, all fueled by the continuing aging of Baby Boomer partners, continuing shortage of staff, and continually increasing difficulty of operating as a very small firm, coupled with challenges in the areas of hiring, offering a diversity of services, and computer technology that are virtually insurmountable to small firms.
"The vast majority of CPA firm partners continue to do a poor job developing successors for themselves," he said. "So, when they look at their staff to see who will buy them out, too often they don't see anyone. Also, there is an insatiable appetite by larger firms to buy smaller firms. In other words, there is a virtually unlimited supply of buyers."
Clark predicted that the future would look good for both buyers and sellers. "We see a lot of our clients that we have worked with to build their client base reaching their late 50s and early 60s. I am also seeing accountants looking to retire at early ages. I think this trend will continue with all us Baby Boomers, and as such, there should be a continued stream of firms reaching the marketplace, although I do believe there will always be a supply and demand factor that favors the seller."
He also thinks that, with respect to buyers, there will always be a good pool of prospects. "We see a lot of corporate accountants who want to enter the public sector, and prefer to do so by buying an existing practice with an existing stream of income to replace what they have left. We have also noticed a slight decline from the corporate sector. As the economy continues to improve, fewer accountants are being downsized."
Sinkin thinks that there will be more sellers and potentially less buyers. "In today's accounting world, there are many more buyers than sellers in highly populated areas." Several keys seem to be on the horizon that will alter this, such as the Baby Boomers. "Many practices have aging partners without their replacements in the firm."
Moreover, he says that staffing in the industry will continue to be a significant problem, and many firms are currently enjoying good organic growth. "The supply of motivated buyers may be adversely affected if these trends continue."
Also, financial institutions and the like are starting to offer free tax services for clients who utilize them for asset management; thus, they will be aggressively competing for clients and staff, which could reduce the value of many practices. Looking at it from one direction, between the aging of the community, the reduction in the talent pool, and clients who may seek non-traditional avenues to satisfy their tax needs, it may be more difficult to find capable successors in the future. This makes it more critical than ever to plan in advance.
Boress concludes that it is clearly a seller's market right now, although that will change in time. "Firms who are planning at not being bought out can only effectively stay in business by consolidating with other firms or buying other experienced people."
